“Best of all he loved the fall … the fall with the tawny and grey, the leaves yellow on the cottonwoods, leaves floating on the trout streams and above the hills the high blue windless skies.”
We are now in the second longest economic expansion since 1900, and more than double the length of the average cycle. However, like the changing seasons, we know that the economy and the markets will enter a new phase at some point. Volatility returned to equity markets this year, but domestic stocks continued to push forward and ended the quarter broadly higher. The same can’t be said of international stocks which are facing headwinds after a strong 2017. As changes come, some of these will be pleasant like the fall foliage, but others may not be so enjoyable. As investors, we vigilantly watch for the emergence of signs that a new season is on its way.
By most measures we are in the middle of a sizzling economic summer. Record low levels of unemployment, strong GDP growth, and positive business sentiment are at the heart of the current cycle. In response, the S&P 500 has continued its meteoric rise, ending the quarter up 7.7% bringing the year-to-date number up to 10.7%. Not only have we seen a nice return so far this year, but exceptionally strong earnings results in the first and second quarter have kept valuations within reason of historical averages. However, what might be the most surprising element of markets this year is that most of these gains occurred during the summer months.
Investors have long focused on seasonality of markets. One of the more popular adages on Wall Street is “Sell in May and go away.” Believed to originate as “Sell in May and go away, and come back on St. Leger’s Day,” the old English saying refers to the habit of aristocrats leaving London during the hot months and not returning until the St. Leger’s Stakes thoroughbred horse race. This year, the trend has not held. Through April 30th, the market was down 0.38%, but between April 30th and September 30th the S&P 500 has increased by 10.98%! However, it would be an unusual year to finish October at the current pace.
More than just an adage, when analyzing data from 1950 to 2017, Ned Davis Research finds that the period from April 30th to October 31st has meaningfully underperformed the rest of the year to the magnitude of an average return of 1.5% (Apr-Oct) vs. 7.0% (Oct-Apr). However, what stands out is that in mid-term election years the differences are the greatest. In those years, April 30th through Oct. 31st has historically realized a mean change of 0.1%, while the other six months have returned 15.6%! To date, the significant run in growth stocks has been the difference, but as we get close to the mid-term elections we wonder will the uncertainty derail that performance?
While assessing the market, it is clear that a handful of stocks are driving returns, and by default valuations as well. The quintessential growth stocks of Apple, Microsoft, Amazon, Facebook and Alphabet account for nearly 15% of the market capitalization of the S&P 500. The mean return of those five names this year is 29.8% - take out Facebook’s miserable year (-6.8%) and the average bumps up to 38.9%!
Valuations, like returns, are also impacted by these select names. To illustrate this, if we exclude just the top three names of the S&P 500 (0.6% of the number of stocks in the index), the overall P/E ratio drops to 16.2x from 17.9x. (nearly a 10% decrease). This has broad implications ranging from passive investing to overall market sentiment. For instance, a passive investor owns all of these holdings at market weight. When the passive investor purchases additional holdings, this investor is disproportionately buying the most expensive portion of the market.
Given that at some point seasons change and valuations matter, it is worth being cautious during these periods. It is hard to predict when change might occur, but since the Great Recession, growth stocks have significantly outshone value stocks. In fact, since March 2009, the Russell 3000 Growth has increased 458.69% on a cumulative basis, while the Russell Value has lagged by 131.05% returning only a “modest” 327.64%.
Historically low interest rates and low inflation have played a major role in the recent run in growth stocks. A low discount rate means the present value of future earnings is higher. As growth companies have high expectations for future earnings they are worth more in that environment. Conversely, a value company is generally a mature company that is focused on returning current earnings or value to shareholders. The result is valuations also usually reflect these differences. Value companies will trade at lower valuations, while investors are willing to pay higher valuations for future returns. Problems can arise when investors grow too optimistic for future growth or there is a change to the discount rate assumption.
This begs the question, when do value stocks outperform growth? The longest period of outperformance of value vs. growth was the 15 quarter period between 2002 and 2006. This was the period, post tech bubble, when the Fed was entering a phase of interest rate normalization following a period of aggressively cutting rates to stimulate the economy during the prior recession – sound familiar? During this period, the Fed increased rates to 5.25% from 1.00% as the economy rebounded from the recession of 2001. As we move towards a similar period, conditions might align for a similar environment favorable to value stocks.
After the yield on 10-year Treasury note peaked at 15.8% in 1981, steadily declining interest rates have fueled a bull market in bonds lasting nearly three decades. Re-emerging from near zero levels, it is not unreasonable to expect a sustained period of rising interest rates. Should this last, we wonder how have stocks performed in this type of an environment? The last sustained period of rising rates we saw began before Elvis made his debut and ended near the beginning of the Regan Administration. While stocks have returned an average of 11.9% per year since 1981, the period of rising interest rates between 1958 and 1981 saw stocks return only about 7.3% per year.
So far, markets have performed relatively well since rate hikes began in December 2016. However, to date, we have only seen real movement from the short end of the curve – the range where the Fed has the most impact. In fact, this summer concerns abounded regarding the possibility of an inverted yield curve – when longer rates are lower than shorter ones. However, the situation seems to be changing as investors are beginning to fret over an overheated economy and unexpected inflation. Should this happen, this could result in a sharp rise in interest rates and that could play havoc on markets. Indeed, maybe we have already seen signs of the potential impact via the sharp sell-off in stocks during the second week of the new quarter in reaction to a potentially more hawkish Fed.
Inflation, which has remained extremely low over the past decade, adds to the conundrum of Fed policy and equity outlook. Inflation and interest rates are tied at the hip. Real (inflation adjusted) interest rates are much less volatile as nominal rates and inflation generally move in concert with each other – meaning when rates are high, so is inflation – so much so that when the yield on the 10-year Treasury note was at its peak in 1981 at nearly 16%, the real interest rate was less than 5%. In today’s inflation environment, real interest rates are around 0.9%. However, the good news of economic growth may lead to a period we have not seen in a while. To date, inflation remains relatively modest and there are more immediate concerns that could derail the growth we’ve enjoyed.
“Of the four seasons, none lasts forever”
Today, a global trade war is the greatest risk to ending the summer of growth. Seemingly, we have resolved the disputes involving our trading partners north and south of the border with the United States-Mexico-Canada Agreement (USMCA). However, the remaining dispute with China is still a concern. As we plod through this negotiation process, economic
weakness in China is apparent. The hardline tactics taken to bring Chinese President Xi to the table are working. However, as we “hurt China,” and don’t have a deal done, there is an increasing risk of us all experiencing the pain.
Per the International Monetary Fund (IMF), on a Purchasing Power Parity (PPP) basis China accounts for 18.2% of world GDP. To put that in perspective, the US accounts for 15.2% and the G7 (Canada, France, Germany, Italy, Japan, United Kingdom and United States) make up 30.2%. Not only does China account for a significant portion of the world’s economic activity, the country’s exceptional growth has played a major part in the world’s growth overall. Over the past two decades, China has grown to its current level from only 7.4% of global GDP at the beginning of the century. Slowing or completely derailing this growth would have wide ranging implications.
On a broader basis, international investments for U.S. based investors have lagged the domestic markets this year. The developed markets as measured by the MSCI EAFE Index are down 1.0% and the MSCI Emerging Market Index has declined by 7.5% through the end of the quarter. Some of the weakness is to be expected as Emerging Markets were the top region in 2017 returning 37.5% while Developed Markets were up 24.6% - well ahead of the 21.8% return of the S&P 500. However, if you focus on what drove returns, China led all markets with a return of 54.5%. With trade war concerns growing, China has reversed course and is down over 9% this year.
There is a certainty to the changing seasons which lends a natural rhythm to life. Just as certainly, markets and economies also seem to have a cycle which drives change and outcomes. While each season presents opportunities and pitfalls, we will continue to enjoy fruit of our current one, but also look ahead in preparation. Like the first yellow leaves of fall, we are alert for those first signs of change in the markets which will inevitably come. A prudent person will enjoy the autumn harvest and store up for the winter. In investing, we believe it is prudent to ensure our stock and bond holdings remain focused on high quality companies which can weather all seasons. It is too early to start thinking about hibernating, but it is not a good idea to think that summer will last forever.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).