Investor Insights: December 2017

By Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA Director of Research Senior Portfolio Manager

See our recap of November's key statistics and market commentary to help guide your investment decisions. 

Noteworthy Numbers

 

green 13.pngThe S&P 500 continues its historic streak of 13 continuous calendar months without a loss. In November, the index was positive by 3.07 percent.

 

green 3.3 percent.pngThe second reading of GDP growth in the U.S. for the third quarter came in at 3.3 percent. This is a revision upward from October’s advance reading of 3.0 percent and marks the strongest GDP growth seen since the third quarter of 2014.

 

green 16.04.pngFor the first 11 months of 2017, the highest closing price achieved by the VIX, also known as the “fear index,” was 16.04. A sign of low volatility in the market, 2017 is on track to be one of only four years since 1990 that the VIX does not break above 20.

 

Our Take

The stock market continued to roll in November as the same conditions that have propelled returns all year showed signs of persistence. In this year-end, holiday edition of Investor Insights, we will look back on 2017 and reflect on the factors that contributed to one of the least volatile years that have investors have seen in modern history.

The primary driver of both domestic and international stock returns has been the broad and significant growth we have seen in economies around the world. For the first time since 2007, the 45 countries that make up more than 80 percent of the world’s GDP are all growing at the same time. The Organization for Economic Cooperation and Development (OECD) forecasts this synchronized global growth to continue through at least 2019. In the age of globalization and trade, the economies of countries around the world do better when their neighbors are doing well, too. This rule applies to the U.S. economy as well. This is evident when you consider how U.S. companies with a global footprint have done in 2017 compared with those who operate mostly at home. According to FactSet, companies in the S&P 500 that generate more than 50 percent of sales outside of the U.S. had an earnings growth rate last quarter of 13.4 percent, compared with a growth rate of only 2.3 percent for companies that generate less than 50 percent of sales abroad.

While many other developed and emerging economies have just recently begun to see growth pick up, the U.S. has been enjoying moderate but steady economic growth for several years. Investors are justified to wonder how much longer the U.S. can grow before the inevitable next recession, and while the timing of such turnarounds is notoriously hard to predict, just about all signs point to continued growth for now.  Unemployment has reached multi-decade lows, but wages and inflation, which tend to rise toward the end of an expansion cycle, have remained low. Business and consumer sentiment numbers suggest that confidence in the economy is strong. Companies in the U.S. have issued optimistic estimates for earnings growth in 2018—11.1 percent—so stock prices should be able to rise without becoming significantly more overvalued.

Perhaps one of the biggest surprises of 2017 has been the indifference that markets have developed toward policymakers in Washington, D.C. The year began in the midst of what has been called the “Trump Bump,” based on the notion that newly elected President Trump and the Republican-controlled congress would enact sweeping pro-growth legislation around health care, tax reform, infrastructure and more. The political realities became clear early on, however, as the factions within the GOP failed to agree on an appropriate course forward for health care and the president frequently distracted attention away from efforts to sell the legislation to the public. Investors are currently waiting to see whether tax reform will be signed into law, but the economy appears to be on sound enough footing with or without the bill’s passage.

Even with the Trump Bump losing steam and geopolitical threats like the growing nuclear capabilities of North Korea, the U.S. stock market has enjoyed a remarkably calm year. This newsletter has commented in recent months about the so-called “fear index,” the VIX, breaking records for how long it has been below 10 this year. Equally significant is the absence of any large short term spike in the VIX so far in 2017. With one month left in the year the VIX has yet to close above 20 once, which has not happened since 2005.

With seemingly all signs pointing to continued growth, what could bring this bull market to an end? In our view the most probable cause will be from the Federal Reserve’s tightening monetary policy. The Fed is already on the path of increasing interest rates, and it has been historically difficult for central banks to get the pace and timing of such increases right. It’s easy to imagine a scenario in which the Fed raises interest rates too quickly, thereby increasing the cost of credit to businesses and consumers in the U.S. and slowing down the economy. While other events could also end the party, a Fed-induced recession seems most likely.

While this tipping point is difficult to predict with certainty, one key metric worthy of attention is the spread, or difference, between the yield on the 2-year and 10-year Treasuries. When the yield on the 10-year is well above the 2-year, this creates what’s called an upward sloping yield curve; an upward sloping yield curve is a strong signal for optimism in the economy. However, that yield curve is said to be inverted when the 10-year Treasury yield falls below that of the 2-year Treasury. Inverted yield curves have been leading indicators for each of the five recessions the U.S. has experienced since 1980. This 2-and-10-year spread has been decreasing since it hit 2.66 percent at the end of 2013—as of this writing it stands at 0.58 percent. We will continue to update you on the state of this spread and our thoughts around its impact.

Now is the time to reflect on your investment allocation and the amount of risk that you’re taking. It tends to be more prudent to make changes when times are good, rather than taking risk off the table once the market has already dropped. You may want to consider the tax impact of making changes now versus in January, which would delay the taxes for another year; tax considerations are important, however, it’s important not to let them entirely dictate your decision. Whatever you do, we caution you against making changes based off what you—or anyone—thinks the market will do over the next 12 to 24 months. Instead, you should base your decision off of your goals and your time horizon for those goals.

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