Four Horsemen
Equity investors managed to put much more space between their portfolio’s market value and 2008, by a nice margin. Several things fell into place to make it so; a global economy that began to grow universally, a powerful earnings rebound in the United States, still-low interest rates partially guided by a Federal Reserve that has been masterful in their attempt to normalize rates, and a more-business-friendly Administration in Washington each contributed to a substantial financial return to business ownership. The Standard & Poor’s 500 enjoyed a total return (price appreciation plus dividends) of 21.60%, as the Information Technology sector powered results by returning 36.91%, with only the Telecommunications and Energy sectors experiencing slightly negative returns. Even bonds had positive returns – in the face of much speculation regarding the doom of rising interest rates the Bloomberg Barclays Aggregate Bond Index returned 3.54%.
Equity markets realized their substantial returns from two sources – earnings-multiple expansion (the “P” increasing at a faster rate than the “E” in the P/E ratio) and increased earnings. Adding the two together is fairly close to rocket fuel for the equity market. As well, interest rates did not rise enough to become an immediate concern; the 2-year Treasury began the year yielding 1.22% and ended yielding 1.89%, while the 10-year began the year yielding 2.45% and declined by one basis point to end yielding 2.44%.
The Trump Administration ran on an economic program consisting of four pillars; reform/repeal of the Affordable Care Act, reformation of the tax codes for both personal and corporate taxpayers, a roll back of the stifling regulation of the Obama years, and increased infrastructure spending. As we wrote in our communication to clients in early 2017 (The Reflationary Presidency) all or any of these would be good for the economy, and they were – our Gross Domestic Product rose by 1.2% in Q1, 3.1% in Q2, and 3.2% in Q3. Expectations for Q4 are for another quarter of roughly 3% growth. The icing on the cake is depicted on the following graph, which reflects the ISM (Institute for Supply Management) Manufacturing Index. The substantial rise from November 2016 is no mistake, but a lesson that the previous Administration might take to heart.
As we communicated on several occasions in the past, businesses made not much more than capital-maintenance investments rather than investments in new plants, new distribution centers, technology etc. over the last several years, holding back what might have been much better GDP reports. That’s the way it goes when a CEO is not exactly sure what new regulatory body blow may be delivered next. So added to all of the above you have businesses much more confident and voila! It’s not magic, it’s simple economics.
There is no current reason to believe 2018 will not be another positive year, albeit not as stellar as 2017. After a 20% return a mean-reverting return of 6% on equities seems pedestrian. Our economy could slow, but we see no recession; recessions are typically the result of growth in excess of an economy’s capacity to grow for several quarters in a row. We also believe earnings could continue a positive trajectory, though not at the 10% clip we likely experienced for all of 2017. We don’t see inflation high enough to result in an unexpected and/or substantial rise in interest rates, which would be anathema to the stock market. And geopolitical risk is a factor in our everyday lives; using it as an excuse to not be or not remain invested is a mistake.
We do see an almost-substantially overvalued stock market. It would be nice to see the market take a breather, or even slightly correct to see if earnings growth can shrink the P/E ratio. We see a corporate America that is almost $3 trillion more in debt than it was at the beginning of the year 2008. Unfortunately the proceeds of the debt accumulation went almost entirely to fund stock buybacks, not investment projects that might have supplied the wherewithal to support that new debt. And an article in today’s Wall Street Journal relays the not-quite-dire straits Deutsche Bank, the 12th largest global bank, enjoys. The entire financial system in Europe remains decrepit and unaddressed, papered over by Euro printing presses. And demographics will remain a wet blanket for years to come.
At our last portfolio manager’s meeting we began “what-if” discussions regarding the economy, stock and bond markets, hence our client’s portfolios. We are not ready to make wholesale changes, and have already slightly reduced our allocation to the U.S. and raised exposure to international equities, recognizing that even U.S.-domiciled companies provide much of that exposure. Our feeling is not “this is as good as it gets,” rather that we recognize that though the economy is doing well and earnings growth may continue, stocks remain in very overvalued territory at the same time the Fed is raising interest rates. That’s never a healthy combination. As we’ve written in the past, we wouldn’t hesitate to reduce risk in our clients’ portfolios should the need arise.
Thank you for being a client of First Merchants Private Wealth Advisors. Michael Joyce has assembled an experienced and highly-capable roster of professionals who can provide financial and planning solutions for you, your family, and your business. We all wish you the very best for the New Year.
Jamie D. Wright, CFA, Research Director
First Merchants Private Wealth Advisors products are not FDIC insured, are not deposits of First Merchants Bank, are not guaranteed by any federal government agency, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency. This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.
