A Take on 2nd Quarter 2017

The U.S. stock market has more than tripled in value during the runup that started in March 2009, and the most recent quarter somehow managed to accelerate the upward trend. We have just experienced the third-best first half, in terms of U.S. market returns, of the 2000s.

Looking at large cap stocks, the the widely-quoted S&P 500 index of large company stocks gained 2.41% for the quarter and is up 8.08% in the first half of 2017. As of a couple of months ago, fully one third of that gain was had by only five companies.

As measured by the Russell 2000 Small-Cap Index finished the first half of the year up a mere 4.99%. Because our portfolios tilt towards small and value, we’ve not seen the out performance generally shared in the headlines that accompany chart topping markets. Do not worry. Our small cap tilted portfolios outperformed last year and we’ve kept those gains this year.

International investments continue to deliver returns to our portfolios. The broad-based EAFE index of companies in developed foreign economies gained 5.03% in the recent quarter, and is now up 11.83% for the first half of calendar 2017. And the highlight of the markets continuing again this year are Emerging market stocks of less developed countries, as represented by the EAFE EM index. They rose 5.47% in the second quarter, giving these very small components of most investment portfolios a remarkable 17.22% gain for the year so far. Compared to companies headquartered in the U.S., international companies are better valued and continue to present more potential upside.

Looking over the other investment categories, real estate, as measured by the Wilshire U.S. REIT index, gained 1.78% gain during the year’s second quarter, posting a meager 1.82% rise for the year so far. The S&P GSCI index, which measures commodities returns, lost 7.25% for the quarter and is now down 11.94% for the year, in part due to a 20.43% drop in the S&P petroleum index. Gold prices are up 7.69% for the year, almost matching the returns of the S&P 500.In the bond markets, longer-term Treasury rates haven’t budged, despite what you might have heard about the Fed tightening efforts. Coupon rates on 10-year Treasury bond rates have dropped a bit to stand at 2.30% a year, while 30-year government bond yields have dropped in the last three months from 3.01% to 2.83%.

Economic growth was admittedly meager in the first quarter—U.S. GDP grew just 1.4% from the beginning of January to the end of March, a figure that was actually revised upwards from initial estimates of 0.7%.  That represents a slowdown from the 2.1% growth in the fourth quarter of last year. It might be helpful to note that the budget proposals floating around Washington, D.C. make the optimistic assumption of an economic growth rate of 3.0%. That is interesting given that the Atlanta Federal Reserve recently forecasted that the U.S. economy will grow at a 2.9% rate for the year’s third quarter.

More good news: the unemployment rate continues to decline and is at a near-record low of 4.7%, and wages grew at a 2.9% rate in December, the best increase since 2009. The underemployment rate, which combines the unemployment rate with part-time workers who would like to work full-time, has fallen to 9.2%–the lowest rate since 2008.

The energy sector, which was a big winner last year, has dragged down returns this year. This proves once again the value of diversification; just when you start to question the value of holding a certain investment, or wonder why the entire portfolio isn’t crowded into one that is outperforming, the tide turns and the rabbit becomes the hare and the hare becomes the rabbit. If only this were predictable.

Guess what! There are many uncertainties to watch in the days ahead. Congress is still debating a health care package, and has promised to revise our corporate and individual tax codes later this year. There’s an infrastructure package somewhere on the horizon, and perhaps a round or two of tariffs on imported goods. Inflation often follows when the Fed raises rates, but we don’t know if or when the Fed will do that, or by how much.

Meanwhile, the current the bull market is aging and the runup has lasted for longer than anybody would have expected when we came out of the gloomy period after the 2008 crisis. Inevitably, we are moving ever closer to a period when stock prices will go down. That day cannot be predicted in advance, but it is always good to spend a moment and ponder how much of a downturn you would be comfortable with when markets finally turn against us. If your answer is less than 20%, or close to that figure (which is the definition of a bear market), this might be a good time to revisit your stock and bond allocations. A 20% decline isn’t unheard of. Twice in the past 17 years, a 50/50 portfolio has declined by such a level. And, as expected, those same portfolios have recovered within a few years.

If you’re not fearful of a downturn, as I know many of you are, then the next bear market will be a terrific buying opportunity for all of us.  Dan