This past year was a banner year for investors, who benefited from remarkably robust equity markets. In the US, the S&P 500 returned 19.42% and the tech-heavy Nasdaq was up 28.24% on the year. Remarkably, non-US returns were even stronger, with Emerging Markets and Developed International stocks rising 37.75% and 25.62%, respectively. While stocks were the standouts in 2017, many other asset classes performed well. Our strategy of maintaining exposure to US stocks, overweighting non-US stocks and diversifying into other well-performing asset classes resulted in strong returns for our clients in 2017.
But while investors are celebrating the great returns, and consumer confidence is high, we continue to urge caution. US equities are expensive. And somewhat ominously, the market's monthly volatility is at its lowest in at least a decade. In 2017, the CBOE Volatility Index, known as the VIX, dropped over 17% and saw 22 of its lowest 25 readings ever. In a year of hurricanes, wildfires, nuclear threat from North Korea, and a #MeToo movement that toppled powerful men across numerous industries, the markets remained eerily calm. We know from experience that could all change, quickly. (As a frame of reference, the VIX hit what looked like a historic low in 1995, two years before the Asian Financial Crisis, and again in 2006, a year before the global financial meltdown.)
Not every asset class experienced low volatility in 2017. Returns in anything related to Bitcoin have been breathtaking, and frankly reminiscent of the dot.com mania of the late 90's (or even the Tulip Mania of the 17th century that we highlighted in a recent Market Digest.) There's no denying that early investors, who have been willing to ride out the volatility, have made a huge return
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on paper. But it's hard for a long-term investor to take seriously a security that plunges nearly 20% in a day and then surges 80% to a record high just a week later. When the market cap of cryptocurrency surpassed that of JP Morgan last month, and with some analysts now predicting it will overtake Apple's market cap within five years, common sense seems to have gone out the window.
While no match for the returns of stocks, or the mania of Bitcoin, bonds had a positive year with the Barclays US Aggregate Bond Index up 3.54% in 2017. High Yield (lower credit) bonds rose 7.62%. 2018 is likely to see a continuation of rising rates emanating from both Fed tightening and market reaction to higher inflation. A return of significant inflation is possible as the unemployment rate is down to 4.1%, the lowest in 17 years. We see a tight labor market having a significant impact on wage inflation-a measure which hasn't grown materially in over a decade. Yet, we still see a role for bonds in investment portfolios. As a non-correlating asset, bonds will be a source of protection when the stock market turns south. There are essentially two sources of return from bonds: duration (linked to maturity) and credit. We suggest investors maintain exposure to bonds but refrain from chasing yield, particularly from higher duration (longer maturity) bonds, and keep credit diverse and appropriate.
Alternative assets, led by private equity and real estate, had strong returns. Private equity (venture capital and buy-out) continues to remain attractive with 3-4% higher expected returns over pricey traditional liquid equities. And 2017 saw better returns for hedge strategies, after a number of years of underperformance. We see roles for private equity, real estate and hedge strategies in our portfolios going forward, as a source of protection and uncorrelated returns.
Not all markets were rosy. Oil and Natural gas prices were lower. Relatedly, MLP index returns were down 7.50%, although most of our clients' returns in this asset class were slightly positive or flat for the year. We still believe in the benefit of investing in MLPs, particularly as the US becomes a net exporter of natural gas. Additionally, MLP's retain a tax advantage which may prove even more important in 2018.
Speaking of tax advantages, the fourth quarter also brought sweeping changes to the tax code which will take place in 2018. The 2017 Tax Cuts and Jobs Act establishes a new corporate tax rate of 21% (down from 35%) and cuts for many individuals as well. The bill represents the most significant change to America's tax system in more than 30 years. We feel the Act will have a beneficial effect for investors, particularly in the short run, but not to the extent of the tax-euphoria which still permeates much of the stock market. As experts begin to deconstruct how the new legislation will affect individuals, we will continue to partner with your tax advisors to ensure that your investment strategies are implemented as tax-efficiently as possible.
We don't know what the catalyst for a correction in the stock market might be. We outlined a number of possibilities in our Third Quarter letter to you. To date-and thankfully-none of them have materialized. But conditions are such that even the slightest tinder could wreak havoc. The timing of economic and investment cycles is impossible to get right. Case in point-and as an exercise in humility-we urged caution over US equity valuations at this time last year. Even though concerned, we did not move our clients out of the markets. Instead, we under-weighted US stocks in favor of international and emerging market equities. Had we recommended investors exit the asset class, they would have missed out on the best annual return in a decade.
The good news for our clients is that we carefully plan for all types of scenarios, and as a long-term investor, the ups and downs of the capital markets are less relevant to your long-term success. While we always talk about the importance of broad portfolio diversification, research-driven investing, and staying true to your long-term plan, their benefits are never greater than at times like these.
