Capital Markets Review, First Quarter, 2018

The first quarter of 2018 is behind us; here's what we know to be true. Price matters. Volatility is normal and present in any investment which seeks return. Diversification is one of the most reliable ways to reduce risk. The world keeps turning and events will occur, often in ways that confound our expectations. In homage to Franklin: taxes are certain, though a moving target in our investing lives. And while death is also a certainty, for most investors that inevitable event is many years away - forcing patience and a focus on long-term investment goals. 

Although the equity markets started the year in much the same way they ended 2017 (the S&P 500 reached a new all-time high on January 26th), volatility returned in a big way as the quarter progressed. The stock markets, early in the quarter, responded favorably to the new Tax Cuts and Jobs Act which went into effect with sweeping tax reductions. The reductions are not just good for business and most individuals, but appeared to also bolster continued confidence for a growing economy. Corporate America has responded to this tax relief, and analysts revised earnings upwards accordingly. Consensus earnings growth for the S&P 500 in 2018 is now projected at the sweltering pace of 18.8% with an additional 10.4% increase in earnings in 2019.  To put these earnings revisions in context, the first quarter's earnings revision was the biggest upward revision to S&P 500 earnings to start a year since the data has been collected. 

So, what happened? After a fast start and a new all-time high, it took just nine days, in early February, for the S&P 500 to enter correction territory with a -10.2% peak-to-trough decline. This decline in the market was the fastest move ever from an all-time high to a correction. Ironically, the impetus for this correction was more good news. In early February, the Bureau of Labor Statistics reported that nonfarm payrolls grew by 200,000 with wages seeing their biggest jump since the end of the Great Recession. This kind of wage growth, on top of an already low unemployment rate of 4.1%, renewed fears of rising inflation. We have been calling for a rate increase for some time, not only because of rising inflation but also due to the Federal Reserve's mandate to de-lever their balance sheet and infuse the market with liquidity. Rising inflation concerns equity investors and puts pressure on bonds and other yield-oriented instruments. As a result, high quality intermediate bonds, international bonds, high yield bonds and inflation protected bonds were all negative for the first quarter. Rate increases, along with the fear of additional rate raises and spread expansion, saw other traditional yield instruments like REITs, BDCs and MLPs post negative returns in the quarter, as well. 

Rising rates were not the only issue effecting investor sentiment. Concerns were elevated by President Trump's surprise announcement about new tariffs on steel and aluminum which called into question continued economic expansion and sent stocks lower on fears of retaliation from trading partners and potential trade wars. Then the administration announced levies of up to $60 billion of Chinese goods. (That number has grown to $100 billion in April.)  Markets around the world tumbled on the news. Congress also added to market tension when it passed a $1.3 trillion spending package. Much like the tax cuts, this spending bill could have a big impact on an already expanded national deficit. To all of this add geopolitical uncertainty with Russia and North Korea and continued social unrest with political drama here in the US and it is not too much of a stretch to see why market volatility increased and first quarter returns were disappointing across almost all investment segments - globally.  So much for diversification!

We believe that experience, discipline and patience is rewarded in times like these. Remember:

Volatility is Normal

Don't let volatility alone scare you into action. 2017 was notable for its LACK of volatility. After all, markets suffered double digit declines during 21 of the last 38 years. Current expectations are for US equities to return 6.5% over the long term, but historical analysis shows that two-thirds of the time, returns could be 14% higher or lower than that long term expected return. That means last year's return of 19.4% for the S&P 500 was considered "normal," just like a -7.5% return on the S&P 500 would be normal. There's a reason we develop a long-term plan together to guide us through the inevitable pull-backs. 

Price Still Matters
Even with the stock market pullbacks this year, stock valuations remain high, which will act as a drag on performance. According to the Nobel Prize winning economist, Robert Shiller, who advanced the way we look at P/E multiples by looking at prices compared to the previous 10 years' inflation-adjusted earnings, high prices are difficult to overcome. In the last 100 years, the lowest periods of returns began with an average cyclically-adjusted P/E of 18.2. Today the Shiller P/E is 31, firmly positioned in the most expensive decile in history!

Diversification Works
We are sympathetic to the reality that diversification away from stocks has hurt recently. Interestingly, it has been diversification away from technology companies, and specifically away from just 5 companies, which has hurt the most. While the S&P 500 lost -0.8% in the first quarter, the S&P 500 Technology Sector Index was up 3.5% and, amazingly, the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) were up collectively 13.2% for the period. One minor detail when considering an investment in FAANG, these 5 companies average a mind-numbing trailing P/E of 115 and a forward P/E of 42! No sane person would consider those investments, together, a diversified strategy. But that is what worked in the first quarter. Higher valuations, concentrated returns, and the uncertainty we see, underscore the need for true, broad diversification and careful portfolio management. Higher valuations and risk in the form of potential policy mistakes or geopolitics mean it's even more important for investors to maintain allocations to a range of asset classes. By including uncorrelated return streams from fixed income, real assets and private investments you are better prepared to weather uncertainty.

Staying Invested Matters
Sometimes fear or greed push investors to make emotional decisions. But there are numerous examples of how timing the market reduces performance. Remember that markets can have bad days, weeks, months even years. But investors who stay invested through the downturns have come out ahead in the long run.