Worldwide equity markets have continued their march upward during the beginning of 2018. Following is a look back at the last year and a look forward into the future and we think circumstances support a continuing move upward, although valuations are high and rising. For last year’s fourth quarter, U.S. stocks continued their year-long advance, with the S&P 500 returning 6.6%. International stocks also fared well, with the MSCI EAFE rising 4.2%. Bonds posted modest gains, with the Barclays Aggregate Bond Index returning 0.4%.
With a sharp rise in the first quarter, 2017 began with a bang and never looked back, topping even the most bullish forecasts. For the year, the S&P 500 rose 21.8%, which was the best performance since 2013 when the index rose 32.4%. Growth oriented stocks greatly outperformed value stocks with the Russell 1000 Growth Index rising 30.2% for the year versus a 13.7% for the Russell 1000 Value Index, reflecting investor optimism in the economy.
Since the Presidential election, the market has remained surprisingly steady, despite political uncertainty, geopolitical risks, and tightening monetary policy by the Federal Reserve. The S&P 500 has now enjoyed 14 consecutive months of positive returns, which is just one month shy of the all-time record of 15 months. This historic run has been characterized by remarkably low volatility, as the VIX index has remained well below its long-term average.
With the extraordinarily strong stock market gains, the question we are hearing most often from our clients is whether the market has become overvalued and might be heading for a decline. Regarding valuation, it is hard to argue that stock prices are not somewhat overpriced, but we do not believe they have become dangerously expensive. The forward price-to-earnings (P/E) ratio for the S&P 500 is currently 18.2x versus the 25-year average of 16.0x. Although higher than average, it remains well below the late-90’s dotcom bubble level of 25x.
In addition to the risk posed by overvalued stocks, J.P. Morgan identifies three other risk factors that are most often responsible for bear markets; economic recessions, commodity price spikes, and aggressive monetary tightening. It doesn’t appear to us that any of these conditions are currently present. It is also worth noting that the investor euphoria that often accompanies market tops is conspicuously absent. Given the current positive economic environment, we remain optimistic that the bull market can continue for the foreseeable future.
The tax reform bill passed by Congress and signed into law by President Trump at the end of the year has fueled much of the positive market activity in recent weeks. The new tax legislation lowers tax rates for individuals and companies which should lower taxes for many families and businesses. Investors hope that this will spur consumer spending and will make businesses more profitable, resulting in further stock market gains.
International stocks were among the best performers last year. The developed markets, as measured by the MSCI EAFE, rose 25.6% and emerging markets performed even better with the MSCI EM Index increasing 37.8%. After years of economic struggles for many countries, we have recently entered a rare period of synchronized global growth, where nearly every region is experiencing an economic expansion. While the U.S. has been in an expansion for many years, the rest of the world is finally catching up.
In December, the Federal Reserve raised the benchmark Fed Funds rate for the third time in 2017, bringing the target rate to 1.25-1.50%. Fed Chairman Janet Yellen has taken a measured approach of gradually raising rates to a more normal level. This strategy is likely to continue under Jerome Powell, who was recently appointed to be the new Fed Chairman by President Trump and will be sworn in on February 5th. Under Powell’s direction, the Fed is expected to raise rates two or three more times this year.
Crude oil continued to rise in the fourth quarter, finishing the year at $64 per barrel, a more than 100% rise from the low of $30 per barrel set in early 2016. Although still far below the $100 +/- level enjoyed by energy companies four years ago, the rally in oil prices from 2016’s low offers a welcome relief for the energy complex, and has greatly improved profitability for the sector. However, the performance of energy stocks greatly lagged the rest of the market in 2017, returning an average of -1.0% versus +21.8% for the broader market.
The U.S. economy picked up its pace in the most recent period and has entered its 102nd month of expansion. This ranks as the third longest expansion in U.S. history. Recent economic readings have continued to confirm the positive trend. Real GDP growth was measured at 3.2% in the third quarter, and unemployment has fallen to 4.1%. With the labor market tightening, and growth accelerating, the focus among many economists has shifted to the possibility that inflation could become a risk. However, at the current inflation rate of 2.2%, it still has a long way to go to reach the long-term average of 4.1%
As we begin 2018, we are hopeful that the coming year will bring further growth in the domestic and global economy, continuing a fertile environment for investment gains. However, given the long and steady nature of the most recent rally, odds are increasing that we will see a pullback at some point this year. Unfortunately, there is no good way to anticipate when a correction might occur, but it is unlikely it would be too severe given the strength in the underlying economy. In any event, it is important to remain positioned in a manner that is appropriate to your circumstances and is consistent with your long-term financial plan.
Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience. Lastly, don’t keep us a secret. If you know someone who would like help planning for their financial future, we will be pleased to speak with them to see if we can assist.
Horizon Advisors is a Houston based fee-only wealth management firm. Horizon specializes in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.