You Can't Know Where You Are Going Until You Know Where You Have Been - Sandi Weaver, CPA, CFP®, CFA®

Marilyn Brohm |

That cliché has a point. What can we learn from what happened in the markets over the last 12 months?

Show Me the Money
U.S. stocks did well. Large companies here made 21%. Small companies here made 14%. But stocks overseas showed even better at 25%, perhaps signaling a change in the trend since our U.S. stocks have outperformed in recent years. That 25% return from overseas companies signaled a strong economic turnaround, since they rose only 1% the year before. Strong returns in stocks are important since we have significant amounts of your money invested in these assets, for most clients.

The Base
Where we didn’t earn a strong return was on your bond investments, the low risk portion of your portfolio. The Barclay’s U.S. Aggregate Bond Index rose 3.5% in 2017. In fact, bonds have averaged only 2% over the last three years. Interest rates on bonds have been in a long-term secular decline since 1981 – that’s 36 years - and have bottomed in the last couple years. We have seen our Federal Reserve initiate five very small increases in rates since 2015, but the federal funds rate still sits at only 1.5% now. That’s low. This part of the investment landscape is changing. In a world driven by drama in D.C., it’s critical that we remain invested here – profitably – because these are the more stable, constant-returning investments in your accounts.

Price-earnings ratios, one approach to assessing if stocks are over-valued, remain at elevated levels. Based on trailing 12 months’ earnings, the S&P 500 P-E ratio is 22 now. A year ago it was 24. If you look at forward earnings, it’s 18. The typical range is 12 to 22, with 16 considered average. This is a flashing yellow road sign, but P-Es can remain high for a long time. These high valuations have been supported by robust corporate earnings, which are expected to have grown about 10% in 2017. The environment has been favorable for businesses under a Republican regime and a lenient Federal Reserve Bank.

Some economic factors highlighted in 2017:

  • We enjoyed coordinated economic growth on almost all fronts: here, overseas, and in emerging markets. That’s seldom seen. Businesses in most countries are humming!
  • Oil prices moved from the mid $40’s per barrel up to the low $60’s. Global demand for oil rose significantly. OPEC and alliances (think Russia) agreed to restrict supply. Shale fracking in the U.S., the marginal producer now, increased production but not enough to overcome these two factors. Result? Higher prices per barrel, which are sticking (at least until Saudi Arabia’s ARAMCO has its IPO and goes public).
  • The slow death of the retail store and shopping malls inexorably marched on, while online shopping increased its footprint. Overall sales during the holidays popped the most since 2005.
  • Why? Partially due to the lowest unemployment rate we’ve seen since December 2000 – 4.1%. Almost everybody in the labor force is working!
  • Inflation remained benign at 2%. With such a tight labor supply, you would think we would have seen more pressure, right? A couple of factors are allowing inflation to sleep, for now. One is the labor pool itself. Many folks retired early, as a result of 2008’s Great Recession. Some of those workers are rejoining the labor pool as jobs open up. A second phenomenon is the retiring of the baby boomers and the hiring of the millennials. The salaries for younger millennials are less expensive than those of baby boomers. Wage inflation was 2.5% in 2017, still low.
  • Although little reported in the media, much regulation has eased for businesses. For example, how many of you read that Obama’s regulations on fracking, scheduled to be implemented last month, were rescinded? Another example, which got more media attention, is the approval of the controversial Keystone XL Pipeline.
  • Technology busted through again, enjoying the best return of any business segment in the economy. The S&P technology sector returned 37% and no other S&P segment came close. We are enjoying the internet of things (appliances), talking to our phones to make calls and ask for directions, and using home assistants to order on Amazon, play music, and add events to our calendars. It was an exciting year for us, with more to come!

I have always doubted predictions of upturns or downturns because “we’re due”, or “a good January yields a good year 90% of the time”, or “this time period looks exactly like the market pattern in the 1980’s”, etc. But knowing where we are in the business cycle matters, the level and direction of interest rates matters, and the growth rate of corporate earnings matters.