CKBlog: The Market

Friday, January 19, 2018

2017 Market Review

US Equities

It was a very strong year for the US stock market in general. The S&P 500 Index was up +21.82%, the Dow Jones Industrial Average was up +28.11%, and the Russell 2000 (an index for smaller US company stocks) was up +14.63%, all including dividends.

Growth versus Value

Growth stocks (think social media, tech, and biotech) outpaced value stocks (cyclicals, dividend payers) yet again in 2017.

• S&P 500 Growth Index: +27.43% including dividends
• S&P 500 Value Index: +15.35% including dividends

Growth has now outperformed value for more than 10 years. No one can predict when this theme will reverse, but reversion to the mean is a universal principle. Another interesting note is the top four companies in the S&P 500 index, Apple, Microsoft, Amazon, and Facebook, now account for more than 10% of the overall index. What do they have in common? They are all “growth” companies and they were all up huge in 2017. With Apple up +48.48%, Microsoft up +40.72%, Amazon up +55.96%, and Facebook up +53.38%, these four companies accounted for nearly 20% of the S&P 500 index’s gain on the year. If you didn’t own these stocks, it was hard for you to keep up!

The next four largest companies in the Index are Berkshire Hathaway (+21.91%), JP Morgan Chase (+26.73%), Johnson & Johnson (+24.40%), and Exxon Mobil (-3.80%)—all classic “value” companies. It will be interesting to see if any or more of these eight companies swap positions in 2018.

Volatility

During 2017, the ascent of the equity markets was a steady grind upwards. This is great for buy and hold investors, but not great for active traders. The S&P 500 index has seen positive monthly gains for the last 14 months. The largest single day drop in the S&P 500 index in 2017 was -1.82% and the largest one day gain was +1.38%. You have to go back to 1964 to find a year in which there was a lower largest single day gain! Slow and steady certainly worked in 2017.

Non-US Stocks

• Europe: As measured by the MSCI Europe Index, European equities had a stellar year as they posted a +26.30% gain in US Dollar terms (+10.81% in Euro terms). Despite outpacing the performance of the S&P 500 in 2017 in US Dollar terms, European equities remain “cheaper” than their US counterparts (as measured by Price-to-Earnings Ratio).
• Japan: As measured by the MSCI Japan Index, Japanese equities also outpaced US equities as they posted a +24.45% gain in US Dollar terms (+20.12% in Japanese Yen terms).
• Emerging Markets: As measured by the MSCI Emerging Markets Index, these equities blew past US equities as they posted a +37.51% gain in US Dollar terms.

US Bond Market

The US Federal Reserve raised rates three times during 2017, yet yields on the US Government’s 10- and 30-year bonds both dropped during the year. Why? Perhaps the Fed didn’t raise rates as fast as analysts predicted (analysts got it wrong again?) or global investors bought US bonds because rates in the US are higher than most developed countries—sovereign yields in Japan and certain European countries are still negative. Wouldn’t you rather be paid interest by a government to own their bonds versus having to pay interest to the government for the privilege of owning their bonds?

US Dollar

Measured against a basket of 10 developed country currencies, the US Dollar dropped by -8.52% in 2017. Every major currency was stronger versus the USD including the Euro (+14.15%), the British Pound Sterling (+9.51%), the Mexican Peso (+5.43%), and the Japanese Yen (+3.79%) except for the Brazilian Real which was weaker by -1.77% against the greenback.

BREXIT

The surprise vote on June 23, 2016 for the UK to exit European Union has had much written about its effect on the British economy and foreign policy. The conundrum is that when adverse news arises about the negative effects of BREXIT on the British economy, the British Pound Sterling drops but the FTSE (UK equity exchange) generally moves up. However, we believe that in general, managers of British companies affected by BREXIT will be spending more and more time on unproductive issues relating to BREXIT. Our preliminary conclusion is that it may be more rewarding to focus on Euroland ex-UK strategies than Euro based investment portfolios including the UK. In 2017 the Euro Index ex-UK outperformed the index for Europe including the UK by roughly 2%.

Cryptocurrencies

 
It’s impossible to write about the year that was in 2017 without commentary on Bitcoin and its crypto friends. So please read what Steve Haberstroh, our resident “expert” on crypto, wrote earlier this year:  Bitcoin, FOMO, and the Greater Fool.

Inflation

Ever since global central banks began printing money and injecting funds into the financial system, analysts have cautioned about inflation. According to the Bureau of Labor Statics, Personal Consumption Core CPI actually dropped in 2017 from an annualized 1.8% (Dec 31, 2016) to an annualized 1.5% (Nov 30th, 2017). Perhaps that is why the Fed was more cautious in raising rates during the year. There is some evidence that inflation and hourly wages may be picking up. The Trump tax plan may add fuel to this slow burning fire.

Cash Providing Returns

For the first time since the 2008-2009 Financial Crisis, we notice cash adding to portfolio returns. This is a welcomed sign but rates need to increase further to attract exposure from equity and bond allocations. For most investors, a 1% cash yield isn’t enough to move the needle. But at 2%?

US Tax Revision Plan

The US Tax Revision Plan is bullish for US companies in general. Short term, the US equity markets have reacted positively to the revision. Longer term, it is a bit more difficult to predict if that it will be a one-time event or whether it will be a long-term plus for the US stock market as companies and individuals adjust to the new rates. But in general:

• Banks should benefit
• Smaller companies should benefit; most manufacturers will benefit
• Corporations which have lower tax rates will likely increase dividends and share buybacks
• Immediate expensing of capital expenditures makes it more attractive for companies to buy more machines, build more factories and invest in equipment
• Residents of the so called “high tax states” such as Connecticut (where we live), New York, New Jersey, California, will not benefit because of the limitation of deductibility of local taxes on US Federal Tax returns

News at CastleKeep

We are proud to celebrate our 18th year in business. We have all of our clients to thank for the privilege of doing what we love. In 2017, the company and our team celebrated several milestones both professionally and personally:

• Lauren Quesada was promoted to Vice President of Investments, directly supporting our CIO.
• Chuck Haberstroh became a partner of the firm and is now a father of FOUR as his wife gave birth to twins, Grace and Eve, in August.
• Steve Haberstroh became a partner of the firm and not to be completely outdone by his older brother, is now a proud owner of a golden retriever, Moose, who makes visits to the office when he is not attached to Steve’s wife, Erin.

2018

I am going to resist the prediction of where markets will reside on December 31, 2018, since virtually all prognosticators get it wrong. There are several crosscurrents at work. On one hand, the new US tax revision plan should be positive for growth as it puts more money in both corporations and individuals hands. Corporations in highly regulated industries should benefit from a continuing better regulatory environment. On the other, several industries face disruption, including retail, distribution, and banking in general. The march towards self-driving vehicles and conversion to electric from internal combustion engines continues. Global growth in general looks assured for the year, while, in part due to the aforementioned disruptions, inflation looks tame.

The biggest threat to equities and bond markets is inflation. Persistently low inflation has befuddled many an economist. Having lived through hyperinflation in Brazil in the mid-1980s, rising and falling inflation is also a result of state of mind. If everyone believes that prices will go up, they will increase their short-term purchases to wage war on inflation’s effects on their pocketbooks. This especially happens when short-term interest rates are negative. On the other hand, if you and I believe that prices such as in electronics will be less next week or next month, we feel no pressure to purchase them. There is some evidence that miniaturization in electronics is reaching current scientific limits and that electronics manufacturers are selling more features to increase prices. Traditional economic theory would indicate that the US is beyond full employment at current unemployment rates. It would be true except for low labor participation in the economy. The US Federal Reserve’s reading of the tea leaves will have a major effect on markets in 2018.

Also in 2018, energy trends and prices will be worth watching. As I write this, OPEC has shown more discipline in regulating members’ output. As a result, short-term petroleum prices have been strong, reflecting the drawdown of inventories in the US and predicted global growth. How quickly shale production in the US and other locales will result is the major question. While some increase in petroleum prices is a bullish sign for global growth, a larger price increase will tend to put a brake on growth.

In 2017, we continued to lower our exposure to US equities in favor of Europe and to a lesser extent Japanese equities. I expect that trend to continue. We continue to reduce our exposure to intermediate bonds, favoring short-term, floating rate fixed income managers. In funds, we focus on the best long-term investment managers. Equity Strategies that we manage as well as individual equities we purchase for our clients, are dependent on the strategies and investment themes for stock selections.

Based on my experience in the late 1990s and early 2000s, I know that high-flying stocks which are ultimately not supported by rising (or any) earnings, return to earth. It is likely that the unjustified prices of so-called crypto currencies will not end well for speculators. We continue to believe a disciplined, investment approach which focuses on earnings and valuation will benefit investors in the long run. It was true when Benjamin Graham wrote The Intelligent Investor in 1949, and it is true today.

Best wishes for a healthy, happy and prosperous New Year!