2017 Q4 Insights

January 23rd, 2018 by John Anderson – Be the first to comment
Posted in Markets, Quarterly Insights


In short, 2017 was a fantastic year for the equity portion of our portfolios.  It seems like we were continually met with heartwarming headlines such as “Relentless Rally”, “The Dow Races Through 23,000”, only to be followed by “The Dow Hurdles Past 25,000 to Record” and let’s not forget “S&P 500 Powers to New Heights”.  In fact, 2017 was so good, that it was the first time ever that the S&P 500 had a positive return for every single month.

Asset Class Representative Index Q4 2017 YTD
Global Equities MSCI All Country World Index 5.7% 24.0%
    U.S. Equities S&P 500 Total Return 6.6% 21.8%
    International Equities MSCI All Country Ex US 5.0% 27.2%
    Emerging Markets MSCI Emerging Markets 74% 37.3%
Real Assets Alerian MLP Total Return -1.0% -6.5%
    U.S. Real Estate Dow Jones US REIT 2.0% 3.8%
U.S. Bonds Barclays Aggregate Bond 0.4% 3.5%

Above, our asset class returns chart tells the story.  Strong returns for most of the major asset classes continued through the fourth quarter to finish the year with some truly impressive total return numbers.  Emerging markets continued their commanding march to finish the year with a 37.3% return.  The sore spot for our portfolios was our exposure to real assets through the master limited partnership business structure (MLP).

Most MLPs own real assets in the form of infrastructure in oil and natural gas industries.  They pay excellent dividends and have historically been more correlated to utilities than to the price of oil.  However, over the past couple of years, they have not been spared the broader pressure on the energy (more specifically oil) sectors.  However, while the chart above shows a -6.5% return for the year, the asset class continues to deliver an 8.6% yield helping to mute the negative return.  This has brought cash into our portfolios which we have either used as income or reinvested in order to compound the return depending on your needs.   Fixed income (bonds) finished the year with a 3.5% return, coming in short of my expectation of 4%

2017 A Year in Review

At the beginning of 2017, it was common to hear in the media that the financial markets would not repeat their strong returns from 2016. Many cited the uncertain global economy, political turmoil in the US, implementation of Brexit, conflicts in the Middle East, North Korea’s weapons buildup, and other factors. Yet, the global equity markets defied predictions by posting even stronger returns for 2017.

Worl Market Perfomance

The broad advance of global markets reminds us of the importance of diversification and discipline rather than prediction and timing. Attempting to predict and time markets require us to be right four times – not only do we have to accurately forecast future events but also predict how markets will react to those events and then finally time our entry and exit points. The 2017 markets were a good reminder that there is little evidence suggesting any of these objectives can be accomplished on a consistent basis.  The outcomes of 2017 also reminded us why we invest globally.  Not only do the global markets outside of the U.S. account for roughly 50% of all the investable markets available, but in 2017, they ‘outperformed the U.S. equity markets by significant margins.   The good news underlying those returns is the fact that the world (as a whole) seems to finally be emerging from the brink of bankruptcy – which caused the financial crisis.

Speaking of GDP (Gross Domestic Product), this time last year I discussed that we would need real GDP (real means accounting for inflation) of closer to 3% for the U.S. economy to begin breaking out and show lasting signs of strength and growth.  At the time, the average GDP growth rate over the expansion (since 2009 Q2) was averaging around 1.8%.  Currently, we’ve managed to push the average up to 2.1% which is getting closer to the 3% target and the 2.8% long-term (50 year) average, but we still have a long way to go.  See U.S. Real GDP chart below.

As I’ve noted in past letters, the primary cause of the financial crisis was the severe debt burden that both individuals and institutions carried.  Money plus credit are what creates demand in an economy (think growth and higher GDP). As our credit level (think debt) rose to be an unserviceable amount of our spendable income (over 100% of disposable income) the economic system eventually collapsed.  For a more in-depth discussion refer to your 2017 Q2 letter.  Since then, the recovery has been driven by economic policies that have allowed debt to be slowly and systematically trimmed back to more manageable levels.  That is why this economic expansion (recovery) has been long and anemic compared to others.  To put it bluntly, the US and world economies have spent the last 102 months –  as of December 2017 – going through bankruptcy proceedings and as a result, we have also suffered through 102 months of slow growth.

Now that a portion of debt has been dealt with (see household debt graph, next page), there is more disposable money (and available credit) in the system to drive expansion.  Nearly 70% of GDP is made up of consumer spending, which shows up in places like corporate earnings which were also very good this year. Combine that with higher production and low unemployment (more money going around buying stuff) and we begin to see real GDP climbing to healthier levels.  Study the household debt chart on the next page; it will shed a whole new light on the financial crisis.

As you examine the chart below, it’s important to keep in mind, that while we’ve seen a 24% reduction in the amount of debt and the amount of income it takes to service that debt, as interest rates rise, it will begin to take more and more income to service the same (or growing) debt burden.  Eventually, the process repeats itself and we have an economic cycle.

Which, of course, leads me back to the topic of interest rates.  (You didn’t think I could go without mentioning them did you?  They are so important to everything!) We have now officially (finally) entered the long-predicted (they’ve been predicting them for two plus years) era of rising rates. The Fed raised rates three times in 2017 (what they said they would do) which has pushed the prime rate (the rate at which banks will loan money to its most valued customers and is the basis for other loans such as mortgages and credit cards) up to 4.5%.

I’ll be keeping my eye on these (and other) measures as we enter the later stages of this recovery.   However, it is not likely that any of us will ever again experience a similar situation as the 2008 financial crisis in our investing lifetimes. An astute study of history (I love history, it tells us so much) will reveal that such an event is the end of a much larger “super cycle” that comes around every 80 to 100 years.  Just enough time for the lessons to be forgotten by the generation that’s in charge!  What we will more likely have to contend with are the smaller debt and business cycles that tend come around every 10 to 15 years.  Something we are much more accustomed to versus a super cycle that only (hopefully) comes along once in a lifetime.

For its part (in the story of history), 2017 was a solid year economically speaking, where hope for a bright future once again is the rule of the day.  We seem to finally be putting many of the negative effects of the financial crisis (high debt, high unemployment and slow growth) behind us and moving forward.  The world economy as a whole is growing again; 2017 seems to be the year where we crossed the threshold and discovered that things really are going to be okay.

Looking Forward

Over the past several quarters, we’ve looked at a lot of reasons why markets behave the way they do. We’ve explored how interest rates affect market prices, and we’ve maintained our view that even though we keep setting new highs (remember the headlines above), we were not in some crazy bubble again.   To this point, it has been an accurate assessment.

Yet the question remains, “Are we there yet?”  After a year of fantastic returns, and accelerating global growth, are markets too high? Are we set for a crash?  To help answer those questions, we once again turn to history and current market valuations.  If you remember (2017 Q1), we looked at CAPE (Cyclically Adjusted Price to Earnings Ratio), which is simply a measure of how expensive the market (in this case the S&P 500) is to its history.   The higher the number the more expensive it is.  The current reading is then compared to its historical average in order to gauge how expensive the market currently is.

Before we look at that, let’s refresh our memory on how securities (stocks, bonds, etc.) are priced.  When you are purchasing a stock (or a group of stocks) what you are really doing is purchasing a slice of ownership in that company.  With your slice of ownership, you are expecting to get your fair share of future earnings (money the company makes) and dividends (payments of earnings that the company pays to owners).  Those future earnings are then brought back to today’s value (discounted) using a rate of return (interest rate) to find the price one should pay to receive that future income.   To get an idea if the price you paid is low, high, or just right, you divide the price by earnings (P/E) to get a ratio – hence CAPE or PE10 (since we’re dividing by average of the past 10 years earnings).  Now, there is a little more to it than that, but at its root, that’s how market prices work.   By the way, that’s also how you know the market will always recover; you actually do own something tangible that has value, even if you can’t hold it in your hands.

Also remember that the interest rate used to arrive at today’s value (discount rate) is very important.  Looking at the chart on the next page, you’ll see that interest rates (orange line, represented by the 10yr Treasury rate) have been declining for roughly 30 years.  Here is the important concept to get from this: declining interest rates are a form of currency (dollar) devaluation.

Here’s an example.  Let’s say you purchase a CD that will pay you $100 in one year and the current interest rate is 10% (similar to rates 30 years ago).  How much would you pay for the CD?  The math fanatics among you are quickly doing a net present value calculation.  For the rest of us, I’ll just tell you the answer is $90.91.  Now, fast forward 30 years and interest rates are 2.5% (about where they are now). How much would you pay for a CD that will give you $100 in a years’ time?  The answer: $97.56.  The same CD, the same $100 in one year, but a big price difference!  What changed?  The value of the money you used to purchase it!  Thirty years ago, someone was willing to give you $0.0665 more for every dollar you had than they are today.  All things being equal, your dollar today isn’t worth as much as it was 30 years ago so it takes more of it to buy the same thing.  This makes sense because as the value of money declines the price of most things measured in it (that $100 CD or a company’s future earnings and dividends – otherwise known as stock prices) rise in relative value.

Back to the question(s) at hand; is the market overvalued?  You may hear many in the media saying that they are.  Some will even cite the long-term CAPE average of 16.8 and its current reading of 33.2 and say “Oh yes it is!”  But we remember how rates affect prices, and say “Wait, what is the average CAPE over the same time period as rates have been falling?”   I’m glad you asked – it’s 26.5.  The last time we had this conversation (a year ago) the current CAPE was 29.2 and we concluded that the market was not overvalued and therefore not due for a decline — and what a year we’ve had!

Now, a year later, things are a little different.  Current valuations are roughly 25% higher than their recent 25-year average, which is getting into that uncomfortable range.  I know the chart below is very busy, but it depicts everything we’ve been talking about so that you can see it (history) play out visually.  As rates have fallen (orange line), the value of earnings (blue line) and therefore the price you must pay for them has risen due to a currency devaluation of sorts.    It is also the reason why I’ve maintained that markets were not overvalued.

You will notice that it has not been a perfect correlation.  There have been periods of “irrational exuberance” as Dr. Robert Shiller coined.  Periods such as the late 90’s and early 2000’s saw valuations go to extremes because people’s suspension of reality – reality being the real value of what they were buying.

Going forward I expect interest rates to “bounce” between two and six percent, which is the range they stayed in until President Franklin D. Roosevelt took us off the gold standard (1930’s), and President Nixon finished the job by delinking the dollar and gold (1971) allowing the value of the dollar to “float freely”, which set in motion the crazy events depicted above.  It often takes years for the economic impact of events to play out and why it’s important to study history.  Many times the reasons behind what’s going on are outside the realm of our own personal experience, but a study of history will often tell us why things are the way they are.  More on that another time.

    What to Do?

If the market is getting into overvalued territory, or even experiencing a bout of irrational exuberance (which I don’t think it is), what should we do about it?  First, remember that we can’t time markets, or even guess what they may do tomorrow.  There are still a lot of good economic indicators that tell us, there is still a lot of growth left in the economy.  Also, the new tax bill should be very good for businesses as well as individuals, therefore promoting more growth.   Since the markets could continue their rise for some time to come (and we want to be there to capture it), the prudent thing to do is maintain our portfolios which are designed to function in all market conditions and deliver the return you need to meet your personal goals.  What we can and will do is rebalance them, to sell some of the gains, and purchase things that have not done as well recently, but likely will in the future.  This has the simple effect of selling high and buying low – which is always a smart strategy!


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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Investing involves risk including loss of principal.