Happy 2018 and I hope your year is off to a great start! I wanted to provide you with our thoughts on the current investing environment, go over the impact of the tax cuts and how it may affect portfolios over time, and go over a few thoughts going into 2018. Here’s what you will find in this post:
- Mike’s Market Commentary
- U.S. or International Stocks, which way should we lean?
- MWA Fund Performance
- MWA Quarterly Review & Bitcoin Article
1. Market Commentary
With new records being set daily, a very common question is, “Should we stay invested in the stock market?”
If you look at the tables below, you will see that the U.S. stock market continued its march higher in 2017, but it could not outpace many of the International and Emerging markets which shot up even higher this year.
*Click to expand these images
I believe the new tax plan is likely to result in much higher after-tax profits for American businesses. The corporate tax rate has been reduced from 35% to 21%, along with many other changes that should eventually, positively impact corporate earnings. As you would expect, markets are absorbing (or have absorbed) this information into their prices. Since markets look forward not backward, stock prices have shot upwards immediately reacting to this good news.
Despite government stimulus inflation has remained in check, for now, however, many economists believe that there will be some pressure on higher wages, higher interest rates, and higher commodity prices. With the economy nearing full-employment, governments around the world are backing off or completely stopping their quantitative easing policies (which are policies used to stimulate the economy). These policy actions have pushed asset values up, and so far, have not caused material levels of inflation. I think that as the economic engine begins to run on all cylinders and worldwide economic growth takes off, it will eventually add pressure for interest rates to rise. It is important to remember that rising rates act as a headwind for investment returns.
Do today’s values reflect all of this information? It is hard to say for sure, but my guess is that much of the news is working its way into prices. I read an article today in the Wall Street Journal that pointed out that since 1927 large U.S. stocks have produced around 6% returns (net of inflation). Given today’s low inflation and high relative valuations, this article postulated future net of inflation returns of large U.S. companies would be around 2% per year. (Lahart, 2018). Rob Arnott and Research Affiliates have also predicted similar returns.
Are stock markets nearing a bubble? I do not think so. I believe prices are “pretty” right most of the time. After all, that is why we advise our clients to own both the U.S. and overseas investments; spread across nearly 12,000 companies worldwide. Let’s continue thinking through this valuation question. Bearish investors are those that think the market will fall and one of their favorite indicators is the Shiller CAPE (Cyclically Adjusted Price Earnings) ratio. This indicator is well above its long-term averages. The CAPE takes the current stock price and divides it by cyclically adjusted earnings per share averaged over the last 10 years. Today, using earnings from 2007-2017 you get several years that had very, very low earnings, which in turn makes the indicators valuations look extremely high. How high? Well, nearly as high as they were valued right before the 1929 crash. The CAPE ratio is currently one of the highest on record, but when you compare this coming year’s earnings and drop off the 2008 low earnings, a different picture emerges. Sure, even with these adjustments, the indicator will still be above average, but nowhere near the lofty values like right before the great crash.
Markets have risen quickly over the last nine years and U.S. market valuations are high. Does that mean the market is probably going to fall? Markets will always rise and fall, and the falls are usually hard to spot in advance. One of the fundamental lessons about investing we must try to remember is that “markets work”, they consider all known information; they react instantaneously like a voting machine for prices. I believe market forces are the best pricing mechanism there is and while prices may not be perfect all the times, they typically will not stay incorrect for long.
While it is possible to beat the market and find a mispricing occasionally, it is extremely difficult to find consistent mispricings. That is why about 80% of professional money managers fail to beat an equally designed low-cost unmanaged index. This fact is also a primary reason why we use a non-guessing structured based approach to investing. We know that if we can lower costs and avoid emotional mistakes, good things will happen with our money. Since risk and return are related, those that assume higher risk will ultimately be rewarded with larger gains (at least if you stick with it and diversify out the risk of one investment hurting your returns).
2. Should I be invested in U.S. stocks or International stocks?
I have been reminding my clients for years that the International stock market funds (especially Emerging markets) are much cheaper (in relative terms as viewed with price to earnings ratios and price to book ratios) than the U.S. stock market. The international stock funds viewed over a long time horizon (greater than the last ten years) have produced higher long-term returns than the U.S. stocks because of their perceived higher risk. Thus, the low relative recent performance of International stocks over the last ten years should eventually revert to long-term average performance. Viewed over the last ten years, the Emerging market stock funds’ 10-year average returns have only increased about 2% a year, which is far below the typical 12-14% they have returned in the past over longer periods. The Emerging market stock funds are starting to revert to their long-term average returns, but they are not there just yet. Thus, we feel there may still be room for overseas assets to continue to rise. So both U.S. stock (because of strong earnings of U.S. companies) and International stocks, because of a long period of underperformance and improved earnings could continue to rise in 2018. We continue to advise being invested in U.S. and International companies.
Remember that selling all assets, paying the frictional cost of trading and taxes is usually a recipe for failure. Diversification is your friend, a portfolio comprised of assets
that zig and zag at different times make the ride smoother much like shocks makes the ride more tolerable when you are on a bumpy, rocky road full of potholes. If you can accept that we don’t have to guess in order to win, we can just sit back, keep a little defense, continue to tilt portfolios to Professors French & Fama’s Five-Factors that produce higher expected returns*, and wait for it to pay off. If you are worried, the higher markets might fall and if you may need access to your funds within five years, then it might be prudent to build up your defensive cash or short-term bond portfolio. Markets do not look like they did in 1999 or in 1929 where excess and stupidity were everywhere, at least not yet. Eventually, we will have a correction. When we do, view it as a buying opportunity to add what falls the most, to buy low and sell high. Finally, remember the 5-year rule: never put short-term needed money in assets exposed to more risk unless you can let them sit for at least five years. Historically, that is how long it has taken for diversification to work.
Best Wishes and have a wonderful 2018. As always if you would like to revisit your financial plan or relook at your overall investment allocation, we are setting up appointments now for first quarter reviews. Thank you for your business and trust, we look forward to sitting down with you soon.
–Mike
Sources
Lahart, 2018: https://www.wsj.com/articles/finally-a-clearer-picture-on-inflation-1515776768
* Kenneth French and Eugene Fama’s Five Factors
* https://newschicagobooth.uchicago.edu/newsroom/eugene-fama-discusses-his-new-five-factor-model
3. MWA Fund Performance
The following MWA holdings make up the components of our portfolio, as you will notice most funds equaled or exceeded their benchmarks over the short and long-term when adjusting for portfolio allocation decisions showing us that the Dimensional methodology is still adding value and winning:
Equity Funds Fixed Income Funds
*Click the images above to view and note that each fund used by MWA is listed below its respective benchmark
4. MWA Quarterly Review & Bitcoin Article
Lastly, click on the image below and view our Q4 Market Review, which dives into world capital market performance and reviews the returns of stock and bond asset classes within the U.S. and abroad. The final piece of this report covers Bitcoin after its incredible explosion onto the investment scene in 2017.
