Market Update – First Quarter 2017

What a difference a year makes! If you have a good long memory, you may recall that the S&P 500 began 2016 with its worst start ever. This time around volatility was much more subdued. Instead of hitting new multi-year lows, as we did in February 2016, we have been regularly hitting new all-time highs.

The first quarter of 2017 provided the highest returns for US large-cap stocks since 2013. The S&P 500 index was up 5.5%, while small cap stocks, which had a stellar year in 2016 (where they delivered returns over 22%) posted a relatively modest 2.2% gain.

Even international investments did well through the start of the year. Finally! The broad-based EAFE index of companies in developed foreign economies gained 6.5%, while emerging market stocks of less developed countries led all asset classes by, rising 11.2%.

Real estate investments, as measured by the Wilshire US REIT index, eked out a 0.03% gain during the quarter. Commodities overall lost 2.5%, which is in part due to a 5.8% drop in oil prices. On the other hand, gold prices shot up 8.6% during the period. Go figure.

In the bond markets, interest rates continued their incremental rise from practically zero to not much more than zero. Bond returns were muted during the quarter, hovering around 1%.

Overall it was a positive experience for investors—smooth sailing, as they say. Stocks continued the rally that started after the presidential election, responding positively to the pro-business agenda coming from the new administration. However, the new administration has been learning the hard way just how difficult it is to get things done in Washington, even when your party controls both houses and the presidency.

The recent healthcare bill setback seemed to temper the markets’ animal instincts and caused it to sell off slightly as the quarter drew to a close. If President Trump’s other policy goals receive similar “cold shoulder” treatment in Congress, particularly his tax, budget, and infrastructure policies, we could very well see a further pause or even a partial reversal of the “Trump Rally” in stocks that we’ve seen since he was elected.

Another looming concern for investment markets has been whether the new administration will act on some of the trade threats that were made during the presidential campaign. A trade conflict with one or more of our major trading partners like Mexico or China may not be viewed favorably by investors. However, in recent months, it appears the rhetoric has toned down, with the Trump administration indicating it will seek only modest changes to trade agreements like NAFTA. Also, the tough talk on China might just be that—talk. It’s no secret that both the US and China depend on each other economically, and upsetting that relationship is not in the best interest of either country.

The future of interest rates will remain on investors’ minds throughout 2017 and into next year. The Federal Reserve seems poised to raise the fed funds rate a couple more times before the end of the year, and Fed officials appear to be going out of their way to telegraph their plans to avoid market surprises. As we have said before, the fact the Fed feels comfortable normalizing rates is a GOOD thing for the economy and investment markets. It means they feel confident that the economy can support higher rates. This does not mean that there won’t be hiccups along the way, but it should not disrupt the continued expansion of the US and global economy.

While a lot of the recent “Trump rally” is riding on pro-business policies, it isn’t as though the rally is otherwise built on sand. There are other positive economic developments around the world that support stock prices.

US corporate profits, which had stalled out for the last 18 months or so, have started rising again. They increased at an annual rate of 2.3% in the fourth quarter. This is what really matters for future stock prices. It can be easy to get caught up in the political events of the day, with the headlines coming at us from every direction. What is important to remember is that while political headlines may influence markets day-to-day, in the long run the main driver of stock market returns are always corporate profits. As you can see from the chart below, corporate profits and stock market returns are highly correlated with one another.

The question long-term investors need to ask themselves is, “are corporate profits continuing to expand?” Said another way, are the great companies in America and the world going to continue to grow and make money? If so, there is no reason the stock market shouldn’t follow that trend line. Politics and anxiety may dominate today’s headlines, but for long-term investors this is all that really matters.

Another positive improvement for stocks is that parts of Europe and developing economies are finally starting to show signs of growth. Many of these economies have suffered years with little to no economic growth, dampening the pace of global economic recovery. Another encouraging sign is consumer confidence, as measured by the Conference Board’s Consumer Confidence Index, surged to the highest level since 2000. High levels of confidence tend to be associated with better than average growth.

After the robust market performance over the past four months, it wouldn’t be surprising if we experienced some sort of short term pullback. If that happens, it doesn’t mean we need to start worrying. Periodic adjustments are actually signs of a healthy market.

There are any number of events that could temporarily disrupt the current bull market trend. We can never predict what those events will be, or when they will occur. The assumption that periodic and temporary declines will naturally occur from time to time is already built into your beautifully diversified portfolio. We will continue to keep our finger on the pulse or the markets and global economy, always looking for opportunities to take advantage of investment opportunities when they present themselves.

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