Market Update: Second Quarter 2017

It has been twelve months since we weathered that short-lived market turmoil known as Brexit, which immediately followed the United Kingdom’s surprise vote to leave the European Union. Turns out that was the last time stock markets across the globe experienced any meaningful pullback. Since then, we have witnessed a largely uninterrupted move higher in the markets.

The second quarter capped off a strong first half for equities around the world. The widely-quoted S&P 500 index of large U.S. company stocks gained 2.6% during the second quarter, finishing the first six months of the year up a strong 8.2%. Small company stocks gave investors a 2.1% return over the last three months, and they are up 4.3% so far this year. While this may seem anemic in comparison to the S&P 500’s numbers this year, it’s helpful to remember that small caps had a torrid +8.8% return in the fourth quarter of 2016.

International investments had a great quarter, and are finally delivering solid returns to globally diversified portfolios. The broad-based EAFE index of companies in developed foreign economies gained 5.6% in the second quarter and is now up nearly 12% for the first half of 2017. Emerging market stocks of less developed countries rose 5.8% in the second quarter and are now up a remarkable 17% for the year!

Meanwhile, interest rates remained little changed in the second quarter, even as the Federal Reserve increased the short-term interest rate by a quarter of a percent in June. The Barclays U.S. Aggregate Bond Index returned 1.5% for the quarter and is up 2.3% for the year.

There were plenty of seemingly legitimate reasons why investors at the beginning of the year thought it was a good idea to exit the market—stocks were repeatedly hitting all-time highs (again), we had a controversial and inexperienced president-elect,  global terrorism was increasing, etc. However, investors who got out of stocks likely regret that decision today as a result of the strong performances discussed above.

So where do we go from here? It would be unwise to extrapolate the returns over the last six months into the future and assume we will see the similar returns during the second half of 2017. Stocks delivered almost a full year’s worth of returns in the first six months. While returns may not replicate the previous six months, economic data suggests that the global economy will continue to improve, and this provides a positive backdrop for stocks.

Despite continued political uncertainty and doubts over the U.S. administration’s ability to push through its fiscally stimulating policies, the U.S. and most global economies are growing. The US economy is currently forecasted to have grown at a 2.9% rate for the second quarter. This is still pretty tepid growth, but it’s a definite improvement from the 1.4% annual GDP growth rate in the first quarter. The International Monetary Fund also currently forecasts faster global growth of 3.5% in 2017. Meanwhile, corporate earnings, which ultimately drive stock prices in the long-run, are expected to be strong for the second quarter, both in the U.S. and abroad.

Yet, there are many uncertainties to be aware of in the months ahead. Congress is still debating a Republican ObamaCare replacement bill and it has also promised to revise our corporate and individual tax codes later this year. There may or may not be an infrastructure package somewhere on the horizon. Much of the president’s agenda has been stymied by controversies surrounding his new administration. These controversies, coupled with a continued lack of action on the president’s promised agenda, could eventually cause investors to hit the pause button on their current bullishness. Fortunately, the current political volatility has not resulted in increased market volatility—at least not yet.

We are now entering our seventh quarter of market gains. After long positive stretches like this, investors tend to become complacent and comfortable, accepting this as the new normal and a sign of things to come. However, we know that market conditions can change, sometimes violently and in the blink of an eye. This is a perfect time to remind you that the tide can and will eventually turn bearish. Consider that every 16-18 months, historically, the S&P 500 has experienced a 10%+ pullback but we haven’t experienced one in about 17 months. Market pullbacks don’t occur on any set schedule but they do happen somewhat regularly. It is always helpful to be mentally and emotionally prepared for the next time we will have to go through one so we don’t find ourselves being whipsawed emotionally.

One of the ways we help clients keep their cool is by providing them with historical perspective that can serve as a framework for viewing the markets. History shows that periodic market volatility isn’t a flaw in the system, but rather it’s one of the features of a normally functioning market. People are usually very healthy, but on occasion we all get sick, and when we do, usually our only option is to wait for it to pass. The markets are basically the same.

Below is a bar chart that illustrates intra-year S&P 500 gains/declines (indicated by the shaded bars), as well as the market’s return for the year (in the darker shaded bar) going back to the end of World War II. The line you see extending from the bottom left to top right is the growth of a dollar originally invested in 1946.

Despite 12 declines of 20% or more, 57 declines of  10% or more, and more than one hundred eighty declines of  5% or more  over the past 71 years, $1 invested in the S&P 500 at the outset grew to over $1,500!  Given these facts, it’s fair to ask why anyone should really have to worry about the periodic pullbacks that inevitably occur. The long-term market uptrend has been relentless as far back as we have reliable records to review. If anything, periodic market volatility provides terrific buying opportunities for patient investors.

We hope you have a great rest of this warm summer!

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