Executive Summary
During the second quarter of 2017, we witnessed a continuation of the strong stock trends from the first quarter, with international equity asset classes outperforming U.S equities. This does look and feel like the early innings of a new trend, which we first discussed in our LTWM Insider Q4 2016 blog, http://www.laketahoewealthmanagement.com/blog/ltwm-insider-market-and-economic-commentary-q4-2016. It is our core belief that globally diversified portfolios offer better long term risk adjusted returns than investing in only U.S. asset classes and we provided detailed research to support this belief in our last quarterly commentary, http://www.laketahoewealthmanagement.com/blog/lake-tahoe-wealth-management-insider-market-and-economic-commentary-q1-2017. We have seen very little downside volatility this year, which is unusual. The largest drawdown (percentage drop in the price of the S&P 500 index) has been -2.8% for 2017, which is the second lowest on record (1995 has a max drawdown of -2.5%). With asset class valuation levels so high, especially in the U.S, and the Federal Reserve raising short term interest rates, it is important to be cautious, since a negative economic or geo-political event could cause a correction in stocks, bonds and real estate. However, higher short term interest rates do not always equal poor stock performance. We will examine the historical relationship between the two at the end of this blog.
World Asset Class 2nd Quarter 2017 Index Returns
Second quarter index returns were strong for U.S and stronger for international stocks, while emerging market stocks led all major asset class returns for the second quarter in a row. For the broad U.S. stock market, the first quarter return of 3.02% was well above the average quarterly return of 1.9% (since January 2001). International stocks returned 5.63% for the first quarter, well above their average quarterly return of 1.5%, and Emerging Market stocks performed even better, up 6.27% vs. their average quarterly return of 3.1%. Global real estate stocks were positive but below their average quarterly return of 2.7%, due to increasing short term interest rates.
A larger sample of asset class returns shows the strength of emerging market and international developed stocks over U.S. stocks, while real estate and small cap stocks lagged behind. The value effect was negative for the second quarter in row (1st half of 2017), after a strong showing during the last quarter of 2016. The size effect was strong in developed international stocks but underperformed in the U.S. and emerging markets.
Bond market returns were positive due to a very slight shift down in the yield curve, except at the very short end, since the Federal Reserve increased the overnight lending rate another 25 basis points. The five-year Treasury yield was down 4 basis points for the quarter, ending at 1.89%, while the yield on the 10-year Treasury Bond decreased by 3 basis points to end at 2.37%; and the yield on the 30-year decreased 3 basis points to end the quarter at 2.99%.
The increase of interest rates at the short end of the yield curve does affect the prime rate and other variable rate debt, increasing costs for companies using variable rate debt to fund projects. The long end of the curve is not going to shift up until inflation expectations are stronger. Currently, inflation expectations are low. However, in her latest testimony on July 12, Federal Reserve Chairperson Janet Yellen has stated the Fed is ready to reduce the size of their balance sheet. This action will likely have the effect of increasing long term interest rates. Notice in the chart below that long term U.S. Government Bonds are the best performing bond sector so far this year, up 5.44%.
One cannot time markets and typically the short term is just noise. The strong start for equity returns in the first quarter, continued throughout the second quarter, in the U.S and internationally. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A DEEPER LOOK
The Russell 2000 Index (small-cap) is up 17.6% in the last year, while the S&P 500 (large-cap) is up 12.9%, over the same time period (price change only). The large cap index has closed the outperformance gap of small cap, but small cap stocks have outperformed large cap stocks since the Presidential election. Here is a one-year chart of the S&P 500 large cap index in blue and the Russell 2000 small cap index in green from July 14, 2016 through July 13, 2017. (Source: Yahoo Finance). Notice the spike up of the green line (small-cap) starting in November 2016:
Long-term research shows that U.S. stock market performance compared to international stocks is cyclical and at the end of 2016, the U.S. had outperformed international stocks for 110 months (over 9 years), which is one of the longest cycles of relative U.S. outperformance on record. As of June 30th, for the past six months, international stocks, as measured by the MSCI EAFE index, have outperformed U.S stocks, as measured by the S&P 500. The positive indicators for international stocks, including a strong U.S. dollar, lower valuations in Europe and emerging markets, economic expansion in Europe with higher inflation expectations, and positive money flows into international stock markets, have supported the continuation of this trend during the second quarter and will likely continue to support the trend through the second half of the year.
Shifting back to equity asset class valuations, the second quarter ended with the S&P 500 index near another high and pushed valuation measures to new highs. At the end of the second quarter of 2017, The P/E 10 ratio (price divided by 10 years of earnings) was 29.3, which is a new interim high, since the dot com bubble (it is now above levels during the great recession of 2008/9); and is also above two standard deviations away from its historical geometric mean. You can view the P/E 10 charts at https://www.advisorperspectives.com/dshort/updates/2017/07/03/is-the-stock-market-cheap
At the end of 2016, the S&P 500 P/E ratio was 20.5 for 2016 year-end EPS, and the current P/E ratio, as of July 5th, 2017 is 19 (based on 2017 year-end EPS), compared to the historical average of 17 for next year’s EPS. If we look at the S&P 500 price to sales ratio, which is the ratio that can’t be manipulated with accounting methods, it has moved up to 2.11, slightly above 2.08 at the end of the first quarter and a new high. With the increased valuation levels, the U.S. stock market has even higher expectations built in for the new “business friendly” administration, which is still caught up in delays of a new health care plan, tax reform and infrastructure spending to help boost our current late stage economic cycle.
With the Federal Reserve expected to continue to raise short term interest rates over the next year or two, let’s take a look at research from our friends at Dimensional, who took the time to look at similar periods in the past to see if a relationship exists between monthly changes in US stock returns and monthly changes in the Federal Funds Rate.
CONCLUSION
The Federal Reserve is on target to raise the overnight lending rate one more time this year and three times next year to bring interest rates to “lower” normalized levels, which does act like a brake on the global economy. However, knowing the Fed is going to raise short term interest rates does not provide any insight into expected stock returns. Valuation multiples expanded and will likely need to be supported by earnings growth during the second half of the year (2017 year-end EPS estimates for the S&P 500 are holding up well). Global GDP growth is still low, global debt levels are still very high. We are closely watching growing auto loans and declining auto sales; and student loan debt in the U.S., non-performing loans in Europe and China and other variable rate debt, which is now more expensive due to higher short term interest rates. The U.S. economy continues to have strong job growth without the inflationary pressure of wage growth. Economic activity is expected to be robust through the remainder of the year, however, due to very lofty valuations, we will remain cautious.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Dimensional Equity Balance Strategy Index Description
Rebalanced monthly. The Dimensional Equity Balanced Strategy Index is comprised of commercial and Dimensional indices, 70% US equity indices, and 30% non-US indices. US: S&P 500, large cap value, small cap, small cap value, Dow Jones REIT; non-US: international value, international small cap and small cap value, emerging markets, and emerging markets value and small cap. Additional index information is available upon request.
Real Estate Strategy weighting allocated evenly between US Small Cap and US Small Cap Value prior to January 1978 data inception.
International Value weighting allocated to Fama/French International Value Index prior to January 1994 data inception, and evenly between International Small Cap and MSCI EAFE Index (net dividends) prior to January 1975 data inception. International Small Cap Value weighting allocated to International Small Cap prior to July 1981 data inception.
Emerging Markets weighting allocated to MSCI Emerging Markets Index (gross dividends) prior to January 1994 data inception, and evenly between International Small Cap and International Value prior to January 1988 data inception.
Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One-Year prior to January 1985 data inception.
For illustrative purposes only. The balanced strategies are not recommendations for an actual allocation.
Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Rebalanced monthly. All performance results of the balanced strategies are based on performance of indices with model/back-tested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies. The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money.
Past performance is no guarantee of future results.
Description of Dimensional Indices:
Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.
Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market-capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.
Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.
Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year.
Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.