Executive Summary
During the fourth quarter stock markets were strong, resulting in excellent full year returns. The U.S. government passed a tax reform package that dropped the corporate tax rate to 21% that enabled the stock market to rally to new highs. Broad U.S. stock indices set over 60 record highs during 2017. The Dow hit 20,000 for the first time on January 25, 2017 and hit 25,000 on January 4th, 2018, setting 71 new record highs during the year. Valuation levels have also increased to near record highs, especially the P/E 10, Tobin’s Q and P/S ratio; all of which are not heavily influenced by a changing corporate tax rate. The tax reform package has increased business confidence and investor confidence may now have reached irrational levels.
Compare the chart above with a chart of the past 20 years for the NASDAQ Composite index, which has a clear bear trap at the early stages of the rally (mid 1998) and a tough bull trap after the collapse of the rally (mid 2000). It took the NASDAQ almost 15 years to regain the peak it reached in 2000 (Chart is from Yahoo Finance, end of day 1/8/18).
Of course, no one can time market corrections. However, if history is a guide, then when valuations reach these lofty levels caution is warranted. Caveat emptor, buyer beware; or as Warren Buffett famously said as a reason for his long-term investing success, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
For those who want to dive deeper into our market and economic commentary:
World Asset Class 4th Quarter and Full Year 2017 Index Returns
Fourth quarter index returns were very strong for U.S., international and emerging market stocks, and above average for global real estate stocks. Emerging market stocks were up 7.44%, significantly above its average quarterly return of 3.2% (since January 2001). For the broad U.S. stock market, the fourth quarter return of 6.34% was well above the average quarterly return of 2.0% (since January 2001). International stocks gained 4.23% and were also well above its average quarterly return of 1.6%.
A larger sample of asset class returns shows the strength of emerging markets (EM), with small cap emerging stocks on top, followed by the broad EM index and EM value stocks in third. For the quarter, growth was stronger than value in the U.S. and internationally. Small cap stocks outperformed large cap stocks internationally, but underperformed in the U.S.
Full year, 2017 results were very strong for most asset classes:
Emerging market stocks were the best performing broad asset class and International Developed Stocks performed better than U.S. stocks. Global Real Estate results were not as good as its historical average return, but returned more than bonds during 2017. For the full year, the value effect was negative in the U.S., international developed, and emerging markets; and small cap stocks performed better than large cap stocks in non-U.S. developed markets, but underperformed in the U.S. and emerging markets. The Russell 2000 Value Index was up 7.84%, well behind the broad Russell 2000 Index return of 14.65% during 2017. It is worth pointing out that in the previous year, 2016, the Russell 2000 Value Index was up 31.74%, well ahead of the broad Russell 2000 small cap index (up 21.31%). Large cap stocks were similar to small cap stocks. The Russell 1000 Value Index was up 13.66% in 2017, while the broad Russell 1000 Index was up 21.69%. However, during 2016, the Russell 1000 Value Index was up 17.34%, well ahead of the broad Russell 1000 large cap index (up 12.05%). Growth was much stronger than value during 2017, after value was much stronger than growth in 2016.
Bond markets around the world were positive due to a shift down in the yield curve at the long end. The downward shift at the long end, combined with the large shift up in the short end of the yield curve, caused a significant flattening of the curve. As a reminder, a steep curve is associated with strong economic expectations and a flat or inverted curve signals future economic weakness. Here is the large shift up in rates for the short end (maturities of 5 years and less) and notice the 10-year maturity stayed the same and maturities greater than 10 years had a shift down:
Most bond analysts were expecting the long end of the curve to shift up with the rest of the curve, since the Federal Reserve was raising short term rates and reducing bond purchases. However, the long end of curve shifted down and the lower rates provided extra return for the longest maturity bonds The Citi World Government Bond Index (1-5 years) finished well behind long term government bonds for 2017.
One cannot time markets and typically the short term is just noise. At the start of every year, major financial news outlets discuss the January effect and how the trend in January sets the tone for the year. There is no empirical evidence to support this theory and we had a great counter example two years ago, in 2016, when January 2016 was the worst U.S. stock market start in history; and we ended the year with strong stock returns. In 2017, January started well for stocks, both in the U.S and internationally and stocks returned well over 20% for the year. History does show that after a year of stock returns above 20%, there is a high probability the following year is positive for stocks. The first week in January for 2018 was the best start to a year since 2003 for the DOW and since 2006 for the S&P 500 and NASDAQ. 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):
CONCLUSION
The fourth quarter was a continuation of the 2017 trend of stock prices increasing faster than corporate profits, faster than cash flows, faster than book value, and certainly faster than revenue; which means valuation multiples expand and they were already elevated in most risky asset classes. The present environment is similar to past stock market peaks, when proponents of the rally provide a reason for why valuation doesn’t matter. At the end of 2017, The P/E 10 ratio (price divided by 10 years of earnings) was 32.1, up from 27.9 at the end of 2016. A P/E 10 value of 32.1 is 106% above the geometric mean valuation, well above 2 standard deviations, which is 86% above the mean. More P/E details are available at https://www.advisorperspectives.com/dshort/updates/2018/01/02/is-the-stock-market-cheap. At the end of the fourth quarter, the S&P 500 P/E ratio was 21.4 for 2017 year-end EPS, and 18.34 for 2018 year-end EPS, compared to the historical average of 17. However, the S&P 500 price to sales ratio is currently 2.35 vs. 2.01 one year ago. The P/S ratio is the highest since the dot.com bubble. Global growth is still low, but beginning to rise. Global debt levels are still very high. NYSE margin debt is at all-time highs. We are closely watching bond markets for any increase in credit spreads or spike in interest rates that could cause a stock correction. It is wise to be prudent and we will continue to be prudent in our investment committee meetings in the coming weeks as more companies provide earnings guidance for 2018; and stock analysts adjust their earnings expectations. We will also be watching for any catalyst that could cause a significant re-pricing of risky asset classes, since a correction could be meaningful as asset valuations are at extremely high levels.
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.