- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Officer
- Jonathan Strok, CFA - Investment Analyst
- Austin Burant - Investment Associate
- The stock market delivered strong gains in the first half of the year, and it did so with remarkably low volatility. Earnings growth has been robust as both the domestic and global economies have improved.
- We believe that current signs point to an economy in the late stages of expansion. However, trying to predict precisely when a downturn will occur is a fool’s errand.
- We currently favor stocks more than bonds, but only slightly. We continue to have low return expectations for both asset classes over a 10-year time horizon, driven largely by relatively high equity valuations and low interest rates.
It's summertime, and, for investors, the living is easy. The stock market delivered strong gains in the first half of the year, and it did so with remarkably little interruption. In the entire first half of the year, the S&P 500® experienced just two days of losses greater than 1%. The index also hasn’t declined more than 3.3% from any of its peaks this year. If it can keep this going, it will mark the lowest intra-year decline for the market since 1995.
Since the S&P 500 bottomed back in March 2009, it has gained more than 250%. This bull market has coincided with what is now the third longest economic expansion in the U.S. since the end of World War II. Does this mean that we are “due” for an economic downturn?
Not necessarily. The recovery, while relatively long on a calendar basis, has also been one of the slowest on record. Gross domestic product has grown at only a modest pace following the financial crisis, failing to reach even 3% in any year.
However, we believe that current signs point to an economy in the late stages of expansion. For instance:
- Job growth has slowed, and the headline unemployment rate recently hit its lowest level in 16 years. Major improvement from here seems unlikely.
- The yield curve is flattening as the spread between long-term and short-term interest rates narrows, a classic late cycle sign.
- Loan growth has slowed recently as delinquencies have started to rise in certain categories from very low levels.
- Auto sales appear to have peaked as recent numbers have been declining.
There are no time limits imposed on the economic cycle though, and trying to predict precisely when a downturn will occur is a fool’s errand. Australia, for example, has gone more than 25 years since its last recession (it’s been a tough quarter-century for their doomsayers). The “late” stage of the business cycle can last for a long time.
We currently favor stocks more than bonds in this environment, but only slightly. In either case, we continue to have low return expectations for both asset classes over a 10-year time horizon, driven largely by relatively high equity valuations and low interest rates.
We believe the economy is in the late stages of expansion, but this stage can last for a long time.
Reaching for Higher Branches
We are struggling to find great bargains in the stock market today as it continues to march upward with nary a pullback. The CBOE Volatility Index® (the VIX, or the market’s "fear gauge") has been near historic lows for quite some time. (Figure 1) Valuations remain above their historical averages, and the margin of safety that we prefer on our equity investments is not as wide as it has been in the past. Famed value investor and Berkshire Hathaway Vice Chairman Charlie Munger recently said that they are having to look on "higher branches" for stock bargains because the low-hanging fruit has already been picked. The problem is that when reaching for higher branches, people have a greater chance of getting hurt. We recommend that investors exercise caution in this market
Volatility was extremely low in the first half of 2017.
Fed Chair Janet Yellen recently provided her own warning about stock prices, stating that “asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios” . However, she provided the caveat that she “wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates.”
This is somewhat reminiscent of former Federal Reserve Chairman Alan Greenspan’s famous “irrational exuberance” speech during the bull market of the 1990s. He asked "how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions...?"
What is noteworthy about his rhetorical question is that it was posed in December 1996. Market historians, or most people over the age 40, know what happened next. The stock market soared, with the S&P 500 more than doubling over the next three years before finally entering a bear market in 2000.
The lesson is this: neither we nor anybody else know when the bull market will end. Perhaps the only thing more difficult than forecasting a recession is predicting when the next bear market will occur. We are only certain that it’s a matter of “when”, not “if”. In the meantime, we are trying to remain rational and looking for opportunities where we can find them.
Growth Leading the Way
In fact, the rising tide of the stock market hasn’t lifted all boats this year. Both the health care and tech sectors have rallied while financials, real estate, and especially energy have lagged. In general, growth stocks have outpaced value stocks (Figure 2), and large capitalization stocks have beaten their small cap counterparts. (Figure 3) The so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have each posted gains of at least 17% so far in 2017 despite recent pullbacks in some of the names.
While it may be tempting to jump aboard the growth bandwagon in this market, we caution that a good business can be a bad stock. As the father of value investing Ben Graham once wrote, "Obvious prospects for physical growth in a business do not translate into obvious profits for investors." Why not? One reason is because valuation matters. Earnings growth may indeed come rapidly, but the stock price can get ahead of itself, and future returns could disappoint. Growth is a key component of our investing strategy, but we demand it come at a reasonable price. We do not believe in changing strategies or relaxing our investment principles simply because Mr. Market is suddenly favoring certain areas more than others.
The stock market gains this year have not been completely without merit though. Earnings growth has been robust as both the domestic and global economies have improved. Estimates also point to strong earnings growth in the second half of the year and throughout 2018. And corporate tax reform could provide a significant boost to profits, if it can make its way through Congress.
However, much of this positive outlook could already be priced into stocks. The 12-month forward price-to-earnings ratio is currently around 18, which remains above its historical average. While low long-term interest rates may somewhat justify a higher earnings multiple, stocks certainly do not look cheap at these levels. (Figure 4)
Optimism appears to be spreading beyond our shores too. Equities have been rallying this year in many international markets, both emerging and developed. Unlike U.S. stocks, however, international stocks have not experienced a long bull market heading into 2017. Consequently, their valuations look much more attractive to us, on average.Economic data has been better than expected in many areas. For instance, GDP growth turned positive in Brazil earlier this year for the first time since 2014.
Economic activity in the Eurozone is hovering near a six year high, according to IHS Markit’s monthly purchasing managers’ index. And consumer confidence in the euro-area recently hit its highest level in nearly a decade, based on the European Commission’s Economic Sentiment Indicator.
Positive economic data has led the European Central Bank to consider reducing its monetary stimulus in the near future. ECB President Mario Draghi stated in April this year that “in 2016 we were speaking of a fragile and uneven recovery. Now it’s solid and broad.”
Fed More Hawkish
Our central bank, meanwhile, raised interest rates twice in the first half of the year. Current projections by the Federal Open Market Committee suggest one additional rate hike this year, assuming the economy continues to improve as expected. The Fed also expects to begin “normalizing” its balance sheet this year by scaling back its reinvestments in Treasuries and mortgage-backed securities – another sign of its increased confidence in the economy.
While short-term rates have been rising, long-term rates have not. This development is known as a flattening of the yield curve. (Figure 5) There are many possible reasons for this, including extremely low interest rates overseas holding long-term rates down here at home, and low inflation and economic growth expectations by investors. But historically, a significant flattening of the yield curve has portended an economic recession on the horizon. This is something we are watching closely
The yield curve has been flattening as long-term interest rates have not been rising with short-term rates.
On the other hand, the spreads between yields on high and low quality bonds have continued to tighten, suggesting a more positive economic outlook by the bond market. (Figure 6) The yields on so-called “junk bonds” are currently near their lowest level in three years. As a result of these low rates and narrow spreads, we prefer a more defensive positioning of higher quality bonds in this environment.
Heightened optimism among both equity and fixed income investors has driven up asset prices so far this year with very little disruption. It has also driven up valuations and tightened credit spreads, making it particularly challenging to find great value in these markets. We do not know when this prolonged period of investor enthusiasm will end, other than it will eventually. In the meantime, we suggest not being lulled into complacency by the placid markets.
We currently have a small preference for stocks over bonds but are monitoring the investment landscape closely. Given relatively high valuations and low interest rates, we continue to expect long-term returns from both asset classes to be below their historical averages. (Figure 7) However, we still believe that a diversified portfolio of stocks and bonds remains the best avenue for long-term investors to achieve their goals.
The S&P 500® Index is an unmanaged index consisting of 500 large-cap stocks. Since it includes a significant portion of the total value of the market, it also considered representative of the market. The index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The yield curve plots the interest rates of similar-quality bonds against their maturities. The most common yield curve plots the yields of U.S. Treasury securities for various maturities.
The CBOE Volatility Index® (VIX Index) is a measure of market expectations of near-term volatility conveyed by S&P 500® index option prices. The VIX Index is widely considered to be the world's premier barometer of investor sentiment and market volatility.
The S&P SmallCap 600® Index measures the small-cap segment of the U.S. equity market and consists of 600 stocks. The index is weighted according to market capitalization.
The Russell 1000® Growth Index is a subset of the Russell 1000® index that includes companies whose share prices have higher price-to-book ratios and higher expected earnings growth rates. The Russell 1000® Value Index is a subset of the Russell 1000® index that includes companies whose share prices have lower price-to-book ratios and lower expected long-term mean earnings growth rates. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index.
The price-to-earnings ratio is a valuation ratio which compares a company's current share price with its earnings per share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be derived from the estimates of earnings expected in the next four quarters (projected or forward P/E). The ratio is also sometimes known as "price multiple" or "earnings multiple."
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.
Moody’s Investors Service provides ratings to securities in order to provide investors with a simple system of gradation by which future relative creditworthiness may be gauged. Moody’s Aaa-rated obligations are judged to be of the highest quality, subject to the lowest level of credit risk. Its Baa-rated obligations are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.
The long-term average return data in Figure 7 comes from Morningstar. The long-term annual return for each asset class is the compound average annual return from the period from 1926 through 2016. Stocks are represented by the Ibbotson® Large Company Stock Index. Bonds are represented by the five-year U.S. government bond. Cash is represented by the 30-day U.S. Treasury bill. Balanced Portfolio is representative of an investment of 50% Stocks and 50% bonds rebalanced annually from 1926 through 2016. These returns are for illustrative purposes and not indicative of actual portfolio performance. It is not possible to invest directly in an index.
Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
May lose value
No bank guarantee
Investment management, retirement, trust and planning services provided by COUNTRY Trust Bank®.
All information is as of the report date unless otherwise noted.
Past performance does not guarantee future results. All investing involves risk, including risk of loss.
This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.
Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.
Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.
International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.
Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.
Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.
All indexes are unmanaged and returns do not include fees and expenses associated with investing insecurities. It is not possible to invest directly in an index.