First Half 2017 Newletter

A Look at this Year through June 30, 2017

After a decade of outperformance by US stocks, their European and Asian counterparts started off the year stronger. The Euro Stoxx 50 Index, a measure of the supersector blue chip stocks in the Eurozone returned over 15% through June 30, 2017 while the S&P China Index grew over 20% through the mid-way point. This, as compared to high single digit returns provided by the S&P 500 and Dow Indices.

Domestic bonds have recovered nicely in 2017 after a very rough Q4’16. This had resulted from a sharp rise in interest rates after Trump’s election win which spurred inflation expectations and so far, only a minor setback for bond prices.

Commodities are a mixed bag. Gold has fared very well this year up 6.96% YTD as measured by the SPDR® Gold Index fund (which holds roughly 27 million ounces or 765 metric tons of gold bullion). On the other hand, oil and the energy sector stocks have retreated. The US Oil fund was down almost 20% through the halfway mark while the Standard & Poor’s Energy Sector Stock Index declined 12.74%.

The strongest industries domestically have been healthcare and technology up 15.92% and 14.21% respectively as measured by the Standard & Poor’s benchmark indices. Bio-tech stocks in particular buoyed the healthcare index returning > 30% in the first 6 months of the year after significant underperformance in 2016 relative to the rest of the US stock market.

Long-Term Outlook

We continue to feel that domestic stock valuations are at levels that can only be justified because of the weak value proposition in the alternative… bonds. Bonds only provide positive returns in two ways: (1) the coupon, a.k.a. interest rate, and (2) price appreciation. Price appreciation typically occurs when interest rates fall. Given that rates are already at near historical lows (the 10-year treasury closed 6/30/2017 at 2.31%), the expected returns from bonds’ coupons and potential price appreciation is weak as rates don’t have that much room to go lower. This is no secret and it’s causing increased demand for stocks which is bidding up their prices as more investors are capitulating thinking rates will be lower for longer. If this low rate trend stays in place for too long it will create stock bubbles (many smart people argue we are already in a bubble) and possibly real estate bubbles as property investors lever up at dangerous levels taking advantage of cheap mortgage rates.

So, why not pull out of stocks altogether? It’s rather simple. We aren’t good enough, and unfortunately no one is, to precisely time when this low interest rate environment will end causing stocks to fall in value. Also, in the long-term, using nearly 100 years of history, stocks tend to provide 8–10% annualized returns if you give them at least 10 years to grow. So, we will never be “all the way out” of stocks, but, given the fact that we are in the 9th year of a bull market, valuations are stretched, unemployment has very little room to go down, individual tax rates have very little room to go down, debt as a percentage of our GDP continues to go up, etc. we are underweight stocks. However, we are also underweight bonds because of the weak expected returns we see given low coupons and insignificant price appreciation potential. So, what are we buying? We are overweight REAL assets such as tangible real estate, gold, and productive commodities. We feel this is our best hedge against inflation. This strategy may take a while to play out but ultimately, we feel it’s the right move. We are also steadily increasing our weighting to foreign stocks (both developed and emerging) as we think the foreign market recovery relative to US equities that started in the first half of 2017 could persist for some time.

Developments You Should Pay Attention to in the Second Half of 2017

Can the US government push through lower corporate tax rates to make our domestic corporations more competitive globally? Will there be a short-term tax rate reduction on Corporations’ repatriated cash coming in from their overseas entities? Will the government push through an infrastructure spending package?

What’s taking so long? We will see what happens, but in general, the market still anticipates headway will be made in all three of these areas. Why do we think so? Because all three agendas would boost corporate profits which ultimately fuels stock market growth. If “the market” didn’t think these things were going to happen, you would have seen a very different result in the first six months of 2017.