The second quarter proved to be another very strong period for global stock markets. Larger-cap U.S. stocks (Vanguard 500 Index) gained 3.1%, developed international stocks (Vanguard Developed Markets ETF) rose 6.4%, European stocks (Vanguard FTSE Europe ETF) jumped 8.4%, and emerging-market stocks (Vanguard Emerging Markets ETF) rose by 3.4%. First half 2017 stock performance was even stronger. Larger-cap U.S. stocks surged 9.3%, while international indexes were each up in the mid-teens. In a reversal of May’s sector trends, U.S. financial stocks rallied in June on strong results from the Federal Reserve’s “stress tests” plus more positive sentiment given rising interest rates, while technology shares declined. Commodities prices and energy stocks remain a weak spot amid a global rally in risky assets. Oil prices fell 14% during the quarter and nearly 20% for the first half of 2017 on fears that production will continue to outstrip demand.
As we look back over the past quarter and first half of the year, a few things stand out. Overall stock market volatility remained extremely low, despite significant domestic political uncertainty and unsettling global and geopolitical events. The S&P 500’s actual realized volatility recently fell to near its lowest level in the past fifty years, according to a recent Goldman Sachs report, while the S&P 500 Index continued to hit all-time highs.
We think it is prudent to construct portfolios that are prepared for, and are resilient to, a range of potential outcomes. We maintain meaningful exposure to other more flexible and opportunistic fixed-income funds as well as to floating-rate loan funds. These investments should also provide some protection against rising interest rates and inflation.
For the U.S. equity market, the economic recovery is ongoing. S&P 500 company earnings are rebounding. And global central banks, including the Fed, are not expected to aggressively tighten monetary policy any time soon. But the current state is not sustainable for very long—something has to give. The Fed holds a big key as to how things might play out: will it tighten too much, too little, or manage it just right? Nobody knows, but based on history, we wouldn’t put all our chips on anysingle scenario. Potential changes to fiscal, tax, and regulatory policies are also big unknowns.
Based on our analysis of valuations and longer-term earnings fundamentals—even putting aside any near-term political or geopolitical risks—U.S. stocks present relatively unattractive expected returns over our five-year tactical investment horizon, evaluated across the macroeconomic scenarios we think are most likely to play out. Valuation risk is high and offers no margin of safety in the event the optimistic scenario currently baked into valuations doesn’t play out. Therefore, we are underweight to U.S. stocks and to equity risk in general, but we don’t see any particular near-term trigger for a sharp market decline.
Outside of the United States, we see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive longer-term expected returns. We have a moderate overweight to both European and emerging-market stocks.
We believe the outperformance of foreign stocks still has room to run given their superior valuations and earnings growth potential versus the U.S market. Even with their strong performance so far this year, our longer-term return expectations continue to favor Europe and emerging markets compared to the United States.
Most of the market reversals we’ve seen this year are consistent with, if not driven by, an unwinding of the so-called Trump trade. This is shorthand for the markets’ almost knee-jerk reaction (which soon became consensus) that Trump’s election and the Republican sweep of Congress would herald a period of inflationary, pro-growth fiscal, tax, and regulatory policies, unleashing the U.S. economy’s animal spirits. Instead, as the Trump administration has gotten bogged down in a myriad of other issues, with little progress on the economic front, confidence in that scenario has diminished.
Strategic Investing for the Long-term
We don’t think anyone can consistently and accurately time short-term swings in markets or inflection points in market cycles. It is when “the experts” are overwhelmingly aligned on one side of a trade and the consensus is strongest that a trend will continue, that it actually has the most potential to reverse.
That said, maintaining a degree of equanimity is a valuable attribute of successful long-term investors. Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macro events or who occupies the White House. Therefore, we believe it is beneficial for investors not to react to every domestic political development or geopolitical event with the urge to sell their stocks nor get overly excited and jump into the market on some piece of news they view positively. We don’t think refraining from such short-term trades is complacency—if the choice is supported by a sound decision-making framework. Having a disciplined investment process and a focus on the long term are essential to best achieve your financial objectives.
Putting It All Together
We don’t expect a recession in the near term, but we remain alert to and positioned to meet the high level of uncertainty that characterizes both global financial markets and the current geopolitical environment. We maintain exposure to assets—core bonds in particular, as well as managed futures—that should generate positive returns in the event of a recession and a bear market in stocks.
The foregoing content reflects the opinions of Treybourne Wealth Planners and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimics the performance of an index would incur fees and expenses which would reduce returns.