July 3, 2017
QUARTER IN REVIEW
For the second time this year, the Federal Reserve raised its benchmark interest rate during the 2nd quarter. Additionally, the Fed announced plans to reduce the balance sheet it expanded in response to the Financial Crisis. Corporate profits and revenues reported during the quarter surprised many to the upside. Earnings were up over 13% and revenues were up over 7% versus the same period a year ago. Not exactly the sign of an impending recession.
Despite the Federal Reserve’s move to raise interest rates, the yield on the 10-year treasury note declined during the quarter. A sign that the market is worried about slowing economic growth rather than inflation. The price of gold held steady during the quarter after rallying at the beginning of the year. Oil prices declined during the quarter. We will discuss our view on interest rates and these commodities later in the letter.
While stocks rose for the quarter, the S&P 500® Index remains in a 70-point range since the beginning of the year. It is also notable that the move higher has been disproportionately affected by the largest companies that comprise the Index. Because the S&P 500® Index is capitalization-weighted, the largest companies contribute more to performance than smaller ones. This can be shown when comparing the performance of the capitalization-weighted version of the index to that of the equal-weighted version of the index. For the quarter, the capitalization-weighted index rose by 3.09% while the equal-weighted index rose by 2.50%. Furthermore, the top 10 companies, in terms of size, saw their stocks rise by an average of 5.63%! That is more than double the performance of the equally-weighted index to which they contributed. This comparison highlights how narrow the performance of the index was during the quarter.
Looking back at our portfolio management decisions last quarter, we regret that we grew too defensive and sold stocks in anticipation of a market decline. The long-awaited decline never came and we find ourselves regretting the decision to sell stocks in our managed account portfolios. Being overly cautious, is a mistake we will make from time to time. We strongly prefer making this mistake rather than being too heavily invested at a time when the market does go through a correction. It is much harder to recover from a significant drop in value than to simply lag a rising market. So, while we regret our decision to be under invested, we believe the decision was made in a disciplined manner.
The market continues to transition into what we believe is the next 17-year cycle for stocks. The 17-year cycle which concluded at the end of 2016 was difficult for investors to say the least. Yet, stocks closed out the period at all-time highs. This has led many investors to feel weary that stocks are poised to “crash” feeling that prices cannot remain at such lofty levels. We feel this “fear” is unwarranted and believe a significant rally in stocks over the next 17 years is ahead.
Below is a chart which shows the price of the S&P 500® Index at the beginning and end of each of the last three 17-year cycles. The first period (1966-1981) is a period like the one which just ended. Stocks also ended this period at all-time highs, yet investors were bludgeoned at several points along the way. Most notably during the crash of 1974 when stocks declined by 50% (reminiscent of the 2008 crash). As you can see, while stocks ended the cycle higher, it was only by 26% over the Index’s price at the beginning of the cycle in 1966.
Now look at the period from 1982-1999. Stocks came into this cycle sitting at all-time highs. Yet over the same 17-year period, stocks rallied over 1,100%! The market crash of 1987 was notable but did not have nearly the same debilitating effect of the 1974 or 2008 crashes. Most of the volatility during this period was to the upside rather than the downside. This point deserves emphasis given that most people associate volatility with losses.
Finally, the chart shows the most recent cycle which concluded at the end of 2016. Stocks were at all time highs at the beginning of the year 2000, just as it was at the beginning of 1983, yet most of the volatility that followed was to the downside. The Index dropped by double-digit percentages for three years in a row (2000-2002) to kick off the cycle. Then, following a rally back to even, the Financial Crisis of 2008 cut the proverbial knees out from under investors as the Index dropped in price by 50%. While the rally since the Crisis has been strong, it has only recently taking the Index to an all-time high.
During this most recent 17-year cycle, the Index increased by 53% over the price it was at to begin the cycle. While this is not an abysmal performance, it pales in comparison to that of the previous cycle. Yet it is consistent with that of the cycle which it more closely resembles.
We believe the alternating pattern, which we have tracked back to 1898, will continue. If so, we expect the S&P 500® Index to trade between 25,000 and 40,000 by the year 2034. This would represent between a 11- and 20-fold increase and would be consistent with the period between 1982-1999.
|Level of the S&P 500||% Gain Over 17 years|
|January 1, 1966||93|
|December 30, 1981||117||26%|
|January 1, 1982||117|
|December 30, 1999||1464||1,151%|
|January 1, 2000||1464|
|December 30, 2016||2238||53%|
In response to this transition to a new 17-year cycle, we are adjusting the primary screen for choosing stocks from “Sector” to “Size.” Our investment discipline dictates that a shift in strategy is necessary when a new market cycle begins. Our managed account clients will notice companies being added to their accounts that represent the largest companies in the S&P 500® Index. Our research suggests that owning the largest companies in the Index is a sound approach to outperforming the overall Index.
The “narrowing” of the market, as we described earlier, is a signal that outperformance is going to come from the largest stocks. At the same time, we believe small-cap stocks will perform well, too. It will be mid-sized companies that will lag in performance relative to the small- and mega-cap stocks.
As we move into the 3rd quarter, we are leaving the decision to raise cash behind us. Our constant analysis of market indicators suggests the “storm” we feared was on the horizon may have passed us by… for now. Of course, a storm will arrive and caution will be warranted again. However, the research we conduct on behalf of clients suggests that the second half of 2017 will deliver solid performance results.
To drive this view home, we turn to our friends at Bespoke Investment Group who put out top-notch research that we rely on to form our outlook. In a June report, they published a report which looked at the performance of the second half of years in which there were few “drawdowns” or declines in stock prices. Only 1995 had a market decline that was less than what we saw in this year. Since 1928 there have been 17 years in which a drawdown of 5% or less has occurred. In those years, the average gain in stock prices for the second half was 7.8% with gains occurring 81% of the time. This compares to the average for all time periods (regardless of first-half performance) of 3.9% occurring 66% of the time.
So, this report suggests that the probability of gains occurring in the second half of this year is higher than average and the potential gains are higher than average.
Further adding to our conviction in moving to a fully-invested posture is the level of fear that exists in the hearts and minds of investors. When we detect a high level of fear among investors, we see this as a signal that the downside for stocks is probably limited. One reason this is the case is that when investors are fearful, they tend not to be fully invested. When investors are not fully invested it means there is cash on the sidelines which can fuel higher prices. If investors were optimistic about the future then they would be fully invested and prices would be at near their maximum levels as this optimism would be reflected in price.
If we are correct, then stock prices will rise in the second half and draw cash currently on the sideline into stocks. Eventually, if this persists, then cash levels will be reduced to a level where there is not enough to propel prices higher. It will also lead to investors “ringing the register” and taking profits. Both of which will cause a (normal) decline a stock prices.
So, rather than remain under-invested, we are moving our managed accounts to a more fully-invested posture with a focus on the largest companies in the S&P 500® Index. Additionally, for our managed accounts that are less growth-oriented and more income- and stability-oriented, we are continuing to focus on sectors but will also move to more fully invested.
For our clients in the Balanced Strategy, we will focus more on the sectors of Energy and Healthcare and less on Financials and Consumer Staples. We believe the dividend yields found in the Energy and Healthcare sector look very attractive and offer the opportunity to secure higher yields than we have seen recently in those sectors.
We believe a new market cycle has begun. We expect stocks to exhibit an upward bias for many years to come. Of course, there will be declines along the way but a multi-year rally reminiscent of the 1982-1999 period is ahead. Innovation, economic growth, tax reform, population growth and many other factors will propel stocks higher. Investors will need to re-learn the discipline of “buy the dip” and forget the “sell in May and go away” mantra.
The largest and smallest companies will perform well in this new cycle. The KIG approach to managing client accounts will focus on these companies to deliver performance.
Our analysis suggests that stocks will rise in the second half of the year. While we regret raising cash in the first half of the year, we are moving managed accounts to a more fully-invested posture in anticipation of these higher prices.
Kessler Investment Group, LLC