Stock markets in the U.S. and abroad continued their strong performance in the second quarter of 2017. The S&P 500 Index generated positive returns for the seventh consecutive quarter, with total returns of 3.1%. For the past two quarters, international markets outpaced U.S. markets. Emerging markets, which have lagged the U.S. for most of the past 10 years, posted total returns of 17.2% for the first half of 2017. Stock performance was fueled by higher corporate earnings, positive economic news, and a continuing low interest rate environment.

The table below shows the performance of major equity indices for various time periods.

Equity Performance for Periods Ending on June 30, 2017

Total Return Index Market Sector Quarter YTD 1-year 3-year 5-year 10-year
S&P 500 Large U.S. Companies 3.1% 9.3% 17.9% 9.6% 14.6% 7.2%
Russell 2000 Small U.S. Companies 2.5% 5.0% 24.6% 7.4% 13.7% 6.9%
MSCI EAFE Developed Int’l Markets 5.0% 11.8% 17.1% -1.5% 5.8% -1.8%
MSCI EM Emerging Int’l Markets 5.5% 17.2% 21.2% -1.3% 1.5% -0.5%

According to FactSet Research, companies comprising the S&P 500 Index are expected to report 6.6% higher earnings in the second quarter as compared to the prior year. Over the next twelve months, S&P 500 earnings are forecasted to rise by 9.3%. Improving earnings help to support the current valuation level. During the quarter, the market’s price-to-earnings (P/E) ratio (based on next 12-month estimates) actually declined slightly, from 17.6 to 17.4, as the increase in forecasted earnings outpaced the advance in stock prices. At this level, we consider the U.S. stock market to be slightly overvalued. While impossible to predict, a small correction would not be surprising. Developed and emerging international markets appear to be more reasonably valued, with forward P/E ratios of 15.8 and 12.2, respectively.

Most economic indicators point to continued modest growth in the U.S. economy. The Wall Street Journal’s survey of more than 60 economists is forecasting 2.5% GDP growth for the second half of 2017. The U.S. unemployment rate currently stands at 4.3%, its lowest level since 2001. Consumers’ balance sheets continue to improve. According to Fair Isaac Corporation (FICO) the average consumer credit score rose to 700, the highest level since 2005. Only 20% of consumers have a credit score below 600, the lowest level on record. Inflation remains low, helped by falling energy prices. Crude oil prices fell 14.3% in the first half of 2017. New home sales slowed during the quarter, but many analysts attributed the decline to a shortage of supply, rather than housing market weakness, as housing prices continued to show strength. In its most recent report, CoreLogic reported that home prices nationally increased by 6.9% in April from the previous year and forecast a 5.3% increase for the next 12 months.

The stock market’s gains for the quarter were especially impressive considering that the proposed changes that fueled the Trump rally following last year’s presidential election are now bogged down in the politics of Washington. The anticipated benefits from lower taxes, healthcare reform, decreased regulations, and increased infrastructure spending now appear to be less certain. While the administration is still perceived as business friendly by the stock market, its inability to achieve change will likely be interpreted negatively.

As was widely anticipated, the Federal Reserve increased its benchmark interest rate by a quarter of a percent to a target range of 1% to 1.25% in June. The Fed also announced that it will begin the process of reducing its balance sheet. In trying to stimulate the economy following the Great Recession, the Fed employed two major tools: it reduced its benchmark interest rate to a range of 0% to 0.25%, and it purchased Treasury, mortgage-backed, and government agency securities to further depress interest rates. Now that the economy is on firm footing, the Fed is attempting to reverse its “extraordinary” actions, primarily so these tools will be available when the economy needs monetary stimulus in the future. In addition, the Fed is interested in returning interest rates to normal levels, since artificially low rates can produce unintended negative consequences. For example, many conservative investors who in the past invested in savings accounts and certificate of deposits have shifted to more risky investments, such as stocks, in search of higher returns. These investors could suffer unexpected losses if markets experience a correction. The current economic expansion will need to continue for several more years for the Fed to successfully rebuild its monetary toolset.

The yield on the 10-year Treasury bond declined from 2.40% to 2.30% during the second quarter. The decline in long-term interest rates likely reflects concern over economic weakness by bond investors, which contrasts with the positive sentiment of stock investors. The Barclays Aggregate Bond Index, the broadest benchmark for the U.S. taxable bond market, generated returns of 1.4% in the quarter. We continue to regard long-term fixed income investments as unattractive due to low return expectations and the risk related to rising interest rates.

On June 9, the Department of Labor’s Fiduciary Rule became effective. This rule requires financial advisors to act in the best interest of their clients with respect to retirements assets, including IRA and 401(k) accounts.

As a registered investment adviser, Vista Investment Management is already required to act in a fiduciary capacity with respect to all accounts under management, not just retirement assets.

The DOL Fiduciary Rule will likely have a significant impact on brokers and insurance agents who sell products for use in retirement accounts. These financial advisors have historically worked under a lower standard of care. Previously, they were simply required to recommend a product that was suitable. Under the “suitability standard” the investment did not have to be in the client’s best interest. As long as it was deemed suitable, it could be a high-commissioned product that was instead in the best interest of the broker or agent. The DOL Fiduciary Rule intends to eliminate this conflict of interest and provide greater transparency regarding commissions and fees. Outside of retirement accounts, brokers and insurance agents will still be free to use the suitability standard to put their interest ahead of their clients.

John D. Frankola, CFA

The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.