Market Review - Fourth Quarter 2017
Major stock markets around the globe ended the year with strong performance. Robust economic growth, higher corporate earnings, and a cut in the corporate tax rate helped to send stocks to record levels, with the S&P 500 Index generating fourth quarter total returns of 6.6%.
The table below shows the performance of major equity indices for various time periods.
Equity Performance for Periods Ending on December 31, 2017
|Total Return Index||Market Sector||Quarter||1-year||3-year||5-year||10-year||15-year|
|S&P 500||Large U.S. Companies||6.6%||21.8%||11.4%||15.8%||8.5%||9.9%|
|Russell 2000||Small U.S. Companies||3.3%||14.7%||10.0%||14.1%||8.7%||11.2%|
|MSCI EAFE||Developed Int’l Markets||3.9%||21.8%||4.9%||5.0%||-0.9%||5.2%|
|MSCI EM||Emerging Int’l Markets||7.1%||34.3%||6.6%||1.9%||-0.7%||9.6%|
The stellar fourth quarter extended the current bull market (which began in March 2009) to the second-longest on record in the 90-year history of the S&P 500. As of quarter-end, the S&P 500 marked the ninth-longest period without a 10% correction (1.9 years), the second-longest period without a 5% correction (1.5 years), and the longest period without a 3% correction (1.2 years). And, for the first time ever, the S&P 500 rose in each of the calendar months of the year. The market’s ascent has also been relatively smooth, with record-low volatility. In 2017, the S&P 500 did not have a single day when it moved more than 2% in either direction. This contrasts with the volatile years of 2008 and 2009, which both had more than 50 days with 2% moves.
The U.S. economy continued to show strength as the year progressed. Gross domestic product (GDP) rose 3.2% in the third quarter of 2017 with expectations for similar growth in the fourth quarter. The current 4.1% unemployment rate is the lowest level since 2000. The Conference Board Leading Economic Index points to continued growth into 2018 on the strength of new factory orders, high consumer confidence, and lower unemployment insurance claims.
Foreign economies are also picking up steam. For the first time since the financial crisis, all 45 countries tracked by the OECD are showing economic growth. This is positive for both international companies and large U.S. companies with a global footprint.
Strong corporate earnings continue to provide support for higher stock prices. FactSet Research, a firm which compiles analysts’ estimates, has forecast that S&P 500 companies will report earnings growth of 10.9% in the fourth quarter and 9.6% for all of 2017. If these estimates are correct, 2017 will have the highest earnings growth rate since 2011. The estimated earnings growth rate for 2018 is even higher, at 11.8%.
The market’s advance in the fourth quarter was at least partially fueled by passage of the tax reform bill, which lowers tax rates for corporations and most individuals. The corporate tax rate will drop from 35% to 21%. The most immediate impact on corporations will be an increase in their earnings per share, which could boost stock prices further. The promised benefits to the broad economy are expected to be increased hiring, higher pay to employees, more spending on research and development, and greater investment in equipment and facilities. The bill’s advocates also hope that the tax cut for individuals will lead to increased consumer spending and a higher standard of living.
The primary arguments against the tax bill are that the tax cuts amount to fiscal stimulus at a time when the economy is already very strong and corporations have cash-rich balance sheets. As a result of the cuts, the nonpartisan Joint Committee on Taxation estimates the U.S. government will need to borrow an additional $1.5 trillion over the next ten years. Furthermore, many have claimed that the tax cuts favor corporations and the wealthy at the expense of the poor and middle-class. While it could take years to determine the true impact of these tax reforms on the economy, the stock market’s initial reaction has been positive.
After such a strong year for stocks, it is always good to reassess the current risks. While the Federal Reserve and other foreign central banks helped restore financial stability following the financial crisis, it is important to keep in mind the extraordinary means employed to that effect. Interest rates have still not returned to historically normal levels and there are still risks associated with the unwinding of monetary policies which could lead to a recession. There are geo-political risks related to terrorism, cyber warfare, election integrity, and the actions of unstable governments. There are market risks related to the valuation of certain sectors and asset classes. There are credit risks related to countries and companies that may struggle to pay creditors as the cost of borrowing rises. Notwithstanding the outstanding performance of stocks in 2017, it is important to remember equities have downside risk. The S&P 500 Index has experienced negative returns in 26% of the years since 1927. While the outlook is positive, a market correction is certainly within the realm of near-term possibilities.
The Federal Reserve raised its benchmark interest rate to a range of 1.25% to 1.50% in the fourth quarter. It was the third 0.25% increase in 2017. Most analysts expect three similar increases in 2018 as the Fed attempts to move rates to more normal levels. The yield on the 10-year Treasury bond increased from 2.33% to 2.41% during the fourth quarter. The Bloomberg Barclays Aggregate Bond Index, the broadest benchmark for the U.S. taxable bond market, generated returns of 0.39% in the quarter. The average maturity of fixed income investments in our managed portfolios remains relatively short, as we regard long-term fixed income investments as unattractive due to the risk related to rising interest rates.
While we always try to proceed with caution, we currently have a positive outlook for the near term. We believe that strong corporate earnings growth, positive economic conditions, low interest rates, and generally reasonable stock valuations provide a good environment for investors. It feels like we are in the sixth or seventh inning of a slow moving game.
We wish all of our clients the best for 2018.
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.