The first quarter of 2017 was very strong for stocks, extending valuation levels even higher, since stock prices increased more than underlying earnings and book value. International equity asset classes outperformed U.S equities during the quarter, and if this is the start of a new trend, which we discussed in our last LTWM Insider Q4 2016 blog, http://www.laketahoewealthmanagement.com/blog/ltwm-insider-market-and-economic-commentary-q4-2016, it could be very good news for globally diversified portfolios. It is our core belief that globally diversified portfolios offer better long term risk adjusted returns than investing in only U.S. asset classes and we will provide detailed research in our “Deeper Look” section below. With asset class valuation levels so high, especially in the U.S, and the Federal Reserve raising interest rates, it is important to be cautious since a negative economic or geo-political event could cause a correction in stocks, bonds, and real estate.
World Asset Class 1st Quarter 2017 Index Returns
First quarter index returns were strong for U.S stocks and stronger for international stocks, while emerging market stocks led all asset class returns. Global real estate stocks were positive but below their average quarterly return of 2.7%, due to increasing short term interest rates. For the broad U.S. stock market, the first quarter return of 5.74% was well above the average quarterly return of 1.9% (since January 2001). International stocks returned 6.81% for the first quarter, well above their average quarterly return of 1.4%, and Emerging Market stocks were even better, up 11.44% vs. their average quarterly return of 3%.
A larger sample of asset class returns shows the strength of emerging market and international developed stocks over U.S. stocks, while real estate lagged behind. The value effect was negative for the first quarter, after a strong showing during the last quarter of 2016. The size effect was strong in emerging markets and developed international stocks but underperformed in the US.
Bond market returns were positive for our fixed income investment funds, even though there was a shift up in the yield curve at the very short end, due to the Federal Reserve increasing the overnight lending rate another 25 basis points. The five-year Treasury yield was unchanged for the quarter, ending at 1.93%, while the yield on the 10-year Treasury Bond decreased by 5 basis points to end at 2.4%; and the yield on the 30-year decreased 4 basis points to end the quarter at 3.02%. Here is the shift up in rates for the first quarter at the short end; please take a look at the maturities from 1 month to two years (the blue line is yields on 12/31/16 and the green line is 3/31/17):
When the yield curve shifts up, bonds lose value but there was very little damage to bond funds since the shift was at the very short end of the curve. The increase at the short end does affect the prime rate and other variable rate debt, increasing costs for companies using variable rate debt to fund projects. The long end of the curve is not going to shift up until inflation expectations are stronger. The Citi World Government Bond Index (1-5 years) is well ahead of long term government bonds for the year. Notice high yield bonds are up over 16% for the past year, which is a sign of continued investor preference for riskier securities.
One cannot time markets and typically the short term is just noise. The strong start for equity returns in January continued throughout the first quarter, in the U.S and internationally. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A Deeper Look
The Russell 2000 Index finished the first quarter up 17.66% going back to November 1st, 2016, while the S&P 500 is up 11.89%, over the same time period (price change only). The large cap index has closed the outperformance gap of small cap, but small cap stocks are still ahead of large cap stocks since the Presidential election. Here is a chart of the S&P 500 large cap index in blue and the Russell 2000 small cap index in green from November 1st, 2016 through March 31st, 2017. (Source: Yahoo Finance)
Long-term research shows that U.S. stock market performance compared to international stocks is cyclical and at the end of 2016, the U.S. had outperformed international stocks for 110 months (over 9 years), which is one of the longest cycles of relative U.S. outperformance on record. For the past three months, international stocks, as measured by the MSCI EAFE index, have outperformed U.S stocks, as measured by the S&P 500. The positive indicators for International stocks, including a strong U.S. dollar, lower valuations in Europe and emerging markets, economic expansion in Europe with higher inflation expectations, and now positive money flows into international stock markets, could continue to support the continuation of this new trend. Of course geopolitical risk could jeopardize both U.S. and International stocks, and past performance is not indicative of future results.
The S&P 500 index has been much stronger than international stocks in recent years and globally diversified portfolios have underperformed. If we compare a global balanced equity strategy that is created from Dimensional indices (the exact details of the globally diversified portfolio used in this analysis are disclosed at the end of this blog), with U.S. One-Month Treasury Bills and the S&P 500 since January 2010, you can see that one dollar grows to $2.33 for the S&P 500 and only $2.12 for the Global strategy:
However, let’s look at other time periods prior to the past seven years. The previous 10 years to the one above, has the global equity strategy well ahead of the S&P 500. This time period, January 2000 through December 2009 was known as the "lost decade" for the S&P 500, since the index actually lost money over 10 years, under-performing One-Month U.S. Treasury Bills. The lost decade was the time period following the dot-com crash.
Prior to the lost decade, the S&P 500 did very well during the 1990s. From January 1990 to December 1999, one dollar invested in the S&P 500 grew to $5.33, while the global balanced equity strategy returned $3.59.
During the 80s, the global balanced equity strategy returned $7.32 vs. $5.04 for the S&P 500, so it was an even stronger time period for the global strategy than the 90s were for the S&P500.
If we go back one more decade into the 70s, the global strategy is again on top, returning $3.50 vs. $1.77 for the S&P 500, which under-performed U.S. One-Month Treasury Bills during the 10-year time period.
One of the most striking graphs is the cumulative return comparison between a DFA Global Balanced Portfolio and the S&P 500 since 1970:
The global strategy returned 400x the money invested, while the S&P 500 returned 100x.
Let’s also take a look at and annual return matrix since 1970 and comparing rolling 10-year period returns since 1980. The global equity strategy performs better than the S&P 500 85.3% of the time (notice the white periods in the late 90s and more recently, when the S&P 500 is better):
The global equity strategy over 10 year periods performs better than the S&P 500 84% of the time. The S&P 500 has better rolling 10 years returns during the late 90s; and just recently in 2016.
There are more benefits to owning a globally diversified portfolio than just cumulative return, since extreme results in both directions are avoided (less volatility). Notice in the following chart, how the globally diversified portfolio has annual returns in the middle, while the S&P 500 Index has more annual returns above (in green) and below the global portfolio (in red):
Remember that the global equity strategy includes U.S. large cap stocks, but it also includes many other asset classes that have returns that zig while the S&P 500 zags. The diversification benefits occur from holding many uncorrelated asset classes. By choosing globally diversified portfolios, we increase the benefits of diversification by removing extreme results and improve long term expected returns.
Shifting back to equity asset class valuations, the first quarter stock market rally in the U.S. pushed valuation measures to new highs. At the end of the first quarter of 2017, The P/E 10 ratio (price divided by 10 years of earnings) was 29, which is a new interim high, since the dot com bubble (it is now above levels during the great recession of 2008/9); and is also two standard deviations away from its historical geometric mean. You can view the P/E 10 charts at https://www.advisorperspectives.com/dshort/updates/2017/04/04/is-the-stock-market-cheap
At the end of the fourth quarter, the S&P 500 P/E ratio was 20.5 for 2016 year-end EPS, and the current P/E ratio April 7th, 2017) is 22.24, comparted to the historical average of 17. If we look at the S&P 500 price to sales ratio, which is the ratio that can’t be manipulated with accounting methods, it is at a new record of 2.08. The U.S. stock market has even higher expectations built in for the new “business friendly” administration, which is now caught up in a failed health care plan and potential delays in tax reform and infrastructure spending to help boost our current late stage economic cycle.
The research is strong for holding globally diversified portfolios, while leveraging the factors of value and size. Economic news around the globe continues to be neutral to positive. Geo-political risk has increased with tough talk in North Korea and military actions in Syria. The Federal Reserve is on target to raise the overnight lending rate two more times this year and three times next year to bring interest rates from very low to normalized levels, which does act like a brake on the global economy. Valuation multiples expanded and will likely need to be supported by earnings growth later this year. Global GDP growth is still low, global debt levels are still very high. We are closely watching growing auto loans and declining auto sales; and student loan debt in the U.S., non-performing loans in Europe and China and other variable rate debt, which is now more expensive due to higher short term interest rates. We will be watching for corporate earnings guidance during first quarter earnings season, which is about to kick off. If there is any significant reduction in the 2017-year end S&P 500 earnings target of $129.78, which equates to a P/E of 18.21 (still above the historical average of 17), stock prices could decline. We will continue to be prudent in our investment committee meetings during the second quarter.