January 15, 2018
Every year at Christmas, my family takes part in a white elephant gift exchange. Everyone brings a gift to the exchange, and then participants draw numbers to determine the order you get to choose a present from the pile — or “steal” a present from someone who already chose theirs.
The goal of the game? Take home the best present. This year, I won a virtual reality headset. Although the headset still sits at home in its unopened box, I can’t help but think of it when I look back at the lay of the investment land from the start of 2017.
After all, as it turned out, 2017 felt much more like virtual reality than actuality.
When 2017 began, many analysts pointed to the fact that valuations in the U.S. were above their long-term averages and cautioned investors of a pullback where stocks would revert back towards their long-term average valuations.
But as we know today, the Dow, S&P 500, and Nasdaq all finished up more than 20%, including dividends – more than double their historical annual returns. To top it off, the S&P 500 achieved gains in every month of 2017, a feat never before seen in its 90-year existence.
At the beginning of the year, many investors also favored the U.S. over International markets. They felt more optimistic about U.S. growth than growth overseas, and had grown tired of recent International underperformance since 2012. The reality of 2017 turned out to be that international markets outperformed the U.S.
What propelled us beyond the forecasted reality for US markets? We can thank an improving economy along with corporate earnings that continued to exceed expectations.
Last year served as an important reminder that while market valuations are a meaningful predictor over the long term, they are a poor prognosticator for short-term returns.
Outside the US, emerging markets led all equity asset classes finishing the year up almost 35% thanks in part to strengthening commodity prices, a weaker U.S. dollar, and strong performance from China. International markets also performed well as deflation fears dissipated and political stability improved.
2017 served as a good reminder for all investors that market leadership between U.S. and International tends to be cyclical — which is why owning International and emerging market stocks can be a valuable contributor to a diversified portfolio.
After President Trump was elected, many bond prognosticators called for higher interest rates in 2017 and thus were bearish on bonds. Analysts expected borrowing for infrastructure spending and improving economic growth to push inflation and interest rates higher, thus sending bond prices lower.
In reality, the benchmark for the U.S. bond market finished up more than 3% as 10-year government rates were unchanged. 30-year government rates actually fell during 2017. Infrastructure spending was pushed to 2018, inflation remained below the Fed’s target, and the relative attractiveness of U.S. interest rates compared to the rest of the world all served to keep interest rates contained.
While 2017 bond returns paled in comparison to stocks, it’s important to remember that bonds serve a critical role in a diversified portfolio by providing a steady income stream and a stabilizing presence when values of stocks decline.
As investors turn the page to 2018, most still feel the excitement and exuberance a terrific 2017 provided. And while there remains reason for optimism as the economy strengthens, we remind our investors that many of the risks from last year remain.
The market will continue to carefully watch the Fed as it continues to raise short-term rates and reduce the amount of bonds they hold as part of their quantitative easing policy.
Though somewhat dormant recently, the geopolitical threats of ongoing disputes with North Korea and Iran could cause a market disruption. Trade disputes surrounding NAFTA and China could also upend markets.
The tax reform should be a positive for the market, but the future benefits remain uncertain. The efforts to pass healthcare and tax legislation should serve as a reminder of the ongoing risk of policy missteps to the market as President Trump continues to implement his political agenda.
Last year felt like a virtual reality of sorts. Equity markets returned more than twice their long-time averages despite concerns of valuations, and bonds generated positive returns in the face of fears of rising rates.
The surprises of 2017 are a valuable reminder to investors that the prediction game is a difficult and dangerous game to play when it comes to achieving your financial goals. While economic growth and corporate earnings suggest the market can continue to prosper in 2018, investors should brace for lower market returns after a banner year and expect more market volatility than the historically low level of 2017 as risks to the market persist.
After such a strong year, we urge you to guard against complacency and overconfidence in your investment decisions. Otherwise, you may wish your reality more virtual and less actualized this time next year.
Don’t let your emotions — even positive ones — override your solid, strategic investment plans.
John Fischer, CFA®, CFP®
Chief Investment Officer