US under-performs Global stock rally…


A lot has been made of the fact that US stocks are making new all-time highs on a daily basis, while seeming to ignore all political volatility. It’s true that volatility measures such as the S&P 500 Volatility Index (VIX) are near record lows. However when we take into account how global stocks are performing, a case can be made that investors are in fact reacting negatively to these issues.

The above chart illustrates the year-to-date performance of the global financial markets. The US large cap index (S&P 500) and US small cap index (which is a barometer of the domestic economy, since most companies in the index generate about 90%+ revenues domestically), although both positive this year, are under-performing the international and emerging market stock indexes by a reasonably large margin.


Even if we go back to election day, US stocks still lag behind a little bit.


Now in fairness, this is a very small sample size. If we look back over the last 6 years, US stocks crush international. So it’s quite possibly a case of reversion to the mean.

International stocks offer more attractive valuations and dividend yields. However investors should also be aware of the equity risk premium, which is still very attractive.


Small cap/Financials weakness a concern?


One of the themes this year has been the relative under-performance of the Russell 2000 index. This index is comprised of small cap stocks that generate almost all of their revenues domestically.

The chart above shows the year to date performance of the index, struggling to stay above the break even level so far. While the S&P 500 is up close to 8.5% in that same time frame.


In the same manner, financials have also struggled to stay positive year to date. Showing similar relative weakness.

Financials make up 14.1% of the S&P 500. So is this combined weakness in small caps and financials a threat to the advance?

Well we know that there is always going to be something to be concerned about. Investors waiting for the perfect moment will be waiting forever, and end up paying high prices whenever they do decide to jump in. That being said I think the answer to this question is simply choosing too small of a time-frame.


If we look at a one year time-frame, all of a sudden we see that there is in fact relative strength in the Russell 2000. Outperforming the S&P 500 by almost 6 percentage points.


Same with the financials. A one year time-frame shows relative strength, with the sector outperforming the S&P 500 by about 5 percentage points.

This of course doesn’t mean we couldn’t suffer a correction. My point is that there is no need to make any serious portfolio changes based upon five months of trading. A simple change in perspective can make a lot of difference.

The stock market has been advancing due to better earnings and global GDP growth. The earnings growth for the S&P 500 came in at 13.9% for the 1st quarter, which is the highest growth rate since Q3 2011.

Much of the rally up likely had little to do with politics. So it’s no surprise that the market has so far been able to ignore the recent headlines.



Data suggests more upside

Coming off a weekend of political disappointment, it’s easy to get caught up in the emotions of it all. As I pointed out, the market was due for a pullback, and it got a reason to. We can “beat a dead horse” and dissect all of the “what-if” scenarios and implications of the failure. But none of this will be fruitful for your investment decisions. We know that pullbacks and corrections are an inevitable part of investing. And once in awhile we get a major decline, usually due to a recession. The key question is does the data suggest a business cycle peak?

The short answer is no.


Consumer confidence numbers just came out at a high not seen since November 2000.

Small business optimism

Scott Grannis points out that Small Business Optimism has soared post election and is near all time highs.


Earnings growth is finally back and is projected to be around 9-11% for 2017. This would be the largest annual increase in earnings since 2011. And this doesn’t even factor in the potential for tax reform and repatriation.

And interest rates are still very low. The earnings yield on the S&P 500 is currently 5.59%, while the 10 year treasury bond yield sits at 2.38%. Even the Fed’s overly optimistic projection suggests the real Federal Funds rate won’t even turn positive until another two years or so. So, even though valuations are on the high side and interest rates have risen quite a bit post elections, stocks still present an attractive risk premium.


An interesting chart to follow going forward is the ten year yield. Post election the 10 year yield has risen on the assumption of pro-growth policies of the new administration. Since then a trading range between 2.3% and 2.62% has been formed. An upside breakout suggests all is clear, while a breakdown suggests that more of the President’s agenda may be in jeopardy.

Time will tell. But for now, things are looking pretty good to me. But I parse this by saying we’re probably closer to the end of the bull market, than we are to the beginning. The stock market and the economy don’t always correlate. We’ve had great performance in stocks over the last 8 years, while the economy largely under-performed. I wouldn’t be surprised if, going forward, we experience a situation where the economy starts to outperform, while stock performance slows down to an eventual crawl.

The great thing about diversification and asset allocation is that we don’t have to be prophetic. We stick to our strategy and re-balance when necessary. It’s that simple, but certainly not easy.

Don’t fear a market correction…


Today the market has experienced its largest intra-day decline for the year. There is no doubt that you’ll hear numerous explanations for the decline, from the health care bill, to Dodd-Frank and bank stocks. The truth is that these market corrections are commonplace and they usually come and go without any real rhyme or reason. The simplest explanation for today’s price action is that the market was simply over extended in the short term and was due for a pullback.

The chart above is the weekly chart of the S&P 500. We see that when price gets too far away from the 50 week average, there is oftentimes a reversion to the mean. This is natural and it doesn’t mean the “big crash” is upon us.

It’s been years since the S&P 500 got this far above its 50 week moving average. And in most instances when it gets 10%+ above the 50 week average, a correction usually follows.

Corrections between 5%-15% occur frequently, and it’s almost impossible to time. This is why having an allocation to high quality bonds can have some benefit. As they will generally appreciate and offset some of the decline in stocks, thus limiting the volatility of the total portfolio. This way you don’t need to try to time the corrections, you simply let the diversification benefits hold you over until the dust settles.

This is also a great time to assess your investment strategy based upon your emotions. If today’s actions have you concerned, you may be more aggressive then you can tolerate. After all, we are still only down about 3% from all time highs. So it’s not even an official correction yet. But it’s better to be prepared beforehand, because they don’t ring a bell and let you know the market is topped out and ready for correction.


Q4 performance not as good as it seems…

Successful investing involves remaining balanced when market forces tempt us to make major portfolio decisions at inopportune times. Q4 was an interesting transition period and I think investors need to understand the bigger picture to avoid making any reactionary decisions.

We’ve spoken at length about how the Dow hitting a meaningless 20,000 target should not change your approach. The Dow is a broken index with only 30 stocks without broad sector exposure.


Let’s dive into the Q4 performance. The chart above shows Q4 performance for the major asset classes. As you can see, it’s not nearly as good as the media portrayed it to be. The S&P 500 was up close to 4%, but the bond market fell by an equal amount and international stocks were also negative, due to a rising US dollar.

It’s very possible that a globally diversified portfolio ended the 4th quarter negative.


If we drill down to the sector performance for the US stock market, we can see that the relative strength came mostly due to Financials, Energy and Industrials. Of course these are the same sectors that have under-performed much of the last five years.  The consumer discretionary (Amazon’s), Technology, consumer defensive and health care sectors all under-performed on a relative basis.

I would venture to say that many investors had more exposure to the sectors that under-performed. So the temptation for investors is to now pile into the thing that has gone up the most. So go all in financials for 2017?


But before you go there. Take a look at this annual sector performance chart. Can you see any discernible patterns here?  If anything you can see that oftentimes the best performing sector one year turns out to be the worst performing sector the next. So before you go making a major change because of one quarter’s data, remember that change isn’t likely to yield any significant positive outcome.

This all brings me to the main message. The markets can do crazy things in the short term. But the reason why we invest doesn’t change. We don’t invest for one quarter, or even one year, we invest for long term goals while maintaining a certain level of risk.

Unfortunately there is no strategy that works well in every market environment. A conservative allocation will do well in periods of volatility, and under-perform when the stock market is rising rapidly. An aggressive portfolio will work great when the market rises rapidly, but will be very painful during the inevitable downturns.

A balanced portfolio will mean that you’ll usually hate some part of your portfolio each year. But oftentimes that part of the portfolio that you hated last year, will be your best friend the next, as mean reversion runs its course.

Rather than trying to constantly predict what type of market environment we’ll experience each year. It’s best to accept that just like the seasons change, the markets seasons change too. Periods of declining markets give way to periods of rising markets, which give way to periods where the market moves up and down without making any direction (not always in that order).

Investors should be more concerned about what what typically works over time, rather than what is working right now. The truth is that long term investing should be rather boring.