We had a very good year. It is fair to say that the stock market did far better than most experts thought possible at the beginning of 2017. The only thing that’s not surprising is that financial markets remain full of surprises – positive ones this time. The most aggressive projection made a year ago by a major institution was for the S&P to end at 2500. It ended at 2673.
Let’s rewind to earlier in the year. In January, a survey of 16 major firms on average predicted a gain of 4.05% for the S&P 500 in 2017 – which would have put it at 2330. And here is an excerpt from an article on the Bloomberg website, dated last April 20 :
Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.
The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure — the value of the stock market relative to the size of the economy — should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.
Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.
Last week, Guggenheim Partner’s Scott Minerd said he expected a “significant correction” this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.
Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.
Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive.”
That was then. In fact, the S&P 500 Index produced a total return of 21.7% in 2017. Corporate earnings rose by an estimated 9.6% this year. The combination of increased earnings, continued low interest rates, and corporate tax cuts has kept this long stock rally going. I think the feeling of a less burdensome regulatory environment contributed to the rally as well.
As is often the case, there is quite a dispersion in returns. The Nasdaq Composite Index returned 29.6% for the year while the Russell 2000 Index of smaller companies returned a more modest 14.6%. Growth stocks returned somewhere between 10.6% and 12% on average more than value stocks, which are generally more stable and offer higher dividends. The lower number comes from Vanguard ETFs; the higher number from Cliffwater, a consulting firm.
Valuation alone is not a good means of timing the market. As we noted in our April letter: “What happens when the market reaches top decile valuation? Well, it got there in January 1997 and nearly doubled from there in the next three years.” But the following three years, when the tech bubble burst, made clear that risk increases when valuations rise.
We do our best to control risk by attempting to limit drawdowns – sometimes with orders designed to limit those drawdowns, and also by diversifying our holdings so we are not dependent on the high fliers that have driven the overall market. Owning the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) provided great returns this year but do not represent a diversified cross-section of the US economy.
We tilted as much as we thought prudent in favor of growth stocks. They are in favor given the optimism around artificial intelligence, communications, entertainment, social networking, brain research, leaps in medical research, self-driving cars, blockchain, and so on. But some of these stocks, such as Applied Materials (AMAT) and Universal Display (OLED) took a hit toward year-end and dented our results for the final quarter.
Value did less well almost across the board. Energy stocks are considered value stocks and did not have a great year. Ditto for telecomm stocks such as Verizon and AT&T; they both have great dividends but still fell as competition squeezed margins. It is worth noting that a good dividend yield is not any sort of guarantee of a good total return; it is more like a good head start that a slow runner can still blow. AT&T has a 5.1% dividend yield, but its price decline was 4% percent last year (adjusted for ex-dividend dates). Verizon has a 4.41% dividend yield, but its stock was up only a modest 4%. It did better than AT&T despite concerns that the company has taken on so much debt that it may not be able to sustain its dividend. And now for the worst of all worlds in value stock land – General Electric plunged 43% this year as its forays into energy and numerous other mishaps made it the worst performer in the Dow. I’m sorry that we owned it, but think it has the potential to be a “dogs of the Dow” turnaround situation in 2018.
So “value stocks” do not always provide a great return. Then again, neither do growth stocks. Remember AOL just two decades ago? How about Blockbuster? Or Polaroid? Things do change, so risk controls are important.
One other category that did well but not quite as well as I had expected was in the private equity space. I thought that with asset values reaching new peaks, incentive fees would boost the earnings of these firms and send the stock prices to new highs. They went up a lot, but not to new highs.
As has been a common pattern in recent years, the rally was fairly concentrated. We do not carry overly large positions in any stock, and this approach can reduce risk but also hurt relative performance versus an index. For instance, Apple comprises 3.8 percent of the S&P 500 Index and returned 48.2% this year. Your joint account has a healthy 2.1 percent in Apple but even so, our underweighting of the stock detracted from our relative performance versus the index.
We did a lot of things right this year. I’m particularly pleased that our continued belief in Amazon has paid off. Most companies this large are constrained in their capacity to grow, but Amazon has grown its cash flow by over 25% on average annually over the past six years – and that pace has accelerated recently. We’ve been a buyer of Amazon when it trades down to 30x cash flow. It began the year at $750 and ended it at $1169. Even so, I feel some need to be concerned about President Trump’s expressed desire to have the post office increase its charges on goods shipped by Amazon.
Although we did not take overly aggressive positions on tech stocks that are potentially very volatile, we did well in a few of them. Nvidia had been a leader in chips for video games but has expanded into artificial intelligence and self-driving cars. The stock gained 82% this year; we caught most of that but with only a small position. We’ve done well in Intel and Cisco, with returns of about 30% in each. And Microsoft has boomed under the new leadership of Satya Nadella and is making great strides, particularly in cloud computing. Moreover, Windows 10 is the most rapidly adopted operating system Microsoft has released to date. The stock returned 40% this year; we did well in it despite selling a bit of the position too soon.
In addition to tech stocks themselves, we benefitted considerably from a bank that specializes in financing them. Silicon Valley Bank (SIVB) arranges many of its financings in a manner that gives them participation in the upside of various firms. The bank gained 36% in 2017.
Our gains were spread out in other industry groups as well. Housing inventories are at their lowest level since 2005 , and so housing stocks did well this year. We were very early on Toll Brothers, but our patience was rewarded as the stock gained 28% this year. Last spring, we added Pulte Homes for economic and geographic diversity, and have a 41% gain in that stock.
We also profited from a local firm – Universal Display Corporation, based in Ewing – a leader in organic light-emitting materials used in i-phones, TVs and other devices. The stock went from $90 to $190 between May and November before falling back a bit; we recently took a bit off the table as competition is heating up in this space and patents are expiring.
We try to balance considerations of risk and reward, and to not get too giddy when markets are moving almost straight up, as is the case now. The economy is good both here and abroad. There is some argument that the news cannot get much better. And there are certain concerns out there. One is the innocuous sounding strategy of risk parity investing, in which algorithms dictate greater weighting of seemingly less volatile assets. Stock volatility is at the lowest level in my memory. Thus the models dictate the purchase of more equities than at other points in history. A spike in volatility would cause the algorithms to reverse their preferences and dictate the selling of stock.
It was an algorithm that was the proximate cause of the 1987 stock market crash – in that case, portfolio insurance which dictated the selling of an ever-increasing amount of stock index futures the more the market declined. I’m still gathering data on how much similarity there is between portfolio insurance and risk parity investing. My initial sense is that portfolio insurance called for continued acceleration of selling, while risk parity models will call for linear but not parabolic increases in selling.
The day after the 1987 crash, the focus turned to the risks in an overly stressed clearing system. Already, some are warning that leveraged bets in bitcoin derivatives may at some point cause similar stress. But that is not a today problem.
We are mindful of the warnings cited earlier on, and know that there are warnings every month. We have no intention of trying to call a market top. Rather, we want to be mindful of overall economic trends, shifts in fiscal policy, unexpected changes in the credit markets, and the potential for shocks that may not be discounted. As for interest rates, pundits have been calling for higher rates due to Fed tightening. But long-term interest rates did not rise in 2017. Rather, the yield curve flattened. Market participants may be ignoring the wide gap between US interest rates and European rates. At year-end, ten year Treasuries yielded 2.4% while ten year German bunds yielded only 0.43%. Given international money flows, investors seeking the best relative value may continue to exert downward pressure on US rates or at least limit the increase in them.
With rates this low, the earnings yield on stocks is still reasonably attractive. The S&P 500 companies are projected to earn $146 in 2018. With the index at 2673, that translates to a forward PE ratio of 18.3 and an earnings yield of 5.46%.
We monitor shifts in the earnings and cash flow of the market as a whole and of key companies. Sometimes changes happen very suddenly. Celgene is a perfect example of that. There was a sudden shock as the prospects for one of the less important drugs in its pipeline dimmed and the stock dropped 32% in three weeks. But I am still a long-term believer in this company, so we limited our selling.
In other circumstances, we have gotten out “too soon”. I view it as a reasonable cost of risk management; there are times we sell when a stock seems to be losing momentum, only to see it bounce back. We tend to use stop-loss orders on growth stocks and smaller companies, and rarely on stocks like GE – where I should have sold. That was a mistake this year. But the approach is generally sound, and if we can avoid enough disasters, that will turn out to be a worthwhile practice. And GE should bounce back.
It is hard to imagine that 2018 will be as profitable as 2017. But most experts said the same thing a year ago. That is why we do our best to ignore such prognostications and simply look for good opportunities which exist in any market environment. That we will continue to do, and we stand ready to help with any other financial planning issues that you may have. Thank you for your continued confidence in us; we work day and often throughout the evening to do the very best that we can for you.