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« Q2 2017 Commentary | Main | Q4 2016 Commentary »

Q1 2017 Commentary

At this time last year we were reflecting on a quarter dominated by fear.  2016 started as one of the weakest on record, and though markets had recovered by the end of the quarter, investors were clearly rattled. 

This year we are reflecting on a quarter dominated by optimism.    

In February of 2016, according to the survey from AAII, investors were less optimistic than they had been at the financial crisis lows.  Contrarily, the latest consumer confidence numbers from the Conference Board show significant hope.  The percentage of respondents expecting stocks to be higher in twelve months is at its highest level since January of 2000 – just two months before the tech bubble peak. This March also saw newsletter writers reach their most bullish levels since 2005. 

One year and a 30% rally (from the February lows) can change a lot.

Not only have stocks risen notably, but they have done so with little in the way of declines.  It has been more than nine months since the S&P 500 saw a 5% pullback.  By some measures, markets are off to the calmest start since 1965.   

Following the price trends and accompanying headlines can give one the impression that there is plenty of conviction in the markets.  More specifically, there seems to be certainty around the widely-accepted narrative that deregulation and tax reform will boost equity values.

All else equal, anticipated policy changes are indeed likely to increase earnings. The lofty expectations are also buoyed by some harder numbers: Q4 earnings growth was up over 6% for the quarter –  the strongest quarter in three years.

Combining expectations with already accelerating growth, there is a rather convincing argument to own stocks.

The narrative has been validated in the short term, but what if markets have overshot reasonable expectations?    

For an illustration of how expectations can leave investors jilted, we need to look no further than the “Trump trade.”  In the immediate aftermath of the election, it seemed probable that the winners under a Trump administration would be those sectors that benefitted most from his campaign promises, namely financials, materials and industrials. Between election day and the inauguration, these sectors outperformed the market by 9.5%, 15.5% and 3.2%, respectively.

Those investing in these sectors on inauguration day, however, have seen those sectors notably underperform – lagging the S&P 500 by 1.4%, 10.9% and 1.8%.

The lesson here is that even if narratives remain in place, prices matter. 

We have discussed prices (valuation) at length in this commentary before, and we will likely do so in the future, but we will keep it short this quarter.  Based on some simple metrics, stocks are at historically unsustainable levels.  In fact, to be valued at the previous “sustainable” valuation peak, prices would have to fall between 12% and 18%. To be valued at the average “sustainable” level, they would have to fall over 30%.

Stocks are expensive.

On top of valuations, we continue to be worried about headwinds posed by the Fed.  The central bank is accelerating its pace of interest rate hikes and could begin winding down their balance sheet by the end of the year.

These are the same concerns noted in the last commentary, and our actions in the face of these concerns have not changed. 

Clients across all Time Overlay approaches continued to reduce equity exposure in the first quarter.  As we reduced market risk, the result was a fairly quiet quarter in terms of asset moves.  Clients have less market exposure than at any point since 2007, and we anticipate continued reductions in equity exposure should investors continue to bid up stocks. 

This caution should not be interpreted as pure pessimism.  In fact, even absent effective new legislation, we see no reason that economic growth should not continue to trudge along. But even if fundamentals hold up, expectations and prices remain worrisome.

Though markets can continue to rise against valuation and central bank headwinds, the risks are high, and probabilities for sustainable price appreciation are no longer on our side.

We will remain vigilant – patiently awaiting probabilities to move in our favor before investing additional capital.


Robert B. Drach


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