Third Quarter Market Review The S&P 500 continued its winning streak, with the index appreciating in value by 3.96% for the quarter (see chart below). This market barometer was up all three months of the quarter, with August being the most stubborn month of the quarter. Third quarter s performance was driven by strong earnings, good economic data, and the average investor s ability to ignore geopolitical static. S&P 500 Third Quarter 2017 Source: Standard & Poor s, Polaris Greystone Financial Group, LLC Third quarter s performance added to what has already been a strong year for the markets. The S&P 500 has appreciated 12.53% year-to-date (see chart below). The S&P 500 finished the quarter at record highs, 62% above the highs prior to the Great Recession in 2007. S&P 500 YTD 2017 Source: Standard & Poor s, Polaris Greystone Financial Group, LLC
Highlights From the Quarter Eleven of the twelve benchmark asset classes we track had positive performance in the third quarter, with the dollar being the only asset class showing negative returns, dropping 2.68% for the quarter and 9.09% for the year. These benchmarks include: Emerging Markets, S&P Commodity Index, NASDAQ, Dow Jones Industrial Average, the S&P 500 (price & total return), the EAFE Index (Europe, Australia, Far East), Gold, the dollar, and three bond indexes. Emerging markets were the strongest benchmark asset class, up 7.58% for the quarter. Commodities rebounded 7.23% for the quarter, erasing their negative performance for the year. As of the end of Q3 they were up 0.28% for the year. Growth outperformed value in all three capitalization tiers - large, mid, and small. This trend may be shifting, however. Value strongly outperformed in September across the board. Technology, energy, and materials were the top performing sectors for the quarter, with 8.28%, 6.03% and 5.55% returns respectively. Only consumer staples showed a negative return in the third quarter, down 2.02%. Technology stocks have led the way for the year, up 26.02%, with health care and material companies as the next best two sectors, up 18.75% and 14.09% respectively. Energy and telecommunications are the only two sectors in the red, down 8.62% and 8.07% respectively. Emerging markets led the way for regional international markets, up 6.70% for the quarter in local currency, followed by the United States and Europe ex. United Kingdom (up 3.95% and 3.89% respectively). Small-caps outperformed large-caps in the third quarter, but large companies still hold a commanding lead over small companies for the year. Global Economies Themes for the Rest of the Year (and 2018) According to the International Monetary Fund (IMF) World Economic Outlook, released in July 2017, emerging and developing economies are projected to see a sustained pickup in activity, with growth rising from 3.2% in 2016 to 3.5% in 2017 and 3.6% in 2018. This uptick in economic growth is not, however, expected to be as a result of an increase of economic activity in the United States. In fact, the IMF lowered growth expectations in the U.S. for 2017 from 2.3 % to 2.1%, and lowered 2018 expectations to 2.1% from 2.5%, due to revised assumptions that fiscal policies will have less impact on our domestic economy. Europe, Japan, and emerging markets were all revised up, impacting the overall global expansion projections. Polaris Greystone is already well positioned for these projected economic expansions in our global strategies, overweighting our international positions as compared to a typical allocation to this area of the markets.
Currency The dollar s strength played a big role in the earnings recession that we experienced during the second half of 2014 and through 2016. The chart below shows the exchange rate between the euro and the U.S. dollar. When the chart is dropping, the dollar is strengthening to the euro. Conversely, when the line is rising the dollar is weakening to the euro. As you can see from the chart below, the euro weakened to the dollar from March of 2014 to March of 2015. The exchange rate between the euro and dollar remained trade ranged until making its low in December 2016. The euro then strengthened, moving from 1.04 up to 1.20 dollars to buy one euro. Euro to Dollar Exchange Rate Source: Macrotrends.net So why does this matter? Currency is a double-edged sword. On the one hand, a weak dollar means that foreign products are more expensive for us to buy. On the other hand, it means that our goods are cheaper to sell abroad. According to S&P Dow Jones, 44.3% of S&P 500 companies sales comes from overseas. According to FactSet, the information technology sector has almost 60% of its sales from abroad. The next highest sectors for international sales are materials and energy, with 47% and 43% of their sales outside of the U.S., respectively. For our purposes, as investors, a weak dollar can drive up international sales, thus improving earnings.
Current Target Rate Probabilities for Dec. 13, 2017 Fed Meeting The Fed There is an 88% chance that the Federal Reserve will raise interest rates before the end of the year. Source: CME Group Current Target Rate Probabilities for Sep. 26, 2018 Fed Meeting There is only a 3% chance of rates remaining were they are today, with a 70% probability that the Fed will raise rates at least two times or more by their September 26, 2018 meeting. Source: CME Group
Earnings Theme As we ve discussed in several prior quarterly reports, we suffered through a six-quarter earnings recession. We ve been out of that earnings recession for over a year. As you can see from the chart below, the consensus analyst estimates for the next four quarters is very strong. S&P 500 Earnings Per Share Source: Compustat, FactSet, Standard & Poor s, JP Morgan
Market Valuation There are multiple ways of determining if an index is over or undervalued. The chart below shows the historical forward P/E ratio (or forward price-to-earnings ratio) readings of the S&P 500. We are slightly overvalued as compared to the 25-year average. There are several valuation measures that show the S&P 500 as slightly undervalued as compared to its historical norms. S&P 500 Index: Forward P/E Ratio Source: FactSet, the Federal Reserve Bank, Thomson Reuters, Robert Shiller, Standard & Poor s, and JP Morgan
Geopolitical Risks There are multiple geopolitical risks that could rear their ugly heads. We view most of them as no more than headline risks to the market. These risks are just not just domestic driven. These are the top geopolitical risks that we are monitoring: Elections Most of the populist political risk in Europe is behind us, with French and German voters having rejected populist governments. There are several elections next year, including the Italian general election and the U.S. mid-term elections that could influence the markets. We are closely watching several elections in Latin America including the Mexican and Brazilian general elections, the Venezuelan and Columbian presidential elections, and the Cuban parliamentary election. Military flare up Tensions between the United States and (Iran, Russia, North Korea) could flare up. We don t think any current standoff has a high probability of escalating into actual bloodshed, but rather view these as saber-rattling to draw attention away from each country s respective internal economic issues. Trade Wars Trump s America First campaign could actually damage our economy more than help it if he imposes tariffs against China or the European Union. I m not sure that he has considered the fact that almost half of the sales of our largest companies come from overseas. Any material change to any trade deals that are currently in place would almost certainly be met with retaliatory tariffs on U.S. goods abroad, lowering our competitiveness and presumably corporate profits. Brexit We are monitoring the impact that Brexit has on the world s fifth largest economy. We believe that most of the currency risk has already been priced into the market but that there are still additional risks to the United Kingdom s economy. Longer Term Perspective As an investor with Polaris Greystone, you certainly know several of the themes that we have been focused on for years. We will conclude our overview by reiterating some of our perspectives and why we have them.
Under Allocated Bonds We are under allocated to bonds, and most likely will be for some time given our low interest rate environment, the almost certainty of unfavorable Fed action in the coming years, and the $15 trillion in international sovereign debt with negative yields. One of the most attractive bonds is the 10-year U.S. Treasury. The chart below shows its nominal yield. An investor can currently get a 2.33% yield by investing their hard-earned money in this 10-year investment. But this doesn t provide the full picture. Let s just assume that our investor has an effective tax rate at 20%. Their earnings have now dropped to 1.86%. Then we have to look at inflation, which is now 1.69%. Our investor earns 0.17% net of taxes and inflation. If inflation picks up our investor could lose their purchasing power. Nominal and Real 10-Year Treasury Yields Source: Bureau of Labor Statistics, Federal Reserve, FactSet, JP Morgan Should you abandon your fixed income investments entirely? No, we don t think that it would be prudent to give up on bonds entirely, but we do think that you need to be creative. For example, we currently hold convertible bonds, international bonds, and floating rate bonds (that move up with interest rates) in our balanced strategies. We would caution you to not invest in leveraged fixed income products, go out beyond 7 to 10 years on the yield curve, or chase yield in derivative products.
Over Allocated Stocks We think that there is a lot more upside to the U.S. stock market and a lot of opportunity in the international stock markets. As we discussed, earnings expectations look good, valuations are mixed but at the very worst slightly overvalued. While economic activity is not robust, it s not weak either. The stock market tends to move in long-term, secular movements. The average secular bear market lasts 13 years, while the average secular bull market lasts 14 years. We went through a secular bear market from 2000 through 2013. The last secular bull market was from 1982 through 2000. There are cycles within these secular movements. For example, we had bear cycles in 1987, 1990, and 1994 during the last secular bull market. Just like we had bull cycles from 2003 through 2007, and 2009 through 2013, during the last secular bear market. The shortest secular bull market in our history was nine years. We could arguably say that our secular bull market should go until at least 2022 at the shortest, and if average we could see our markets generally rise until 2027. This does not mean that we won t experience setbacks in the market. No market goes straight up or straight down. S&P Composite Index Source: FactSet, National Bureau of Economic Research, Robert Shiller, JP Morgan
We do not see anything that should impede the markets from continuing their upward trend. We will continue to be over allocated to stocks until our research indicates that risk is increasing beyond what we feel is appropriate for your portfolio. If you have any questions regarding anything that you have read in this article, please feel to reach out to your Polaris Greystone wealth advisor and schedule a time to meet. As always, I welcome your questions and comments. Sincerely, Jeffrey J. Powell Managing Partner, Chief Investment Officer