April, 2017
By Darren Nyce, CFA

Senior Research Analyst, Castle Investment Advisors®, LLC

Remember “back in the day” when we all subscribed to a newspaper? Periodically you would get a notice in the mail letting you know it was time to renew your subscription. They gave you the option of renewing for 6 months at a slight discount to the cover price, or if you signed up for a year, you’d receive even greater savings, and if you signed up for 2 years, it would bring the cost down to pennies per issue! The company providing the newspaper was willing to give up some income next year in order to increase their income now. As an investor in the U.S. stock market the past few months, you are the newspaper company. Not in the sense that you are currently on the fast track to extinction, but in the sense that you are currently receiving an advance on the long-term gains you are expecting.

The chart below shows the performance of the S&P 500 over the past 25 years and how its performance has related to its Price to Earnings (P/E) ratio. If you are unfamiliar, one of the ways we measure the cheap/expensive–ness of the stock market is by taking the price of the index (the quarter closed at 2363) and dividing that by how much in aggregate the companies in the index are expected to earn over the next year (the current estimate is $134.91). In other words, how much does each dollar of earnings cost? Notice that the long-term average P/E is 15.9, while the current P/E is 17.5 (2363/134.91), demonstrating a slightly over-valued situation. Particularly since the election, markets have risen faster than the rate of earnings growth. We are receiving higher returns now and will likely have to endure lower returns at some point in the future.

1st Qtr 2017 Chart 1 4.2017
Since it is likely that at some point in the future, each dollar of earnings will be worth less than it is currently, should we not be investing in stocks today? The problem is, even though valuations like this are mean-reverting, the x-factor is time. Notice how in 1997, the market reached a similar valuation as today and then proceeded to continue to rise for the next 3 years. The prudent course it seems to us is to realize a portion of this profit and reduce stock market exposure slightly, but nowhere near completely. The truth is that neither we, nor anyone else, knows if a sharp market correction is coming this quarter, or 3 years from now, and we would rather be approximately right than precisely wrong. From an expectation standpoint, it is always good to keep in mind that market rallies haven’t usually gone 4+ months without a 3-5% correction.

As mentioned earlier, and the following chart indicates, the stock market as a whole continued to rise in the first quarter, the 6th consecutive quarter to show gains. The NASDAQ put up double digit returns and had its best quarter since 2013. It was a period without much volatility. The average daily change (either direction) for the S&P 500 was 0.32%; this was the lowest since 1967. There were 15 trading days where the market moved less than 0.1%. The stock market was positive on 60% of the days, which is a pretty high number, the highest number of positive trading days in a calendar year since 2000 was 58% in 2013.

 Index

1st Qtr
2017 Return
1 Year Return 3 Year
Annualized
Return
5 Year
Annualized
Return
S&P 500 6.1% 17.2% 10.4% 13.3%
Nasdaq Composite 10.1% 22.9% 13.4% 15.3%
Russell 2000 – Smaller Companies 2.5% 26.2% 7.2% 12.4%
MSCI EAFE – International 7.3% 11.7% 0.5% 5.8%
Barclays US Aggregate Bond .08% 2.7% 3% 2.2%

Most of the gains came without the help of the sectors that surged initially following the election like financials and energy. As the initial health care plan died in Congress, investors became concerned that much of the expected pro-growth agenda could be in jeopardy. Market focus seemed to shift away from areas that could receive a political boost and toward those that benefit from improving global economic fundamentals.

Some of these economic highlights are:

  •  The United States unemployment rate remains low at 4.7%; wage growth has picked up a little but remains low.
  •  Inflation continues to hold around 2.2%.
  •  The dollar remains strong.
  •  Oil dropped from the mid $50s to the low $50s.
  •  Consumer confidence has climbed to its highest point since the late 90s as household debt service has declined while household net worth has risen.
  •  U.S. GDP remains positive at 2%.
  •  Positive economic news is not limited to the United States.
  •  Eurozone unemployment is down to 9.5%.
              - While the U.S. rate peaked at 10% in October 2009, the European rate continued to rise to 12.1% in July 2013, but has steadily declined since.

              - 1st Qtr 2017 Chart 2 4.2017
  • International Emerging Market countries have seen a rebound in their GDP growth.
  • 84% of countries are experiencing expanding manufacturing activity.

In response to the improving economic conditions, the Federal Reserve raised their interest rate another 0.25% while reaffirming the expectation of 2 additional rate hikes in 2017.

To summarize the current state of affairs, the markets have done well, but are perhaps due for a correction. The worldwide economy is improving which should limit the depth of a correction as overall growth continues. Keep in mind that even a 10% decline in the market is quite normal and happens at some point during most calendar years. If corporate tax cuts do indeed become a reality, we would expect the market to react favorably.

A positive development in the financial industry in the past several years has been a trend toward lower expenses. The custodian that Castle’s clients use, Charles Schwab, recently announced a reduction in both trading costs and lower expenses within their funds and ETFs; a move cheered by us.

Our website’s Meet the Team page has been updated to include our two newest team members, Sharon Cosby and Benjamin Mart. We have also added a few personal tidbits about each member of our team. Visit www.castle3.com/about/meet-the-team to learn more. Not only does our firm continue to grow, but the families of our staff do as well. This winter, financial analyst Benjamin and his wife welcomed a new baby girl into their family; and later this spring Marcie Gronberg and her husband are expecting the birth of their second child. Congratulations to both families!

Thanks for reading. Have a great spring!

      DarrenSignature

Disclosures:
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.