January, 2018
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

This past holiday season I often found the television in our living room tuned in to one of the ubiquitous Hallmark Christmas movies. These heartwarming tales designed to instill some holiday spirit frequently go by titles that refer to Christmas at either a cottage, an inn, a lodge, at home, or on a train. It didn’t take long to discover that they all follow pretty much the same formula with many similar elements: a nosy best friend, an ex-boyfriend who acts like a jerk, a misunderstanding that leads to confusion, an interrupted first kiss, a playful snowball fight…all followed by a happy ending. Being confident that I wasn’t the first one to notice this, through the magic of Google, we soon had our own version of Hallmark Christmas Bingo! As a result on various December evenings in the Nyce household you could hear phrases like “Were those wise words from an older person?” or “That’s snow falling on a gazebo, I’ve got Bingo!”

Stock investors felt like their 2017 story was written like a made for TV movie; complete with a happy ending filled with good feelings; except the writers took out the “something suddenly went wrong” part. The S&P 500 smoothly rose 21.8%, posting its 9th consecutive positive year, and did not experience a drop of more than 3%. While news headlines focused on natural disasters, mass shootings, political shenanigans, and celebrities behaving badly, the stock market continuously shrugged off these plot twists and kept climbing upward. This was not just a domestic event, as stock markets around the world experienced much of the same.

When the market goes up 21.8% (or any change for that matter), some of that increase is due to the dividends that have been paid, some due to companies increasing their earnings, and some because of a higher valuation (change in P/E ratio). The chart below shows this breakdown for the 2017 performance from several geographic perspectives. It shows that the 21.8% U.S. return came from a combination of companies’ earnings growing about 13%, a 7% increase in the P/E ratio, and about 2% from dividends. You can compare that mix to what is going on in other parts of the world; earnings are growing everywhere, but valuations have come down in Europe and Japan.

Deutsche chart 12.2017Source: Deutsche Return Drivers, 1/10/2018

Since the market is more expensive and has risen 9 years in a row and it has been a long time since the last recession, many investors are wondering if they should now be getting out of the stock market. If you flipped a coin and it lands heads-up 9 times in a row, does this change the probability that the 10th flip will be tails? No, it is still 50-50.

The probability that the stock market will rise in any year is about 66%. Does this probability change if the market is up or down the previous year? What about if the market was up significantly like it was last year? The chart below that Mark Hubert posted in a Marketwatch article a couple of years ago reminds us that past performance does not give us much help in predicting future returns.

Hulbert Chart 12.2017

While we are certainly at above average valuations, (current P/E of 18.2 compared to the 25 year average of 16) there isn’t a magic valuation level that indicates that a crash or even a correction is coming. As Ben Carlson wrote in a recent Bloomberg article, “Stock market valuations have never worked as a timing tool. They don’t tell you when to get out of the market or when to get back in. … But valuations can help investors better frame their expectations for future market returns. … The tricky part is this is not a precise relationship and it doesn’t work on a set schedule.”

While locking in some gains can be prudent, getting out of the market can be costly. The average return 1 year before a recession starts is a solid 8%; and the average annual return 2 years before a recession starts is 21%.

Goldman Sachs chartSource: Goldman Sachs Market Know-How Q4 2017

While we caution against doomsday prediction because of the market’s rise, we would also suggest not to extrapolate the gains received in 2017 as representative of the average returns that you will receive on an annual basis in the future. Here are the performance numbers for the past quarter:

 Index

4th Qtr
2017 Return
1 Year Return 3 Year
Annualized
Return
5 Year
Annualized
Return
S&P 500 6.6% 21.8% 11.4% 15.8%
Nasdaq Composite 6.6% 29.6% 14.7% 19.4%
Russell 2000 – Smaller Companies 3.3% 14.7% 10% 14.1%
MSCI EAFE – International 4.2% 25% 7.8% 7.9%
Barclays US Aggregate Bond 0.4% 3.5% 2.2% 2.1%

The event that got the most economic attention in the past quarter was the passing of the new tax law. This law provides corporations with lower tax rates as well as a special one-time repatriation of foreign earnings. For individuals and families, it also means lower tax rates and some adjustments to the deduction schedule. We will soon be providing a more detailed analysis of the new law that you can find in your email inbox or on castle3.com. From an economic perspective, most analysts expect that this will give our economy a short-term boost; but the long-term expectations are all over the board.

The most common line of thinking is that the short-term improvement will drive down unemployment to about as low as it can structurally go in the mid 3% range. This will likely spur on wage inflation, which could lead to higher inflation across the board, which may cause the Federal Reserve to move more aggressively in raising interest rates than they have currently planned. We’ll see.

While we haven’t given any market predictions for the coming year, I did find some people in our office who were willing to give their thoughts on a few non-investment topics.

Prediction Chart

A few parting thoughts. It has been a good year; enjoy it. Resist the temptation to waste mental and emotional energy wishing you had owned more of something else that went up even more and made someone richer than you (maybe Amazon or Bitcoin). The best long-term results come from an investment allocation you can stick with, even though sometimes diversification makes you look silly. 

Here’s to a great 2018.

        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.