2017 saw a remarkable juxtaposition between 1) headlines around the globe and here in the US presaging very significant political, social and geopolitical risks and 2) investment markets which were universally positive. The schematic in the Appendix provides a nice trip down memory lane for just the political headlines.
Yet despite the above, 2017 marks the first year in memory that the S&P 500 (total return) was positive in every month of the year. In fact, its positive streak now extends to 14 months. And it was not just equities that performed well in 2017 as each of our three main asset classes (equities, fixed income, and alternatives) were accretive to our overall portfolios.
Specifically, the S&P 500 returned +21.8% in 2017, international stocks of developed countries posted a +27.2% return, and emerging markets were even stronger at over +30%. Large cap stocks outperformed small cap stocks and growth stocks bested value stocks. Technology returned 10% more than the next best performing sector, coming in at a healthy +34.26%, while Energy was the only negative sector in 2017 at -.89%. Outside of equities, taxable and municipal fixed income were generally in the +3.5-4.5% range for the year. Alternative strategies are much more diffuse than equity and fixed income markets, but our managers were all positive, from +4.2% to +12%.
Note: Clients can reference the version of this letter that went out with the December monthly statement, which goes into more specifics in this section.
We made two primary changes to our core models in 2017 in addition to our standard and regular rebalancing: 1) at the end of the summer we increased active management within our fixed income sleeve and 2) at the end of the year, we added a new manager to our liquid Alternatives sleeve. Note for implementation efficiency (taxes, avoiding large capital gains distributions, etc.), many of these changes were made in 2018.
We regularly meet with managers, both existing and prospective. We find these meetings remarkably useful to question our market insight, to confirm or refute something we heard from another manager, to evaluate whether a new manager or asset class would improve the portfolio, etc. One question I like to ask of a Portfolio Manager in these meetings is: “Tell me the name of a portfolio manager or asset manager firm besides yours that you think does a particularly good job, whether in your particular asset class or not.” You learn a lot from their answers! To these ends, we held 101 manager meetings in 2017. Page 2 of 3
We titled the first section of last year’s Year-End Investment Letter “A Useful Reminder on the Futility of Predictions.” It is apropos again this year. An interesting analysis I did supports such futility. In the 50 years ending 2017, the earnings per share (EPS) of the stocks in the S&P 500 have grown by 6.26% per annum and the level of the S&P 500 itself has increased 6.71% per annum. That they are close makes sense: prices of stocks should, over the long run, be driven by earnings, which help fund dividends, buybacks, and the valuations that market participant choose to pay for such earnings should smooth out. Yet the correlation of these two figures on a year-by-year basis is essentially zero (.075). That is, knowing with certainty what the S&P 500’s change in earnings will be over the next year gives you ZERO insight into the price of the S&P 500 a year from now. But that does not mean we do not have views nor does it mean we throw up our hands and do nothing.
What are some of our views? The real economy, both in the US and around the world, shows increased signs of growth and confidence in such growth continuing. This is leading analysts to predict 25% growth in earnings per share for S&P 500 companies for 2018 (1) which, if true (analysts are universally bullish), would be the best year in earnings growth since 1994 with the exception of the post GFC rebound in 2010. Those with long investing memories should perk up with the mention of 1994 as in the fixed income world that is the year of the “Bond Rout.” We do think that the relatively strong economy coupled with the ending of the Federal Reserve’s bond buying program could put upward pressure on fixed income yields. Before immediately concluding that we should reduce our fixed income allocation remember that 1) fixed income is our flight to safety “ballast” in the allocation, 2) even in the 1994 “Rout” high quality municipals and taxable fixed income were only down ~ – 2.5%, and 3) assuming a high quality fixed income portfolio (which is what we have), any losses are simply temporary. For the long term investor, we should want nothing more than a material rise in yields!
What are we doing? As mentioned above, we have increased active management in fixed income precisely because of the potential for increased volatility there, while also diversifying our Alternatives sleeve. We read analysis and commentary that both supports our market views and (equally importantly) provides opposing views, we meet with managers and market strategists, and we meet and debate internally at our monthly Investment Committee meetings. And we will remind you not to expect such good portfolio performance in the medium term as we all enjoyed this year. We revisit our long term capital markets assumptions annually, and this year they will probably indicate a slightly lower return environment going forward.
And what can you do? Re-affirm your risk profile. Talk to your Advisor about what your risk profile says about a reasonable worst case scenario. Contemplate opening a monthly statement showing this loss in your portfolio and make sure you still are OK with that. Re-visit your financial plan with your Advisor – we find doing so especially appropriate after very good years (2017) and very bad ones (2008/9).
Thank you for your continued trust. We take this trust with the seriousness and humility it deserves.