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January 2018

Number 78

The Year 2017

Are you surprised?  We are!  At the beginning of 2017 there were plenty of reasons to believe that it could be a mediocre, if not difficult, investing year.  A new, and somewhat controversial, presidential administration was coming into power.  Policies were unknown.  The political climate was difficult with strongly held differences among the two parties.  Yet 2017, for investors, turned out to be placid with a steady uptrend in earnings and valuations.

This past year proves the adage that earnings and business fundamentals drive stock prices, not the political backdrop.  Of course, there are exceptions, but 2017 is a strong affirmative example.  Earnings this past year were up over 10%, so, it’s no wonder that price performance reflects this.

Not all stocks or even categories did well.  Large-cap growth was the most favored sector.  This is a result of the prevailing wisdom that the U.S. economy was in a lackluster growth cycle.  In this environment, companies that could grow well in spite of this were sought out.  As investment capital chased these firms, they gained momentum and then even more money poured into those stocks that were already moving.  The result was a narrow group of favored issues that drove the averages.

The commonly followed stock market averages are market weighted which means bigger companies influence the average more than smaller ones.  The S&P 500 weighted index is about 4% higher than the equal weighted S&P 500 index.  Even starker is the difference between the large cap growth sector versus the value sector; over 15% more for growth.  The mid and small-cap sectors also had large differences.  So even though, to casual observation, the markets look to have had a great year, there are significant differences depending upon how one was invested. 

Bond returns were lackluster, but at least positive.  Interest rates did not move much.  That will not be the case going forward; see the Forecast section for this prediction.  The Federal Reserve raised short-term interest rates three times in 2017, ¼% at a time.  This did not impact long-term rates at all.  It seems that since U.S. intermediate and long-term interest rates are much higher than those of many of our major international trading partners, our bonds attracted more and more global funds, holding interest levels down.  The result was a flattening yield curve; one where the difference in rates among different maturities declined.

So, a great year is now behind us; what now?  We give our predictions in the next section.

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Diversification in investing is most often thought of as a methodology to spread risk and reduce losses; and it is.  It follows long held common sense statements such as “don’t put all your eggs in one basket.”  Nature itself diversifies.  Each specie comes in a variety of versions so that if environmental conditions change there may be examples that can more easily adapt.  That is nothing to say about why nature has created so many species in the first place.

Speciation is a technical term used to describe how when a life form gets isolated it changes as it adapts to local conditions.  Again, this is another method nature uses to ensure some life endures no matter what.  There have been several mass extinctions in the history of this planet, yet life has continued.  Survival of life is a direct result of the diversification process.

There is, however, another aspect to diversification.  It is one of optimizing opportunity; the more varied the better chance that one or many will turn out to be very successful.  This applies to life as well as investments.  Any experienced investor knows that what works and what doesn’t in any given year is often surprising.  Good research and analysis often fails to predict success.  At best it is a guide, but not definitive.  Every year we continue to be surprised by which companies from among our well researched and analyzed list emerge as the best performers.  Those performers change from year to year.  Even during any year there are a several changes (we call them rotations) among winners and also-rans.

So, diversification can also be seen as casting a wider net to capture opportunity and not just as a technique to reduce losses.  Diversification, by definition, requires variety.  Owning many energy stocks may not offer any benefits.  Buying companies in different industries and even of different sizes may indeed provide advantages.

An investor may go further in investing in a variety of asset classes, not just stocks.  Private venture or equity investments may be another method to both protect capital as well as offer opportunity.  Direct real estate purchases could be another diversifier.  Riverplace Capital does provide some of these other opportunities through a subsidiary, Riverplace Analytics.  This diversification needs to be done with care.  Good, or even great performance depends on picking successful companies in every case.  So, if you want to work with a firm that understands and is thoroughly immersed in the investing process, Talk with Us.

Forecast

Economy

The U.S. economy modestly accelerated last year from around 2% to 2.5% – 3%There is every expectation that this growth will continue.  The tax package, passed by Congress at the end of the year, may help accelerate that pace even more.  There is a lot of controversy as to how much more growth this new tax regime will stimulate.  However, almost no one expects it to detract from growth.

Earnings, the key to advancing stock prices, are expected to grow nicely in 2018 as well.  The current estimates are around 7%.  That may be low depending on how much more activity lower taxes create.  A good economy, higher earnings, and potentially higher stock prices, what’s not to like?  It would be nice if it were always that simple and it might be, but macro events that have serious consequences are always possible.  These are unpredictable, so the best we can do is say the prospects look good.

Equities

 Good years are generally followed by good years.  Common instinct would indicate the opposite, but it just doesn’t hold.  Trends stay intact until something major comes along to derail them.  As noted in the Economy Forecast section, we expect economic growth to continue at a healthy pace and may even accelerate.

However, stock leadership is undergoing a sea change.  Growth stocks have been the leaders of this stock market since the bottom in 2009.  They do best in slow growth environments because they offer consistent progress.  When growth picks up, value stocks usually come to the fore.  That is now happening.  These companies are geared to economic activity and increased rates benefit these companies disproportionately.  Look for a reversion to the mean in the value sector as the growth one languishes.

In general, however, public companies are getting about a $1 trillion windfall over the next decade from the new tax bill.  For investors, what’s not to like?  This will result in greater earnings and dividends and inevitably higher valuations.

Fixed Income

 The Federal Reserve will prevail.  It wants higher rates and it will get them.  So far, long-term rates are not responding to Fed policy changes, but that will happen.  International money flows, which still see U.S. rates higher than their own, continue to move into our bond market.  There is a limit to that and we may be fast approaching it.

As the Federal Reserve pushes up short-term rates, there are many beneficiaries.  Savers, banks, and insurance companies are a few.  It is important to get back to interest rates that are reflective of the economic strength our economy has been showing.  This is necessary for the health of the economy and to avoid unwanted distortions.  These occur when investors reach too far to keep income levels up.

Investment Strategy

Equities

 We have been shifting portfolios to more value orientation.  We believe these holdings are still undervalued and will play catch-up to other sectors.  We are also rebalancing accounts to cash in some portions of the winners and add to the laggards that we believe are still cheap.  We have already started this in tax sheltered accounts.  We will rebalance taxable accounts after the first of the year.  We manage the tax implications as best we can.

The reality is that after many years of good markets, there are large gains in most portfolios and few, if any, losses.  However, we cannot let taxes totally drive investing moves.  So, we apologize for the taxes, but we are grateful for the gains.

Fixed Income

 Because short-to-intermediate interest rates have risen, we are applying some fixed income allocations to instruments here.  Some of the best rates available today are in negotiable bank CD’s.  We are keeping maturities relatively short.

 Wealth Management

 Asset allocations in our sector allocation strategy will be changing.  We will rebalance these accounts during the first quarter.  This is necessary to emphasize those sectors that we believe will give us superior returns.

Major Indicies

as of 12/31/2017

Large Cap Stocks (S&P 500) 19.4%
Dow Jones Industrial Average 25.1%
Mid Cap Stocks (S&P 400) 14.5%
NASDAQ Composite 28.2%
Small Cap Stocks (Russell 2000) 13.1%
MSCI EAFE 21.78%
Barclay Aggregated Credit Index 6.42%
Inflation 1.7%

Equity indices are twelve-month returns excluding dividends.

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“Nature always wins; go with it.”

Anonymous

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© 2019 Riverplace Capital Management, Inc.
Information contained herein is prepared by and is the sole property of Riverplace Capital Management, Inc. Written by Peter E. Bower, President.
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