Second Quarter 2017


Last quarter, we noted how monetary and fiscal policies are the two levers the government pulls to drive economic growth.  Also, we noted how, after many years of using monetary policy as the primary lever, the post-election perception was that the new administration would turn to fiscal policy.  Based on this perception, stock markets performed well.  From November 8, 2016 (one day post-election) through February, the S&P 500 Index rose by 10.8% while the Russell 2000 Index rose by 14.7%.  The latter measuring small cap stock performance, and thereby, the “animal spirits” of investors1







% Change

Dow Jones Industrial Average (DJIA)



↑ 4.5%

Standard & Poor’s 500 Index (SPX)



↑ 5.5%

NASDAQ Composite Index  (COMP)



↑ 9.8%

Russell 2000 Index (RUT)



↑ 2.1%

Federal Funds



↑ 100.0%

10Y US Treasury Bond




30Y US Treasury Bond




London Gold PM



↑ 8.6%

Remember, when bonds prices rise, yields fall and vice versa.
But, the first quarter of 2017 reminded us that perception and reality are not one and the same.  In March, stock markets corrected 2%, as the Fed raised short-term rates for a third time and Republicans failed to repeal and replace the Affordable Care Act (“Obamacare”).  This failure marked a turning point.  Real reform doesn’t come quickly or easily and the new administration’s other fiscal proposals – tax reform, infrastructure spending and banking reform – will beget a long slog through a bitterly divided Congress.
Economic Data 
Since fiscal reforms won’t provide an immediate injection into the economy, a closer review of recent data is warranted.  Current readings are sending mixed signals, the primary issue being a divergence between the soft and hard data.
“Soft data” is qualitative data, like survey and sentiment data.  Of late, it’s been exceptional with small business optimism hitting its highest level since 20042 and consumer confidence hitting its highest mark since December 20003.  However, the strength of the soft data has yet to manifest itself in the “hard data”, which is quantitative data, like the rate of job creation and wage increase.  As shown below,  we’re experiencing the greatest divergence since 2011 and second-greatest diversion since measurement began4.
Further, the U.S. labor market continues to tighten.  In turn, wages and benefits continue rising as businesses compete for fewer workers.  Ultimately, this trend could crimp corporate profits and boost inflation. 
Lastly, the current economic expansion (which began in June 2009) has lasted for almost nine years long.  Since the average expansion lasts five years, it seems likely this one is getting a bit long in the tooth.  That said; a longer than usual expansion may be warranted based on its slower pace.  While we believe this is true, growing evidence suggests we’re in the later innings of the game. 
Equity Outlook
At first blush, stocks look over-priced.  First, the S&P 500 Index is selling at 17.8 times 2017 estimated earnings5, compared to a five-year median of 15.8 times and ten-year median of 14.7 times.  Second, the total value of all domestic stocks is 140% of the total GDP(see below). 
However, we must determine what is driving stock valuations to determine if they’re truly over-priced.  First and foremost, we’re in year nine of a slow growth expansion and interest rates remain historically low.  In turn, low rates drive up the value of other assets, like your home and stocks.  Second, the overall profitability of U.S. companies has increased dramatically during the past 40 years.  From 1976 through 1996, the average profit of U.S. companies was 5.5%.  Whereas, from 1997 through 2016, it was 9.1%.  Simply put, U.S. companies are more profitable now than in the past. 
So, although stock may look over-priced at first blush, current valuations appear warranted by the underlying fundamentals.  However, valuations will be monitored closely as a dramatic rise in interest rates or impending recession will lead to a correction.
Fixed Income Outlook 
We remain convinced short-term rates are on a slow, steady climb as the Fed tries to stay in front of inflation.  Of particular note during the quarter, the Fed changed their stance from maintaining a “2% ceiling” to maintaining a “2% range” for inflation.  In terms of strategy, we continue building laddered portfolios of short-term bonds.  Assuming rates are on the rise, doing so mitigates interest rate risk and will allow us to more quickly re-invest at higher rates as they emerge. 
Since the election, the stocks markets have been euphoric based on the perception that major change was coming in terms of fiscal policy.  However, the euphoria was short-lived as the reality unfolded … fiscal and other change will be a long slog with a bitterly divided Congress.  This plus an aged economic recovery sending off mixed signals, fair-to-high stock valuations and rising rates suggest some caution moving forward.  As always, we emphasize a well-diversified portfolio of high quality stocks, especially those with strong competitive advantages (“wide moats”) relative to their peers.  Also, we emphasize high quality bonds with shorter maturities. 
1The term “animal spirits” was coined by economist John Maynard Keynes to describe the naturally exuberant spirit of humans that drives consumer confidence.
4Morgan Stanley, Bloomberg Research
5On April 13, 2017, the S&P500 closed at $2,328 with a consensus earnings estimate of $131. 
6Famed investor Warren Buffett uses this “stock market capitalization to GDP” ratio to measure the underlying value of the stock market.  Stock market capitalization is defined as the total value of all publicly traded stocks.  Gross Domestic Product (GDP) is defined as the total value of goods produced and services in a given year. 


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