3rd Quarter 2017 Market Commentary

Stocks continued to climb higher during the third quarter, with international and emerging market stocks increasing their lead on U.S. markets. S&P 500 earnings rose to an all-time high of $30.51 per share for the second quarter. International and emerging markets continued to soar, assisted by a declining U.S. dollar, low valuations, and strong earnings. Large cap stocks performed better than small caps, and growth stocks outperformed value stocks. Technology was the highest performing sector in the S&P 500, and was up 27.4% for the year. On the flip side, energy and telecom stocks have posted negative returns this year. Bonds posted small positive returns as short-term interest rates ticked higher. International and emerging market bonds outperformed U.S. bonds.

*US Stocks represented by the S&P 500 Index, International Stocks represented by the MSCI EAFE Index, and Emerging Markets represented by the MSCI Emerging Markets Index

Where is Volatility?

Volatility has been conspicuously absent from financial markets this year. The CBOE Volatility Index, known as the VIX, which is a measure of market expectations of near-term volatility, has traded near historic lows all year. Here is a chart of the VIX since its inception in 1990. You may notice the spike ahead of the 2008-2009 financial crisis.

The Dow Jones Industrial Average has only moved more than 1% on three of 188 trading days in 2017. This is despite a pretty tumultuous media environment. Those three days were all down days for the Dow; March 21, May 17, and August 17. You probably don’t remember them. A search of headlines found nothing newsworthy for financial markets on any of these days.

Richard Thaler, who won this year’s Nobel Prize in economics, commented on his skepticism of market volatility to Bloomberg, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.”[1] I had the pleasure of attending a presentation by Thaler at the CFA Annual Conference in Philadelphia in May. He compared investors to an animal that is spooked. The spooked animal either runs or freezes. Thaler believes investors are frozen, hence the absence of volatility.

Fed Policy Normalization

The Fed is calling the reduction of its balance sheet, which is the reversal of Quantitative Easing (QE), policy normalization. In June, the Fed released a statement to clarify the plan to allow assets to roll-off the balance sheet, which was increased to over $4 Trillion during QE.[2] The program begins this month, with a plan to allow $10 Billion in assets consisting of Treasuries ($6B) and agency debt and mortgage-backed securities ($4B) to mature without reinvesting the proceeds. The Fed will gradually increase this amount to $50 Billion per month over the next 12 months. At a rate of $50 Billion per month, it would take 40 months to reduce the balance to $2 Trillion, a common expectation of the Fed’s end goal.

This is a glacial pace that hopefully allows the market to absorb the loss of the Fed as a continual purchaser of these securities.  In the press release, the Fed also reserves the right to change the pace and even resume reinvestment if a “material deterioration in the economic outlook were to warrant” such a change. Given this timeline, it is unlikely the Fed will return to a normal size balance sheet before the next economic downturn. However, investors should likely applaud them for their “success” thus far in managing monetary policy in such dramatically unchartered territory.

Valuations and Spreads

 It’s no secret that U.S. stocks are trading at relatively high valuations compared to historical averages. The forward Price/Earnings (P/E) ratio for U.S. stocks is 17.9 versus a 15-year average of 15.0. Shiller’s P/E, a longer term look at earnings, is currently 30.7 versus a 25-year average of 26.3. While both of these measures make U.S. stocks look rich, growth of earnings, the denominator of this metric, would mean that stocks are not overvalued. However, international and emerging market stocks are priced lower. International stocks trade at 14.8 times future earnings, and emerging market stocks at 12.5 times.[3] It’s possible the outperformance of international markets has the runway to persist.

Bond valuations are less talked about than stocks. As the Fed continues to raise rates on the short-end and reduce asset purchases for its balance sheet, bond investors face headwinds. Credit spreads across every asset class of fixed income have narrowed considerably year to date. A credit spread is the difference between the current yield of a bond versus the yield of a comparable Treasury bond. High yield, investment grade corporates, agency mortgage-backed securities, agency bonds, and non-agency CMBS are all trading at 52-week lows for their spreads above Treasuries.[4] Rising rates and tight credit spreads leave little room for bond markets to absorb a shock and may lead to a market correction in the short-term.

Where do we go from here?

With both stocks and bonds trading at high valuations in the U.S., and a mysterious lack of volatility, investors should not be surprised to see a short-term pullback in either market. The underlying fundamentals of the U.S. economy, global economy, and corporate earnings appear positive and steady. In 2016, both Brexit and the U.S. election proved that the market can very quickly reverse course on its consensus. Last week’s Nobel Prize winner in economics, Richard Thaler, taught us that markets are human and not necessarily rational. This is a long way of repeating that we cannot predict the future movements of the market.

What we can do is build properly diversified portfolios designed to participate in up markets and provide some cushion in down markets.  One asset class we own for protection in down markets is managed futures. Historically, managed futures have been a wonderful thing to own during bear stock markets. If clients look at their performance reports today, they’ll notice it’s the one asset with a negative return year to date. It may be irritating to see that negative return among so many high flyers this year. But I’d be extremely cautious of any portfolio where all the holdings move in lock step. That’s a sure sign of a portfolio lacking diversification.


Blair duQuesnay, CFA, CFP®

October 2017


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[1] “Nobel Economist Says He’s Nervous About Stock Market”, Jeanna Smialek, October 10, 2017, https://www.bloomberg.com/news/articles/2017-10-10/nobel-economist-thaler-says-he-s-nervous-about-stock-market

[2] “Addendum to the Policy Normalization Principles and Plan” June 14, 2017; https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614c.htm

[3] JPMorgan Asset Management, “Guide to the Markets U.S. 4Q 2017, September 20, 2017.

[4] Guggenheim Partners, “Fixed Income Outlook Chart Highlights: Q3 2017”, Slide 3, https://www.guggenheimpartners.com/perspectives/macroeconomic-research/fixed-income-outlook-chart-highlights-q3-2017.