Investment Update

A strong fourth quarter gave stocks their best year since 2013.  Broad equity indices hit multiple new highs as volatility remained historically low through year end.  Feeding off the momentum that began in late 2016, the S&P 500 finished the 2017 calendar year without a single down month for the first time since 1970.

Bond returns were generally positive for the year as longer-term interest rates ended the year somewhat lower compared to the beginning of 2017.  Shorter-term rates moved noticeably higher in the fourth quarter, most likely in anticipation of additional rate hikes from the Federal Reserve in 2018.

Key Storylines:

Markets enter the New Year with increased confidence. Recent signs of an improving economy appear to be on firmer footing.

Last year’s hopes of a stronger economy faded quickly as post-election enthusiasm was out ahead of economic conditions and legislative realities. The prospect of rising interest rates and inflationary pressures ultimately gave way to another year of benign financial conditions.  In combination with growing corporate earnings, coordinated economic growth around the world, cooperative Central Bank policy, and tax-reform on the horizon, 2017 turned out to be an unexpected sweet spot for stocks already in the ninth year of an economic recovery.

Recent economic indicators show strength in consumption data and increased activity on the private investment side.  This now coincides with the enactment of major tax reform, providing the likelihood of an additional boost to growth.   While there are no assurances, the long-awaited transition from slow growth to respectable growth may finally be at hand.  So, too, would be the likelihood of firming inflation and higher interest rates, which has important repercussions on the duration of the current bull market.  We will take a closer look at this in our Outlook commentary.

Recently enacted tax reform is a positive for the economy in general, financial markets, and most taxpayers. Naturally, the implications beyond the centerpiece of improving corporate profitability will take time to fully comprehend.

With most CPA firms issuing their own summary of the new tax code, we will defer to their expertise and not attempt to do so here.

Three months ago, consensus thought gave tax reform slim odds of passing before year end, so we put this in the surprise column.  Setting aside issues of process and fairness, this tax plan should provide significant stimulus to the economy from the corporate side through new investment with the potential for job creation.  The 40% reduction in corporate taxes (35% to 21%) and the ability to expense capital investments immediately rather than spread out over time should provide a meaningful boost to earnings and capital investment, all which should be well received by the market. Most individual taxpayers will keep more of their earnings for the first time in many decades, which should translate into both increased consumption and savings.

For now, investors will focus on first order changes, namely which companies will benefit most and least from the new tax code.  Looking at the tax changes more broadly, some have noted the potential benefits of second and third-order effects.  These would include how companies pursue growth opportunities in the new tax environment that were not previously economically feasible, and how other countries respond to restore their own relative competitiveness, now that their tax advantage has become more neutralized.

Whether the expansionary effect of lower taxes will be enough to begin to reduce the massive debt accumulation, particularly of the past decade, and to offset the projected deficits resulting from the reform package is unknowable at this time.  What we do know is that in all aspects of life, people’s behavior changes when the incentives change.  Corporations will have more attractive choices to invest capital than just buying back their own shares or paying out more in dividends.  That said, it will take time for these ancillary effects of tax reform to develop and to truly assess their impact.

The “FAANG” stocks (Facebook, Apple, Amazon, Netflix and Google) attracted a lot of attention last year, and for good reason, but in our world, stock selection comes down to analyzing one company at a time.

We appreciate the impressive returns generated from the FAANG stocks last year, largely because our bottom-up security selection process gave us the opportunity to own all but Netflix in our Growth strategy. Many other technology stocks produced superb returns last year as well.

Most stocks are not part of a popular group with a catchy acronym, so it requires more effort to discern the investment merit of one investment opportunity from another.  When glancing at the annual lists of winners and losers for 2017, two stocks stood out that underscore the importance of security selection.  Both are large-cap industrial stocks and both are long-time components of the Dow Jones 30 Index.  That’s pretty much where the commonality ended last year.  Boeing gained 89% for 2017; General Electric lost 45%.

It would have been hard to imagine the fortunes of these two stocks diverging as dramatically as they did in a single year, but looking more closely at their respective businesses, it is not a surprise.  Boeing consistently beat their earnings expectations, raised guidance on future earnings and increased the dividend, currently have a multi-year backlog on new orders, and participated in a market where there is an upswing in global and military aircraft demand.  Our valuation selection process identified Boeing as an attractive yield stock in mid-2016.

General Electric was poorly positioned going into the Financial Crisis and has hindered their own recovery by poor decisions in restructuring their areas of emphasis.  New leadership took over last year, intent on cutting costs and rationalizing their existing business model.  GE has not ranked as an attractive buy candidate in our process for over five years.

While this example may seem striking, it is not unusual. This happens every year inside every sector and industry – two companies operating in a similar space, markets rewarding one for executing well and punishing one that is not.  The point here is that the “FAANG” moniker will be relevant as long as these stocks continue to move up in tandem.  It will go away when that’s no longer the case.  Such was the fate of the “Nifty Fifty” stocks of fifty years ago.   It’s endearing when it works, but there is no shortcut to evaluating the individual investment case for every stock that is owned.

Outlook:

The economy is poised to perform better, but it will be hard to top the combination of factors that have made the current slow-growth environment so attractive for stocks.

In our 2016 year-end Investment Update, we included a special commentary titled In Search of the Business Cycle. In that piece we acknowledged that it was difficult at the time to see how the current slow growth cycle would come to an end, given the absence of “overheated” conditions that typically force the Fed to raise interest rates.  This becomes less of a conundrum with the pickup in economic activity and tax reform.  The irony about this prospective good news to the economy is that it may eventually lead to less good news for stocks.

In reality, there is ample room for the economy to perform better and for inflation and interest rates to move higher before anything resembling “overheated” starts to worry the Fed.  At the same time, corporations should see better top-line growth to support higher earnings, along with the reduced tax rate.  All this should provide a positive window for stocks to continue to perform well.

Once this phase of the cycle starts, it is a matter of time before the implications of higher wages and goods and Fed tightening weighs on equity valuations that are already at high levels.  After years of experiencing strong equity returns in a weak economy, it could be feasible to see the inverse of this with stock gains slowing down as the economy begins to pick up steam.

In the event the expected boost to the economy does not materialize, like we have seen multiple times before, we are back to the status quo with a muddling economy, low level of inflation, and a retreating Fed.  Even in that scenario, given today’s high valuation levels as a starting point, history tells us that the upside to stocks from here will be more limited than the kind of gains we’ve previously seen under these same conditions.

Lower return expectations for stocks are hardly a profound thought after a year like 2017, but it does provide a good context to affirm an investor’s overall commitment to stocks.  Even at lower returns, relative to the return opportunity from bonds and cash, stocks remain the most attractive asset choice.  The key issue is being comfortable with an asset mix that enables one to stay invested through the next cycle.