2017 continues to be a year of market behavior that defies predictions. In fact, we are not aware of a single “market outlook” from late 2016 that accurately described ahead of time what has occurred so far this year. It may be even more vexing to investors that the financial media is having a difficult time stitching together a coherent narrative after the fact. And so we proceed into the second half of the year with market participants feeling worried that they are peering into the unknown, yet enjoying the above-average growth in their balance sheets.
Any investment professional with more than a decade of tenure in this industry is obviously someone that survived the Great Recession. Hundreds of thousands of people left this industry, never to return. And for those of us that survived, the uncertainty of 2008 and 2009 tended to make us think we had seen it all. Until now. When two investment advisors run into each other in 2017, it often goes something like this: Advisor One says “hi there, how about this market?”. Advisor Two says “hey there, yeah—this market!” And then they both walk away shaking their heads in confused disbelief because nothing in their professional lives seems to make any sense.
The business of generating a market outlook swung into high gear right before the elections in November. The financial media interviewed hundreds of economists and investment strategists to produce stories that would tell us what might happen once Hillary Clinton was elected. And I can’t recall reading a single market outlook being right.
While statistical research consistently proves that markets are unpredictable, human beings strive to find patterns in the chaos. The more educated advisor knows that many of these patterns are only visible after the fact. And so we cling to that daily explanation from the financial media that tells us the big “why”, “why markets did what they did” that day, that month, that year.
But lately we’ve been deprived of our stories that help us to think we understand what has been happening. It just doesn’t make any sense. After a strong surge in interest rates just after the election, yields across every part of the curve past one or two years have been falling. While the Federal Reserve is “normalizing” the overnight rate by moving it farther above zero, the market is dropping yields for the intermediate to long end of the curve. So even while the Fed is expressing confidence, the market is not. The fall in yields due to market pressure is seen by many as an expression of economic pessimism.
This fall in yields since the beginning of the year has caused the Bloomberg-Barclays U.S. Aggregate Fixed Income index to generate a total return of 2.27% through June 30, 2017, with the second quarter contributing 1.45%. The return for the past six months is roughly equal to the annual yield of this benchmark, and for purely mathematical reasons it cannot be expected to continue for much longer at this pace.
And during all of this the stock market has rallied. At half way through the year the MSCI ACWI Net Global Equity Index is up 11.32%, with the second quarter contributing 4.25%. This is seen by many as an expression of economic optimism by the markets. It has occurred despite the Fed’s persistent effort to raise rates, which would have been an unthinkable reaction during years past.
And it isn’t just the stock market rally that caught everyone off guard, the measures of expected and realized volatility fell to levels rarely seen before. The “VIX”, a measure of how stock market options prices predict future volatility, fell into single digits for one of the few times since its start in 1990. And it happened right in the middle of Congressional testimony by James Comey, the former Director of the FBI, as he was questioned about issues that had the potential, according to some, to lead to the eventual impeachment of the President.
But the markets didn’t care one bit about that uncertainty. Right now we also have significant uncertainty about many policies coming out of Washington on issues such as corporate taxes, individual taxes, health care reform, Medicare, Medicaid, Social Security, infrastructure, immigration, Russia policy, China policy, and on and on. You may have heard the expression that “markets hate uncertainty”, which implies that an increase in uncertainty about significant issues will raise the discount rate applied to future earnings and therefore drop the current price of the market. Maybe that isn’t true after all.
And so this raises the question about what an investor should do. At BIP our approach to planning your investment future is to use simulations that explore a wide variety of possible scenarios. The one thing we don’t do is attempt to contrive a theory or explanation of how the future will work. For instance we don’t assert that a particular economic policy will achieve dominance through our political process. We also don’t build a strategy that is fragile, and by that we mean that we don’t construct a portfolio that requires us to be right in some prediction about the future for you to succeed. Humility in these endeavors is the key to avoiding investing traps.
In summary, the markets may continue to defy our ability to construct a comfortable narrative. But that shouldn’t stop you from sticking to your investing plan. It is entirely likely that the political environment produces some big surprises that do finally generate some volatility. We want you to know that we have already contemplated that, and we’re ready.
Disclosure: This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. The Global Equity index is the MSCI ACWI IMI Index, which is a free float-adjusted market capitalization weighted global index selected as the best available proxy for a diversified stock portfolio consistent with modern portfolio theory. Approximately 55% of the index is comprised of the U.S. stock market and 45% is comprised of international stock markets, including both developed and emerging countries. The “Net Total Return” version of the index is reported here, which means the index reinvests dividends after the deduction of withholding taxes, using a tax rate applicable to non‐resident institutional investors who do not benefit from double taxation treaties. The U.S. Fixed Income index is the Bloomberg Barclays Capital U.S. Aggregate Bond Index, which is a broad-based benchmark selected as the best available proxy for a high quality, diversified fixed income portfolio suitable for a U.S. investor. It is comprised of the Barclays Capital U.S. Government/Credit Bond Index, the Mortgage-Backed Securities Indices, and the Asset-Backed Securities Index. It is an unmanaged market value-weighted performance benchmark for investment-grade fixed-rate debt issues, with maturities of at least one year, and an outstanding par value of at least $100 million. The “Total Return” version of the index is reported here, which means that dividends are included and reinvested. It is not possible to invest directly in this or any other index.