2017 Review and 2018 Outlook

 

Last revised:       February 4, 2018

 Disclosure:  None of the information or data presented herein constitutes a recommendation by Composed Financial Management, LLC (“the Firm”) or a solicitation of any offer to buy or sell any securities. Information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. Although information has been obtained from and is based upon sources the Firm believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change.  Past performance is no guarantee of future results.

 

I cannot believe we have already put a month of 2018 behind us!  This 2017 review and 2018 forecast are a bit late, but as it turns out – somewhat timely.  The S&P 500 has just dropped 3.9% in this past week.  he last time we had a larger weekly decline than that was over two years ago when when the index dropped 6.0% the week ending 1/8/2016.  This week I have received many communications from concerned clients, which is to be expected when we have seen such low volatility for over a year.

 

Thus, I thought it would be good to first do a review on risk.  Then I will then show a summary of what the largest financial institutions are predicting for the S&P 500 in 2018.   Finally, I will dive into all 14 asset classes (not just U.S. Large Cap Stocks) and give my thoughts on 2017 and what may happen in 2018.

 

Of course, none of these forecasts (the financial institutions or my own) are likely to be correct.  There are many inputs to a forecast and a small change to any input can have a drastic impact on the forecast.   Diversification remains the best way to get the most out of your returns for a given level of risk.

 

A Return to Volatility in 2018

In 2017, volatility in the S&P 500 was low and it was a very good year for the index.  Consider the chart below showing full year returns for the past 20 years, and the intra-year declines for those years.  2017 was one of only three years out of the past twenty where at no point was the current year’s price ever below the prior year’s close.   The S&P 500’s closing price for 2016 was 2,239.  It opened higher than that on January 3, and made a steady climb.  The lowest return in any week in 2017 was -1.4%.  In our 5th week in 2018, we have already far exceeded that.  But the point to be made is that 2017 was the outlier, not this past week in 2018.

2017.Q4(1)

 

The average return over the past 20 years was 8.7% for SPY.   But the average range between the intra-year minimum and the end of year return over the past 20 years was 20.0%.

 

That means in order to realize that 8.7% by the end of the year, at some point during the year you would be down 11.3%.

2017.Q4(2)

 

 

 

 

 

 

 

 

 

But the real question is:  why has volatility returned, and what is the risk this year of a downturn?  The easy out – because we have had a 9 year bull run and all things must come to an end is not correct.   Perhaps a better way to phrase would be that the answer is lazy.  Let’s take a deeper dive and look first at the big guys’ estimates for 2018.

 

2018 Institutional Targets for the S&P 500 

2017.Q4(3)

 

 

 

 

 

 

 

As shown above, this is a fairly wide range from -0.9% to 17.8%.  Not a lot of consensus by experts.  That alone shows that volatility could rise.  But why such disagreement?  Different signals from economic and technical indicators show why there is such differing opinion.

 

The 10 year minus 2 year Treasury Spread is one of the most well-known predictors for a recession.

 

2017.Q4(4)

 

As the red line shows above, many times as that spread approaches or goes below 0.0%, a market correction may occur.  Normally, holders of longer term bonds should be expected to earn more interest since they are taking on more risk by locking into a longer time frame.  Investors in 2 year treasuries are not taking on as much interest rate risk, as they will be exiting their contracts sooner than those locked in for 10 years.  However, recessions can be thought of as monetary issues, and are usually dealt with through monetary intervention.  For example, our last recession was due to a monumental lack of credit (which is a money issue), and our Central Bank pumped more than $3 trillion into our system to restore credit in addition to propping up financial institutions that were on the brink of failure.

 

When there is suspicion of a money or credit issue, the yield curve tends to flatten or invert.  This happens for a variety of reasons that are all interrelated.  People suspect asset prices may be inflated, banks may be less inclined to lend money or cannot because of liquidity issues, or people generally become less excited about longer term prospects as compared to shorter term prospects.  All of these are interrelated, and all of these can cause the 10 year treasury interest rate to approach or go below the 2 year interest rate.

 

Clearly the red line representing the spread has been declining, but will it continue?  In my view it is because people are suspecting inflated prices.  There are no clear signs the economy is about to falter or take off, as many economic signals are mixed.  These mixed signals cause increased volatility and a wider range of targets for 2018.

 

One reason why the bond market is a good predictor comes from its size and number of participants compared to the equity markets.  The global equity market is worth $80 trillion.  The global bond market is worth $104 trillion!

 

In fact, many economic indicators show a robust economy:  employment figures, manufacturing surveys, and housing starts all tend to show positive momentum.

 

Some indicators are not bullish but neutral such as housing starts.  Still others such as consumer sentiment and the decline of the dollar are negative or at least could justify overweighting foreign assets compared to domestic.

 

Next I will give a brief review of 2017 and lay out my outlook for 2018 for the 14 asset classes that we track.

 

US Equity

2017.Q4(5)

 

Although domestic equities had a good year in 2017, they lagged behind foreign equities.

 

Large caps performed the best here at home up 22.0% in 2017.  As far as the US economy goes, the unemployment figures are at 4.1%, holding steady at a historically healthy figure (3).   Housing starts in December were at an annual rate of 1,192k, down 8.2% from the November reading and 6.0% from a year earlier (4).

 

Corporate earnings continue to rebound with a backdrop of a strengthening oil sector.  The estimated earnings per share of the S&P 500 for the full year 2017 was nearly $137 per share on December 31, 2016.  2017 earnings are estimated to come in around $124, a decline of 13.1% from expectations but up 28.6% versus 2016.  2018 estimated earnings are nearly $131, a 23.4% jump from 2017 earnings (5).

 

I expect a positive year for US equity in 2018, not to exceed 10.0%.

 

Foreign Equity

2017.Q4(6)

 

Emergings soared 31.5% in 2017 and developed companies were not far behind returning 25.1%.  These were the two best performing asset classes in 2017.  Emerging markets benefitted from improvements in the oil sector.   International markets in general are still benefitting from a low interest rate environment as compared to their US counterparts.  Furthermore, the weakening US dollar made foreign markets more attractive.  The US dollar declined 11.0% in 2017 as shown below (6).

2017.Q4(7)

 

 

 

 

 

 

I expect for continued over-performance in foreign equity compared to domestic due to mixed signals in the US and still favorable environments abroad.  Performance in the 10.0% – 20.0% range.

 

US Bonds

2017.Q4(8)

 

Bonds have been subpar recently, but are still a good hedge against a market downturn.  Each asset category above performed positively in 2017, and only US Government Bonds did not outpace inflation of 1.8% in 2017.

 

The Fed is most likely to make 3 rate increases in 2018, raising the target from its current level of 1.5% up to 2.25%.   There is a 41% likelihood that the target rate will be lower than 2.25% by year end, a 34% chance it will be at 2.25%, and a 25% chance it will be higher (7).

 

However, it is not the actual rise that hurts bond returns.  Instead it is the changes in those probabilities of rate changes.  Changes in expectations are what hurt or boost any market.

 

I expect for a weak first half of the year, but a normal second half.   Bonds will more than recover from a weak first half to finish the year at their 5 year averages.

 

Foreign Bonds

2017.Q4(9)

 

Look how foreign diversification benefitted your portfolio in 2017. Foreign bond prices grew by roughly 10% in both developed and emerging economies.

 

I expect for a gradual return to normal in 2018.  The first half of the year may over-perform.

 

Outlook for 2018

The outlook for 2018 has changed to normal performance as compared to 2017’s over-perform.  We expect the return from the moderately allocated benchmark portfolio (asset category weights shown below) to return between 5-10%.

 

The remainder of this review will focus on our discretionary portfolio at Interactive Brokers.  These accounts are adjusted quarterly for perceived strength or weakness seen across the various asset classes that we track.  We compare performance versus a moderately allocated benchmark portfolio.  The purpose of this portfolio is for growth and trading profits obtained through investments in ETFs according to a moderate risk profile.   This portfolio is not meant for retirement and as such does not have the same risk profile of such accounts.

 

The current portfolio versus the benchmark portfolio is shown below.  As you can see, the biggest shift in our current allocation for Q1 is from domestic bonds (-7.0%) into foreign equities (+8.0%).

2017.Q4(10)

 

 

Please see below for the inception to date performance of the discretionary accounts at Interactive Brokers.

  2017.Q4(11)

 

 

 

 

 

 

 

 

 

Sources:

1 –  Oyedele, Akin.  “Here’s what 13 Wall Street pros are predicting for the stock market in 2018.”  Business Insider.

http://www.businessinsider.com/stock-market-forecasts-year-end-targets-for-2018-2017-12/#hsbc-2650-1.  Accessed February 4, 2018.

 

2 – Wang, Lu.  “Wall Street’s Rushing to Raise S&P 500 Forecasts for 2018.”  Bloomberg.

“https://www.bloomberg.com/news/articles/2017-12-21/wall-street-rushing-to-raise-s-p-500-forecasts-heading-into-2018.  Accessed February 4, 2018.

 

3 – “Labor Force Statistics from the Current Population Survey.”  Bureau of Labor Statistics – US Department of Labor.  Accessed February 4, 2018.

 

4 – “Monthly Residential New Construction – December 2017”.  https://www.census.gov/construction/nrc/pdf/newresconst.pdf.  Accessed February 4, 2018.

 

5 – “S&P 500 Earnings and Estimate Report.”  S&P Dow Jones Indices. https://us.spindices.com/documents/additional-material/sp-500-eps-est.xlsx.  Accessed February 4, 2018.

 

6 – “US Dollar Index Futures”.  Investing.com.  https://www.investing.com/quotes/us-dollar-index-historical-data.  Accessed February 4, 2018.

 

7 – “Countdown to the FOMC”.  CME Group.  Accessed February 4, 2018.

 

 

Disclosures:       

 

None of the information or data presented herein constitutes a recommendation by Composed Financial Management, LLC (“the Firm”) or a solicitation of any offer to buy or sell any securities. Information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. Although information has been obtained from and is based upon sources the Firm believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change.  Past performance is no guarantee of future results.

 

1 – The discretionary investment portfolio and associated benchmark portfolio are assumed to be rebalanced at the same time (every 3 to 4 months).

2 – The inception starting balance is set to $10,000 and performance is tracked as if no additional contributions or withdrawals are made to the portfolio.  This is known as the time-weighted return.

3 – Fees are applied only to the discretionary portfolio managed by the Firm.  No fees are applied to the benchmark portfolio.  The assumed fees applied to the discretionary portfolio are 0.8%, based on our current maximum AUM fee.  All fees are negotiable and not every client is charged a fee of 0.8%.  No clients are charged an AUM fee of more than 0.8%.  For a complete view on the pricing of the Firm, please visit www.composedfinancial.com/pricing.

4 – Risk Disclosure:

Investing in securities involves risk of loss that clients should be prepared to bear.  No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment.  There is no guarantee that our investment processes will be profitable.  Past performance is no guarantee of future results.  The value of investments, as well any investment income, is not guaranteed and can fluctuate based on market conditions.  Diversification does not assure a profit or protect against loss.

Our discretionary investment management style invests in ETFs that are exposed to a variety of different asset classes which may be subject to some or all of the following risks.

Equity Securities Risk – Equity securities include common stocks, preferred stocks, convertible securities, ETFs, and mutual funds that invest in these securities.  Equity markets can be volatile.  Stock prices rise and fall based on changes in an individual company’s financial condition and overall market conditions.  Stock prices can decline significantly in response to adverse market conditions, company-specific events, and other domestic and international political and economic developments.

Risk Related to Company Size –Investing in mid, small and micro capitalization companies generally involves greater risks than investing in larger companies. The market may value companies according to size or market capitalization rather than financial performance.  As a result, if mid-cap, small cap or micro-cap investing is out of favor, these holdings may decline in price even though their fundamentals are sound.  They may be more difficult to buy and sell, subject to greater business risks, and more sensitive to market changes, than larger capitalization securities.

Fixed Income Securities Risk – Fixed income securities include corporate bonds, municipal bonds, other debt instruments and mutual funds that invest in these securities.  Issuers generally pay a fixed, variable, or floating interest rate, and must repay the amount borrowed at maturity.  Some debt instruments, such as zero-coupon bonds, do not pay current interest, but are sold at a discount from their face value.  Prices of fixed income securities generally decline when interest rates rise, and rise when interest rates fall.  Longer-term debt and zero-coupon bonds are more sensitive to interest rate changes than debt instruments with shorter maturities.  Fixed income securities are also subject to credit risk, which is the chance that an issuer will fail to pay interest or principal on time.   Many fixed income securities receive credit ratings from Nationally Recognized Statistical Rating Organizations (NRSROs).  These NRSROs assign ratings to securities by assessing the likelihood of issuer default.  Changes in the credit strength of an issuer may reduce the credit rating of its debt investments and may affect their value.  High-quality debt instruments are rated at least AA or its equivalent by any NRSRO or are unrated debt instruments of equivalent quality.  Issuers of high-grade debt instruments are considered to have a very strong capacity to pay principal and interest.  Investment grade debt instruments are rated at least Baa or its equivalent by any NRSRO or are unrated debt instruments of equivalent quality.  Baa rated securities are considered to have adequate capacity to pay principal and interest, although they also have speculative characteristics.  Lower rated debt securities are more likely to be adversely affected by changes in economic conditions than higher rated debt securities.

U.S. Government securities include securities issued or guaranteed by the U.S. Treasury; issued by a U.S.

Government agency; or issued by a Government-Sponsored Enterprise (GSE).  U.S. Treasury securities include direct obligations of the U.S. Treasury, (i.e., Treasury bills, notes and bonds).  U.S. Government              agency bonds are backed by the full faith and credit of the U.S. Government or guaranteed by the U.S. Treasury (such as securities of the Government National Mortgage Association (GNMA or Ginnie Mae)).  GSE bonds are issued by certain federally-chartered but privately-owned corporations, but are neither direct obligations of, nor backed by the full faith and credit of, the U.S. Government. GSE bonds include: bonds issued by Federal Home Loan Banks (FHLB), Federal Farm Credit Banks (FCS), Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae).

Foreign Securities Risk – Investments in foreign securities involve certain risks that differ from the risks of investing in domestic securities.  Adverse political, economic, social or other conditions in a foreign country may make the stocks of that country difficult or impossible to sell. It is more difficult to obtain reliable information about some foreign securities.  The costs of investing in some foreign markets may be higher than investing in domestic markets.  Investments in foreign securities also are subject to currency fluctuations.

Exchange-Traded Fund Risk – ETFs are open-end investment companies, unit investment trusts or depository receipts that hold portfolios of stocks, commodities and/or currencies that commonly are designed, before expenses, to closely track the performance and dividend yield of (i) a specific index, (ii) a basket of securities, commodities or currencies, or (iii) a particular commodity or currency.  Recently, the SEC has authorized the creation of actively managed ETFs.  Currently, the types of indices sought to be replicated by ETFs most often include domestic equity indices, fixed income indices, sector indices and foreign or international indices.  ETF shares are traded on exchanges and are traded and priced throughout the trading day.  ETFs permit an investor to purchase a selling interest in a portfolio of stocks throughout the trading day.  Because ETFs trade on an exchange, they may not trade at NAV. Sometimes, the prices of ETFs may vary significantly from the NAVs of the ETFs’ underlying securities.  Additionally, if an investor decides to redeem ETF shares rather than selling them on a secondary market, the investor may receive the underlying securities which must be sold in order to obtain cash.

Liquidity Risk – Trading opportunities are more limited for fixed income securities that have not received any credit ratings, have received ratings below investment grade, or for fixed income and equity securities that are not widely held.  Liquidity risk also refers to the possibility a security cannot be sold at an ideal time.  If this happens, a client account may be required to continue to hold the security and losses could be incurred.

Investment Management Style Risk – We take an active management approach to investing.  There is no guarantee that our strategies will produce their intended results.  There is a risk that a particular type of investment on which an account focuses (such as small cap value stocks) may underperform other asset classes or the overall market.  Individual market segments tend to go through cycles of performing better or worse than other types of securities.  These periods may last as long as several years.  Additionally, a particular market segment could fall out of favor with investors, causing a strategy that focuses on that market segment to underperform those that favor other types of securities.

Value Investing Risk – A value-oriented investment approach involves the risk that value stocks may remain undervalued, or may not appreciate in value as anticipated. Value stocks can perform differently from the market as a whole or from other types of stocks and may be out of favor with investors for varying        periods of time.

Focused Investing Risk – With a focused portfolio there is the risk that a material event, which negatively impacts one or more of the securities, could have a meaningful negative impact on portfolio performance.

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