December Newsletter: Taking Stock of 2017

Posted by Alex Frey (@alexhfrey )

As we write this we are counting down the hours left in 2017, which among other things means we are well into the annual season where prognosticators everywhere make mostly-bad predictions about the year ahead. We say mostly-bad because there is little evidence that so-called "experts" have much more than average ability to predict the future, and while we are open to the idea that some true experts might, they don't tend to be the ones making headlines. Instead, the news networks (financial or otherwise) turn to the same breed of loud commentators that cater to a consistent worldview and provide entertainment value without any real predictive value (perfect example: Peter Schiff, who has been featured on CNBC seemingly at least quarterly for as long as I have been paying attention, despite being utterly and consistently wrong for the past decade, and not presenting much of a coherent argument). It's clear that the annual rite of prediction-making is more about entertainment than informational value.  

At IvyVest, we are about investing the rational way, so entertainment wrapped in the guise of investing doesn't pass the muster. Nonetheless, we DO think it is instructive around this time to take stock of some of the major issues that COULD change the way we invest for the future. We think about it not so much as predicting what is going to happen in 2018 (we have no crystal ball), but in predicting what issues will change the world over the next year.  

Let's start by taking stock (no pun intended) with where we are in terms of some of the key drivers of investing performance.  

First, the macro economic status, which can be characterized as cyclically-strong, if a bit secularly weak. The cyclically strong part of that: U.S. unemployment declined during the year from 4.8% to 4.1%, a 17 year low and a number which usually characterizes quite "full employment" given that there will always be some residual portion of people "in-between jobs." U.S. economy has grown at an average annualized rate of 2.5% through the 3rd quarter. The annualized growth rate in the third quarter was 3.2%.

Other economies also did well in 2017. The International Monetary Fund says that the developing countries grew at a 4.6% annual rate, and advanced economies grew at a 2.2% annual rate. Europe grew at a 2.2% rate, and the Asia Pacific countries grew at a 5.5% rate. It has been a while since the whole world saw economic growth at the same time, but most of the world was growing in 2017 (South America may be the exception; growth there was very slow in 2017).  

What about that "secular weakness" mentioned above? That growth rate of 2.5%, while decent, is not super-strong and reflects the fact that underlying growth in productivity (output per hour worked) has been weak since the 2008 financial crisis. In other words, relatively more of the economic growth experienced has come from putting resources (I.e. workers) that had been on the sidelines back to work, versus technological improvements in the underlying efficiency at which we produce goods and services (of course, as we have covered in past newsletters, there is considerable debate about the causes of this and some dispute it altogether as a purely statistical anomaly). As we reach full employment and beyond, the low-hanging fruit has largely been picked.  

So what happened to financial assets this year? Figure 1 shows how the world equity markets fared during the year. A 10 year history of various market segments is shown, but we are most interested in the last year. The world markets did very well. Every component (U.S. stocks, European stocks, Pacific stocks, and emerging market stocks) made strong gains. It has been a long time since all of these components were moving up simultaneously. Over the 10 year period, the U.S. market has markedly outperformed the others (note the change in scale for the Vanguard VTI ETF), but in past year or year and a half, foreign markets have moved up significantly. In other newsletters and blogs we have noted that the U.S. market doesn’t always lead the pack; there have been time periods when foreign markets significantly outperformed U.S. markets. That’s why we believe in having diverse holdings, and this has been a positive driver of performance this year that we expect will continue to work next year.  

Img1Figure 1: The growth of $10,000 over the past 10 years for different market components. The components are represented by Vanguard ETFs, and the data if from Vanguard. 

Table 1: Parameters pertaining to market components. The data is from Vanguard
and Morningstar  

Market ETF Growth in past 12 months P/E ratio* Dividend Yield (%)
US Stocks VTI 18.6 21.8 1.84
Europe Sotcks VGK 23.4 16.0 3.49
Pacific Stocks VPL 15.5 14.6 2.63
Emerging Markets VWO 18.9 14.6 2.60

*The price/earnings ratios given here were taken from Morningstar. They use prospective earnings (expected for the next 12 months) and may treat negative earnings in a way that reduces the computed PE ratio. Vanguard reports higher PE ratios for these same funds.

Figure 2 shows how U.S. real estate investment funds, represented by VNQ, and international real estate funds, represented by VNQI, fared. The U.S. real estate market had very strong performance over the last 10 years, but in the last year it has been basically flat. For the foreign counterpart, more or less the opposite is true. 

Figure 2: The performance of real estate assets over the last 10 years. The data is from Vanguard. 

Figure 3 shows how gold and the U.S. dollar have fared in the same time period. Gold has been rather stable for the last year and a half, but we continue to like holding it as part of a balanced portfolio as we expect that it would rise in an environment where inflation picks up and the market starts to re-question "fiat" (or government-created) currencies. The trade weighted dollar index fell a little during the year but is still above its level for most of the past 10 years. Both of the measures indicate that inflation expectations are low. Overall, 2017 was a very good year for equities.

Img3Figure 3: The price of gold and the value of the trade weighted Dollar Index for the past 10 years. Data is from Federal Reserve Economic Data (FRED).  

How about interest rates? Every year we highlight the Federal Reserve's ability to move beyond its unprecendented zero-interest-rate-policy following the financial crisis as a "thing to watch." Thus far there hasn't been much to see. The Federal Reserve raised the target federal funds rate (the fed rate) three times during the year, bringing the target range to 1.25% to 1.50%. This is the “overnight” rate that banks charge one another. It is very short term and available only to very creditworthy institutions. These increases ended a long stretch during which the fed rate was near zero. The current rate, still low by historical standards, is the highest since 2009. One might have expected that an increase in the fed rate would be reflected in higher rates for longer duration loans. This has not been the case. Figure 4 shows how the 10 year treasury rate and the 30 year treasury rate have varied over the past 10 years. For the past two years, they have been basically stable and very low by historical standards. In fact, the trend for 2017 was very slightly down. The long awaited and much prophesied interest rate reversal has not occurred. Instead, the interest rate curve has flattened with very short rates moving up but longer term rates remaining nearly constant. This seems to indicate that market participants have very low inflationary expectations. But, (as always) it is possible this situation may be about to change.  
Figure 4: 10 year trends in treasury in 30 year and 10 year treasury interest rates. The data is from Federal Reserve Economic Data (FRED). 

Valuations on the U.S. equity market grew during the year. A number of people thought they were already too high when the year began. Are they too high now? Obviously, opinions differ. We discussed market valuation in our March newsletter, and we won’t repeat that discussion here, but we will update a few relevant numbers. The Shiller CAPE ratio is now 32.4 per Shiller’s online data. The Shiller CAPE is a price earnings ratio that uses the average earnings for the past 10 years in the denominator. It has only been higher twice before: just before the Great Depression and just before the “dot com” bust. So the Shiller CAPE presents an ominous picture. The current price earnings ratio for the U.S. market (based on current earnings) is about 23 as compared to a post-World War II average of about 17.6. On this basis the market value is high, but perhaps not disastrously so.  The counter argument is that the economy and the markets themselves have changed greatly over time, and the historical averages may not be meaningful now. Also, with the present low interest rates, bonds provide less completion to stocks, and the future earnings of companies look much better when they are discounted with a lower interest rate. Of course that argument depends on interest rates remaining low, which requires that inflation also remain low. Much more could be said on this topic, but for now we refer you to our March newsletter. We will probably write another newsletter on this topic in the near future. However, some foreign diversification appears to be a reasonable strategy. 

Another very interesting development during the year was the explosion of bitcoin. Our July newsletter discussed this in more detail, but figure 4 shows the more recent price action. Bitcoin started the year with a price of about $997. As we wrote our July newsletter, the price was about $2500, but it fell to about $2000 as we were writing. As we are writing this newsletter, it is about $15745, but it made a high in mid-December that was close to $20,000. Just two years ago, at the beginning of 2016, you could have bought it for $434. We think that cryptocurrencies are one of the most interesting developments in the world of finance in the past few decades and are closely monitoring the situation. While we were cautiously positive on bitcoin during the last two times we wrote about it (and even encouraged investing a small amount of play-money in it), it now seems more or less clear that the "crypto" world has entered a bubble with "fear of missing out" driving future price increases. That doesn't necessarily mean that bitcoin won't go higher over both the short and long-term, but it does add considerable medium-term risk.  

Our view is that the rational long-term value in bitcoin lies as being a kind of "digital gold", a decentralized digital asset that has a fixed supply and is not dependent on any government or centralized entity that investors could lose trust in over time (as history shows happens eventually with government-sponsored currencies). Other investors have concentrated on bitcoin's ability to efficienctly send payments (a "medium of exchange"), but the current network is far too congested and expensive to do this more effectively than current methods. It seems unlikely that mass-market consumers will be buying coffees with bitcoin (or any other crypto-currency) anytime soon.  

We should mention that a new network, called Lightning, is under development that may solve these payment problems. Lightning would be an overlay on top of the bitcoin network that would permit many transactions to be conducted without using the underlying block chain. Lightning might make bitcoin more useful. However, we would urge extreme caution about investing in bitcoin if your thesis is that it will be a payments innovation. In our opinion, there is a small possibility that it might break into real commerce at mass scale.   
Figure 4: The price of bitcoin over the past year. The data is from Coinbase.  

The last development that we should comment on is the new tax law just passed by Congress. You almost certainly know the major features of this law. Corporate taxes are reduced from 35% to 21%, the standard deduction is almost doubled to $24,000 for a married couple, and rates for individuals are generally reduced. Many of the individual tax law changes expire in 2025, but the corporate changes are permanent. The law has been more fully described in many places, so we won’t go into detail here. In our opinion, the reduction in the corporate tax rate was needed to make U.S. corporations more competitive internationally, and it will have obvious positive effects on after tax corporate earnings, a good thing for investors. However, the macroeconomic effects of the new law are not clear. On a static basis (i.e., assuming that the law does not affect the level of economic activity), the law will reduce federal revenues and add to the national debt by about $1.5 trillion over a decade. Most economists agree that tax cuts create an economic stimulus which will offset some of the loss of revenue, but most do not think that the economic growth will be great enough to offset the decline in tax rates. Therefore most economists predict that the new law will increase the budget deficit. For instance, the Tax Foundation, a generally conservative group, predicts that the law will decrease total federal revenue by $448 billion over the next 10 years (as compared to the baseline case which has no changes in law).  This is after allowing for a 1.7% increase in the Gross Domestic Product (GDP) over the 10 year period. The Tax Policy Center, a generally liberal group, predicts that GDP will increase in the early years, but that there will be no net increase in GDP after 10 years. They predict that the deficit will increase (compared to the baseline case) by $1,260 billion.  

The interesting thing about this new law is that it creates a fiscal economic stimulus (adds to the deficit) at a time when the economy has been growing for 8 years and when unemployment is low. Economic theory generally calls for budget deficits to stimulate the economy when unemployment is high, and budget surpluses when the economy is running well. Of course, virtually no nation in the world actually does this. The U.S. and most other nations run nearly continuous deficits. The U.S. has had only 9 surpluses since 1950. Nevertheless, this is an interesting time to be cutting taxes. The current 2017 budget deficit is estimated to be $693 billion by the Congressional Budget Office. With no changes in law, the 2018 deficit is predicted to be a little lower, but for the following years out to 2027 the deficit is predicted to grow annually (ignoring the new tax law and any other changes in law). The growth in the deficit is driven by demographic changes as the baby boomers move into retirement. The new tax law will add to those growing deficits. So, the government will need to borrow ever larger amounts of money, and the effect on interest rates and the economy must be considered. In essence, the U.S. is running a very interesting experiment to see if economic stimulus works when unemployment is already low and when the budget is already in deficit.  We don’t know how this will play out, but there is certainly a scenario here that would lead to inflation and higher interest rates. So, once again, we see advantages for a diversified portfolio. The IvyVest portfolio includes commodities, gold, and TIPS, all of which may do well in an inflationary environment. We certainly don’t recommend getting out of stocks, but diversification may payoff in the long run.

In any case, 2017 was a great year for investors. We should hope for many more like it, but expect that the good times may end soon. Whether 2018 is one of the last of the good-years or one of the first of the bad ones, history and basic logic show that a change of the seasons is coming sooner or later. It is a founding principle of IvyVest that while the true "fair-value" of a stock market may be an impossible thing to ascertain given that the feedback effects from prices to underlying economic conditions operates in both directions (I.e. the level of the stock market simultaneously determines and reflects the real economy), markets tend to oscillate between periods where investors are overly-rosy and willing to look past pending clouds and periods where they are overly-pessimistic. We think we are entering one of those first type of periods now. However it is notoriously difficult to predict turning-points and impossible to do so with enough accuracy that it make sense to "take the chips off the table" entirely, so getting out of the game entirely would be a mistake.  

For the past five years, it hasn't much mattered what you did in the markets so long as you were in them in a broad way. Our sense is that's about to change. We think the diversification and dynamic-allocation potential of the IvyVest model may prove essential over the next three to five years.  

Happy 2018 to you all. Wishing you the best of investing success in 2018: Stay safe, stay diversified, and stay invested.  
Alex Frey 

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By Alex Frey