2017 Third Quarter Review

The strength of the stock market continued in the third quarter. The S&P 500 Index was up 4.48% for the quarter and 14.24% for the year. The strength in U.S. Large Cap as measured by the S&P 500 Index was driven by the S&P 500 Growth Index with returns of 5.29% for the quarter and 19.33% for the year. This compares favorably to the S&P 500 Value Index with returns of 3.48% for the quarter and 8.49% for the year.

The S&P 500 Index has significantly outperformed the S&P Mid Cap 400 Index with a return of 9.40% year to date and the S&P Small Cap 600 Index with a return of 8.92% year to date. Based on valuation, Virtue Asset Management continues to recommend overweighting exposure to Large Cap stocks compared to Mid and Small cap stocks. International Stocks have continued their strong performance of 2017 with a return of 5.35% for the third quarter and 19.94% year to date.

In a response to the financial crisis of 2007-08 the U.S Central Bank implemented several rounds of quantitative easing by purchasing fixed income securities composed of U.S Treasury and Mortgage-Backed securities. The U.S. purchased over $3 trillion of securities from 2008 to 2014 and has rolled over maturing securities – using the proceeds of matured securities to buy additional securities. This process has led the U.S. Central Bank to hold just over $4.2 trillion in fixed income securities. The U.S. was not the only central bank to try this policy. The European Central Bank, the People’s Bank of China and the Bank of Japan have purchased a mixture of equites and fixed income for a total of $15.1 trillion. Combined with the U.S Central Bank, the total assets purchased since 2008 are $19.3 trillion.

The result of Global Central Banks purchasing $19.3 trillion of assets is that they have lowered the supply of investable assets. This decrease in supply drove up the prices of fixed income instruments, which lowered the interest rates available on fixed income securities. The lower rates provided by fixed income securities encouraged some investors to rotate investments from fixed income to equities. In fact, the U.S. Stock market saw an increase of market capitalization of almost $16 trillion from 2008 to 2017

In September, the U.S. Central Bank announced the gradual unwinding of their $4.2 trillion fixed income balance sheet. The process will begin by not reinvesting maturing bonds. Starting in October, at an initial rate of $10 billion per month and increasing to a maximum of $50 billion per month in October 2018. At a rate of $50 billion a month or $600 billion a year it will take until 2025 to completely unwind the balance sheet. In fact, the Bank of Japan has been making purchases of approximately $50 billion a month. This makes it likely that the total assets purchased by global Central Banks could still rise over $19.3 trillion in the medium-term.

The S&P 500 has now gone over 300 days since experiencing a 5% drawdown during a six-month trailing period. There have only been four periods in history where more time has passed without a 5% correction. If the market can go to January without a 5% drawdown it will be the longest period in history. We continue to believe one of the major factors to the strength in the stock market has been purchases of assets by major Central Banks since 2009.

Investors are entering uncharted territory with the U.S. slowly unwinding their balance sheet. At some point the supply of investible assets will increase and some of the $19.3 trillion will have to be purchased by investors instead of Central Banks. The question is how much appetite is there for more investible assets? Is a trillion dollars enough to drive asset prices lower? Is it $10 trillion? At Virtue Asset Management were trying to create portfolios that protect on the downside and make sure our clients are prepared for a possible pullback during this monetary experiment. We continue to recommend clients review their exposure to growth stocks versus value stocks and that their stock exposure should be at the lower end of their acceptable range.

2017 First Half Review and Second Half Outlook

The first half of the year continued the seven-year bull market for stocks with the S&P 500 up 9.17%. Virtue Asset Management continues to recommend over-weighting US Large Cap stocks versus US Mid Cap and US Small Cap. This allocation worked well for the first half of the year with US Mid Cap returning 7.68% and Small Cap returning 4.99%. The first half of the year saw strong performance outside of the US with International Stocks returning 14.57% and Emerging Markets returning 18.8%. Fortunately, India did better than the Emerging Market Index and returned 20.19%.

The increase in the S&P 500 was powered by growth stocks and overall earnings growth. Earnings in the first quarter for the S&P 500 were $28.21 versus $23.97 for the previous year – an increase of approximately 20%. The S&P 500 growth index returned 13.33% for the first six months of the year compared to the S&P 500 value index that returned 4.85%. The strong performance of growth was helped by the 35% weighting in technology. For the first six months of the year the NASDAQ, which has a 44% weighting in technology, returned 14.07%.

The month of June saw a change in the trend as the S&P 500 Value Index returned 1.9% while S&P 500 Growth Index returned -.39%. Currently, the Price to Earnings (P/E) ratio on the S&P 500 Growth Index is 25.14 compared to the P/E ratio on the S&P 500 Value Index at 18.4. It is possible that June was the beginning of a rotation from growth to value. Historically, value has outperformed growth over the long term. As displayed in the above chart, the last 10 years have seen growth index returning 8.96% annually versus value index returning 5.24% annually. Currently, we favor stocks with value characteristics given the lower valuation and lower performance of value over the last 10 years versus growth. It is not uncommon for growth to significantly outperform value for select time periods. In 1997 to 1999 the growth index returned 34.76% a year versus the value index which returned 18.16% a year. Of course, that period was the dot com bubble and eventually that bubble popped. The annual performance of the value index from 1997 to 2006 was 9.08% versus the growth index returning only 6.95%.

It is important to understand the underlying holdings in a portfolio and the potential risk of these holdings. In the extreme example of the dot com bubble bursting from 1999-2002, a portfolio of 60% invested in the NASDAQ was riskier than a portfolio that was invested 100% in the S&P 500. From 2000-2002 the 60% Nasdaq portfolio would have been down 32% versus the 100% S&P 500 portfolio down 31%.

Virtue Asset Management is not a value only firm but our individual stock picks tend to have more value characteristics. When we invest in a stock we imagine that we are buying that company and try to model earnings growth to project how many years before we would receive our initial investment back and then earn a profit. When we look at a company such as Amazon we look at a market cap of $450 billion. In a simplistic exercise, versus our more complex model, you can calculate the average earnings needed to receive your original investment back before profits. For a company that is $450 billion market cap, to receive your initial investment back you would need to average earnings of $45 billion a year for a 10 year span. Last year Amazon had earnings of $2 billion. If you stretch the time horizon out to 20 years you would need a return of $22.5 billion a year which is still ten times the profit Amazon made last year. At Virtue Asset Management we want to own companies that have a shorter time horizon to return the individual investment and that don’t rely on such high growth assumptions. We believe these more conservative companies will protect more on the downside in the event of a market pullback.

Fixed Income continues to provide low but positive returns. The Barclays Aggregate Bond Index returned 2.42% for the first half of the year. The preferred stock index had a better performance and returned 4.51% for the first half of the year. We continue to recommend holdings in preferred stock for fixed income because of the higher dividend payouts. We don’t expect the Federal Reserve to raise rates to a level high enough that other products will compete with the four to five percent coupon that the preferred stocks are currently offering.
The strong earnings of the first quarter has raised earnings estimates for the S&P 500 Index in 2017 to approximately $128. At the beginning of the year we applied a P/E ratio of 20 to set the upper bound target for the S&P 500. Using the P/E ratio of 20 brings the end of year target of the S&P 500 up to 2560 for an increase of 5.6% from the end of second quarter level. If you use the 10-year historical average P/E of 17.14 and earnings of $128 you get a lower range scenario of 2197. This would be a decrease of 9.3% from the end of second quarter level.

This limited upside potential is one of the reasons we continue to recommend investor’s stock exposure should be at the lower end of their acceptable equity range. We also recommend that investor’s conduct an in-depth review of the holdings in their account to understand their exposure to growth stocks and the risks such exposure may carry.

2016 Investment Review and 2017 Outlook

The US Stock market showed surprising strength and velocity in the eighth year of the current bull market. The S&P 500 returned 11.96% in 2016. This strong performance was driven in part by a 4.98% increase in the S&P 500 since November 9th, the day after the election. The strong post-election results have been driven by optimism on Wall Street. This optimism should not come as a surprise. Recently, every Wall Street analyst in Barron’s predicted an up market for 2017. Unfortunately, if you go back every year since 1998, when Barron’s first published predictions, we see the same result: every analyst predicting an up market. Of course, it is easier to sell products with an optimistic sentiment and a rising stock market. In our view, there is a potential conflict of interest when Wall Street manages money and is trying to sell their own products.

Wall Street’s annual optimism, in our view, creates two major problems. First, they aren’t looking for early signs from the market that a pullback is happening. Second, their bureaucratic structure makes it slow for them to adjust portfolios when the pullback happens. We believe that our current asset allocation continues to provide protection in the event of a pullback. We continue to recommend significantly overweighting US stocks compared to international stocks. This asset allocation worked well in 2016 with US Large Cap returning 11.96%, US MidCap returning 20.74% and US Small Cap returning 26.56%. This compares to International Stocks returning 4.5% and Emerging Markets returning 10.87%. We continue to favor US Large Cap stocks with a lower P/E ratio than the overall market.

Despite the strong year in equities, fixed income still provided a positive return. The Barclays Aggregate Bond Index returned 2.65% for 2016. Protecting the portfolio for inflation paid off in 2016 with Treasury Inflation Protected Securities returning 4.68% for 2016. The traditionally riskier asset classes of fixed income provided stronger returns for the year. High Yield returned 13.41% and Emerging Market Bonds returned 9.26%. We still feel that most investors don’t understand the risk in these fixed income asset classes which has been distorted with governments purchasing bonds. We recommend avoiding High Yield and Emerging Market Bonds in 2017.
The historic optimism of Wall Street is why we don’t use forward earnings when valuing companies or the stock market. We prefer to look at the actual earnings of companies and the overall market. Over the last 12 months the S&P 500 has earned roughly $101 a share. If you take the value of the S&P 500 at the end of 2016 it was 2238.83. This gives you a trailing Price/Earnings (P/E) ratio of 22.17. Over the last 10 years the average trailing P/E has been 17.14.


Source: S&P Dow Jones Indices

Wall Street’s optimistic earnings estimates vary, but they average approximately $125 per share for the S&P 500. Yes, that is approximately a 25% increase in earnings in 2017. This scenario must assume every positive aspect of the new Trump presidency and ignore any risk. It is true that lower taxes and less regulations will help the economy and most company’s earnings. There is still the risk of getting the legislation passed and the question of how long it takes to implement the legislation and any unintended consequences.

If you use a P/E ratio of 20 to value the S&P 500, which is still higher than the 10-year historical average of 17.4, then you get a target of 2500 for the S&P 500. This would provide a return of 11.67% for 2017. This is our upper range scenario for 2017. We view more realistic earnings estimate for 2017 as $110 a share. If you apply a P/E ratio of 20 to these earnings you get a target of 2200 for the S&P 500 which is a decrease of 1.7% from the end of year level. Finally, if you use the 10-year historical average P/E of 17.14 and earnings of $110 you get a lower range scenario of 1885. This would be a decrease of 15.80% from the end of year level. These assumptions are based on increased earnings and are ignoring some of the worst-case scenarios possible with a Trump presidency. We view any trade wars or tariffs as a negative for the economy and these actions would lower earnings in 2017.

Our upper range scenario is an increase of 11.67% and our lower range scenario is a decrease of 16.61%. Given this outlook, we recommend that investor’s stock exposure is at the lower end of their acceptable equity range. We also caution clients to be prepared for increased volatility in both equity and fixed income markets in 2017.

First Half 2016: Investment Review & Outlook

The first half of the year was volatile with the S&P 500 down 11.44% on February 11th and up 3.75% on June 8th. The double digit drop in February was fueled by lower oil prices and slower economic growth. The Gross Domestic Product (GDP) for the United States in the 4th quarter of 2015 grew 1.4% and for the 1st quarter of 2016 it grew 1.1%. The stock market, like most people, hates uncertainties. The uncertainties make it harder to value stocks and the market in general. After the Federal Reserve raised rates in December, there was a belief by the market that they would continue to raise rates. The prospect of higher rates, lower economic growth and an upcoming presidential election drove the markets down. In the beginning of the year the market believed we would see fed rate hikes in 2016. This view has changed and the market has now priced in zero rate hikes for the year.

The prospect of continued low rates for the year helped to drive the market from the lows of February with the S&P 500 ending the first half of the year up 2.69 percent excluding dividends. Unfortunately, we have now seen earnings growth decrease in 5 of the last 6 quarters. In the chart below you can see the price of the S&P 500 versus the quarterly earnings of the S&P 500. Quarterly earnings peaked in the 3rd quarter of 2014 while the market reached all-time highs in June of this year.

The price to earnings ratio (P/E) of the S&P 500 is calculated by dividing the price of the S&P 500 (numerator) by the earnings of those companies (denominator). When the earnings (denominator) have stagnated, or gone down, but the market has gone up that means the P/E ratio has increased.  On Junes 21st, Janet Yellen mentioned that “[f]orward price-to-earnings ratios for equities have increase to a level well above their median of the past three decades.” This quote brings back memories of Alan Greenspan on December 5, 1996 and his famous “irrational exuberance” quote. The S&P 500 rallied 105% percent from his quote to the peak on March 24, 2000 before experiencing the infamous tech bubble bursting.

We have the self-awareness to recognize that we could never call a top in the market. What we can do is utilize the tools available to us to try and protect our portfolios. The first strategy is to avoid what we view as risky asset classes that are not providing an attractive risk/reward profile. We are avoiding high yield, emerging market debt and most emerging market countries. The second tool is finding individual large cap stocks trading at a lower valuation than the S&P 500. This is why we focus on attractively priced companies that have had a history of book value growth greater than the S&P 500. Finally, when appropriate we can utilize options to protect the downside of stocks, asset classes and portfolios.

There is some optimism for the upcoming 12 months. We will know the results of the presidential election and the results will remove some uncertainty from the stock market. We believe that a significant pull back in the market will lead the Fed to an easier monetary policy. However, the uncertainty of the market has increased with the recent Brexit vote. The Brexit vote combined with the upcoming US presidential election points to more volatility in the next six months. Given valuations and market uncertainty, we are recommending most clients’ portfolios to be positioned at the lower end of their recommended equity range. Until we see growth in earnings, we will continue to keep a conservative stance in our portfolios.