December 21, 2017
“The four most beautiful words in our common language: I told you so.” – Gore Vidal
''When I make a mistake, it's a beaut.''– Fiorello LaGuardia.
A lot went right and very little went wrong for diversified investors in 2017. The same cannot be said for those of us who make bold predictions about the global economy and financial markets for a living. So let’s start with a quick review of 2017 through the lens of some of our most- and least-accurate predictions from our 2017 outlook article, published in early January.
HIT: “We expect most asset classes to improve on their 2016 performance, particularly outside the U.S.” Returns across virtually all major asset classes surpassed our expectations in 2017. Global equities enjoyed a broad-based rally amid synchronized growth worldwide, while longer-dated bonds posted modest gains as interest rates barely budged. Both asset classes comfortably outperformed cash. And for the first time in several years, international stocks outpaced their U.S. counterparts, at least in U.S. dollar terms. We also foresaw the dollar’s two-and-a half-year rally coming to an end, which contributed greatly to the outperformance of international assets for U.S. dollar-based investors.
Brian Nick, Chief Investment Strategist, TIAA Investments
MISS: “Investors hoping for muted volatility may be disappointed.” During the late 1990s, high market returns came with a cost—higher market volatility. The 2017 global equity rally entailed no such tradeoff. Despite uncertainty about U.S. tax policy, concerns over North Korea, weather-related disasters and more, daily market moves this year were more gentle than at any point in modern history. Here’s one potential explanation: correlations among individual stocks were extremely low in 2017 as company fundamentals diverged, and the impact of policy disappointments and stubbornly low inflation affected different sectors differently. When correlations are weak, volatile days are few and far between.
HIT: There is no guarantee that a politically inexperienced president will be able to usher multiple complex pieces of legislation through a still-contentious Congress as easily as has been assumed.” We wrote last year’s outlook when nearly all markets, including stocks, bonds, and currencies, were already pricing in a successful passage of the Republican agenda: repeal of the Affordable Care Act, individual and corporate tax reform, and fiscal stimulus through infrastructure spending. Of these, only tax reform will be signed into law by the end of the year. The lack of progress on the other fronts has led to a weaker U.S. dollar, mildly disappointing GDP growth, and a flatter U.S. yield curve. The tax bill’s effectiveness in stimulating the economy next year will help determine to what degree these trends reverse.
MISS: “We are comfortable forecasting a year-end [S&P 500 Index] target of 2,400.” Missing an S&P 500 target by nearly 300 points—the S&P 500 closed at 2,679 on December 20—isn’t as disastrous as it used to be (say, when the index level was 700), but clearly we were not optimistic enough about U.S. stocks at the start of the year. The first two months of 2017 saw a marked rise in equity valuations, specifically the price-to-earnings ratio, which peaked on March 1. For most of the rest of the year, stock prices rose in line with earnings growth until valuations surged again in the fourth quarter as the tax reform bill moved through Congress. Still, stocks’ impressive 2017 run is a sign of improving corporate fundamentals, not just increasing investor risk appetite.
Lifted by Congressional passage of tax-reform legislation on December 20, the S&P 500 Index gained about 0.4% for the week through December 21. Investors appeared to be positioning for a “Santa Rally”—a rise in stock prices that is often observed between Christmas and New Year’s. European shares also advanced, with the STOXX 600 Index returning 1.5% in U.S. dollar terms.
In fixed-income markets, yields on longer-dated U.S. Treasuries rose significantly. In particular, the 10-year note closed at 2.49%—a nine-month peak—on December 21 after beginning the week at 2.35%. In our view, investors may be anticipating higher yields next year. That is partly because Treasury issuance is set to roughly double over 2017 levels, partly as a result of the deficit funding required by the new tax bill. Should the tax cuts increase GDP growth above consensus, yields could rise further still.
The Citigroup U.S. Economic Surprise Index, which broadly measures whether economic data has exceeded or lagged forecasts, has risen steadily during the fourth quarter. Recent housing market strength, fueled by improving household balance sheets, has contributed significantly to this uptrend. This week’s positive reports include:
The “January effect” is intriguing. According to this theory, developed by economist/investment banker Sidney Wachtel in 1942, stock prices should fall in December as investors engage in tax-loss harvesting, the practice of selling stocks in order to offset winners with losers. This should be followed by a January rally as investors re-enter the market.
When Wachtel developed the hypothesis, more than 90% of equity owners were households, and year-end tax planning was especially important. Not only were tax-deferral vehicles such as IRAs or 401(k)s not yet available, but marginal tax rates were much higher than they are today. For example, from 1932-1941, the top rates ranged from 63% to a whopping 81%.
At first blush, this so-called phenomenon may make intuitive sense. But it’s not supported by data. According to Yardeni Research, during the current bull market, which began in 2009, average returns for January and December have been identical, at 1.8%. And since 1928, December’s average S&P 500 returns (+1.4%) have actually exceeded January’s (+1.1%). If investors had indeed been selling in December and buying in the new year, December’s returns should be lower, not higher.
Data aside, there are practical reasons why the theory fails to pass muster. A lot’s changed since 1942. Individual investors, while undoubtedly still concerned about tax planning, now make up less than one-third of all stockholders; institutional investors now control the lion’s share by a wide margin. Institutions are less concerned about seasonality, rebalancing throughout the year after periods of strong equity performance and buying bonds.
In our view, prudent tax planning is always advisable. That includes meeting with qualified professionals before making any year-end tax decisions. In terms of developing an asset allocation, January is best spent beginning to fulfill New Year’s resolutions, not trying to time the market.
Please note that the next Weekly Market Update will be published on Friday, January 5, 2018.