Market Update

Much to the enjoyment of investors, large company domestic stocks defied gravity in 2017 with the Standard & Poor’s 500 index rising 21.8%. Volatility was virtually non-existent. According to the Wall Street Journal, the S&P 500 has experienced 1% drops every seven or eight trading days on average over the past 30 years, and 2% drops about 10 times a year. In 2017 there were only four days with at least a 1% drop. There has not been a drop over 2% since two months before the election in November, 2016. Amazing.

While the performance of the large cap domestic stock indexes is impressive, the major foreign stock indexes fared even better. The MSCI EAFE index of established foreign stocks was up 25.0%, and the MSCI Emerging Market index was up a sizzling 37.3%. After many years of outperformance by U.S. equities, driven in part by a strong run-up of the U.S. Dollar, it appears this trend has changed.

Lost in all the excitement was a notable underperformance by small and mid-sized companies. While their returns were still attractive in the low to mid teens, they paled versus their large cap domestic brethren. Growth stocks also continued their recent dominance versus value stocks, regardless of whether the companies were small, medium, or large cap stocks. I fully expect the tables to eventually turn on both of these fronts as well (large cap vs. small cap and growth vs. value outperformance).

The biggest news in the 4th quarter of 2017 was the passage of tax reform. This was an important accomplishment, primarily due to the lowering of the corporate tax rate from 35% to 21%. Our nation’s corporate tax rate has been significantly higher than that of other developed countries, making the U.S. an unattractive place for companies to do business. This change alone should be a long-term positive for our country. Low to middle income taxpayers nationwide should also be pleased with the lowering of personal tax rates and the increase in the standard deduction. I am less certain about the impact on high wage earners, in particular in states with high income taxes such as California. Those of you fortunate enough (or wise enough) to live in states with low or no income taxes, don’t be surprised to see some new neighbors move in from out of state. Much ado has been made by the mainstream media that some of the tax cuts expire after 2025. This is not unusual, as previous tax reform has also had “sunset” provisions. These typically get extended or made permanent prior to expiration.

Bonds as measured by the Bloomberg Barclays U.S. Intermediate Government/Credit index were up 2.1% in 2017, which isn’t bad considering how low yields are. With higher interest rates on the horizon, the 36 year bull market in bonds may finally be running out of gas. Admittedly, people have been expecting interest rates to go up for many years now, but given the fact that the Federal Funds rate has increased five times now, the tide is shifting. Despite the rise in short term interest rates, intermediate and longer term yields have remained stubbornly low. I expect these to also rise over time as central banks around the world scale back their bond purchases. I believe the greatest risk to the financial markets to be inflation and the actions of the Fed. The Fed expects three more rate increases in 2018; the markets think it will be just two. Should market expectations be too low, which I think is a high probability, this could finally result in some volatility. The tax reform could add fuel to an already healthy economy at full employment, forcing the Fed to get more proactive raising rates to fend off inflation. While bonds are still an integral part of most investors’ portfolios, knowing what you own and where the risks lie is going to be critical going forward in a rising interest rate environment. I believe index funds are especially ill-advised in this climate.

The question du jour on investors’ minds seems to be how much longer can stocks continue to rise. While anything can happen to disrupt the markets, the tax reform does provide some continued momentum for domestic stocks in the near-term, though with risks as previously noted. I have recently seen some very uninspiring long-term real return (after inflation) projections for the S&P 500, from a variety of reputable sources. The U.S. stock market is another area I believe investors need to selectively invest in, and I cannot understate the importance of maintaining globally diversified portfolios.

I look forward to 2018, and hope you do as well. If you have any questions, concerns, or anything I can help you with, do not hesitate to give me a call.

Sincerely,

Glenn S. Rank, CIMA®
Certified Investment Management Analyst®
President, GSR Capital Management

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The Russell 2000 index is comprised of approximately 2,000 of the smaller securities from the Russell 3000. Representing approximately 10% of the Russell 3000, the index is created to provide a full and unbiased indicator of the small cap segment. The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market. The MSCI EAFE index and the MSCI Emerging Markets index are unmanaged indexes compiled by Morgan Stanley Capital International that are generally considered representative of the developed international stock market and emerging international stock market, respectively. International securities involve additional risks including currency fluctuations, differing financial accounting standards, and possible political and economic volatility, and may not be suitable for all investors. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing in small cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. The Barclays Capital U.S. Intermediate Government/Credit Bond Index measures the performance of U.S. Dollar denominated U.S. Treasuries, government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year and less than ten years. Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
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