May You Live in Interesting Times …

The times, they are certainly interesting.  Calm has descended upon financial markets in an unprecedented fashion this year as equity markets across the globe have trended higher with little interruption.  Through the end of the third quarter, all major asset classes in the table below posted positive returns for the quarter and year-to-date, with Emerging Market and International stocks leading the way, both up more than 20% for the year.

In our view, this outperformance by non-U.S. stocks is a natural progression.  The U.S. economic expansion post-financial crisis turned 100 months old earlier this year, and while the foundation of the U.S. recovery remains intact, the bull market in the U.S. has likely moved into a later phase.  Given International and Emerging Markets were slower to emerge from the crisis era, they are still much earlier in their economic expansions which could be a tailwind for their equity markets.

It was also a great quarter for U.S. Small Cap stocks, as their 6% return in the quarter made up roughly 70% of their 8.9% total return for year.  After a sleepy start, small caps again became the object of investor’s affection in mid-August as early discussions around corporate tax cuts began to take place in Washington.  Unlike their Large Cap peers that do business across the globe (think IBM or Starbucks), Small Cap stocks generally have domestic focused business models, and thus carry higher effective tax rates which make tax cuts more relevant to their bottom line.  Interestingly, the small cap performance in 2017 is eerily similar to 2016, when small cap stocks were barely above neutral through mid-year, only to break out to finish the year.

In fact, roughly 40% of the total return in 2016 came after the election!  Patience is required to derive good investment outcomes and that is especially true in Small Cap stocks.

In fixed income, bonds in almost every category experienced positive returns for the quarter.  Though the U.S. 10-year Treasury started and finished the quarter in roughly the same place, around 2.35%, the 10-year did hit its lowest point of the year intra-quarter at 2.04% on September 7th, as investors sought safety behind geopolitical flare-ups and one of the toughest hurricane seasons in recent memory.

The narrative this year has been less about markets advancing and more about the lack of resistance they have encountered on the climb.  Through October 9th, the largest decline from a recent high in the S&P 500 this year has only been 2.8%, as the action has been one-sided and market volatility has seemingly been without a pulse.  The CBOE Volatility Index, or VIX, has now closed below 10 on 29 separate occasions this year, a reading that indicates a general lack of fear among investors.  To put that in perspective, from 2003-2016, the VIX only closed below 10 four times.


Source: Y Charts


While this period of low volatility is a more recent story line, it’s important to step back and consider how far we’ve come to get here.  Almost ten years ago to the day, on October 9th, 2007 the S&P hit its peak before the Financial Crisis of 2008, where the S&P proceeded to fall approximately 55% before the market bottomed out 18 months later in March 2009.  During the chaos that ensued in 2008, the U.S. unemployment rate rose to 10%, multiple Fortune 500 corporations had to be taken over by the government, and the economy experienced its deepest recession since the 1930s.  And through all that, even if you invested in the S&P at its peak on October 9th, 2007, your investment would have more than doubled as you sit here today.


Source: Y Charts


This serves as a good reminder that over time the stock market arguably anoints more wealth for the masses than anything else out there.  And regardless of what happens over the next 10 years, that will likely still be true.

It would be foolish to believe the status quo will not change at some point.  While our crystal ball is no better than anybody else’s, a pillar of long-term investing is having a plan in place when volatility reemerges from its slumber.  Admittedly, we don’t know when that will happen nor what the catalyst will be, but we do know that rising markets can go further than most people think and they certainly don’t ring a bell at the top.  While we are indeed living in interesting times, it is important that investors distinguish between that which is interesting from that which is actionable.  In our experience, there tends to be little overlap between the two.