Second Quarter 2017

July 7, 2017 / Quarterly Newsletters

Equity markets around the globe overcame geopolitical concerns and continued their upward trend.   As in the first quarter, international stocks, emerging markets, and US technology stocks led the way.  The S&P 500 index of large US stocks is now up 9.3% this year.   Turkey, Korea and European stocks were top performers in the recent quarter, and although US small companies lagged they still posted respectable returns.  International returns were strengthened as foreign currencies strengthened about 6% on average compared to the US dollar.

The Federal Reserve increased short term “federal funds” interest rates by 0.25% (to target a range of 1.0% to 1.25%) in June, the second increase this year and the third since 2015.  The rate increase indicates that the Fed believes the US is making progress toward its objectives of full employment and it wishes to avoid inflationary pressures.  In contrast to rising short term interest rates, the rate on ten year US Treasury bonds declined modestly from 2.4% at the beginning of the year to 2.3 %, but remains considerably higher than the 1.4% low last July. The recent decline in long term rates is somewhat perplexing since it may indicate that bond investors are not quite as optimistic about the prospects of economic growth as the Fed.  The Fed also announced it will begin reducing the $4 trillion in US Treasury and mortgage securities that they acquired during the financial crisis.  They will initially reduce bond holdings by $10 billion per month and gradually increase that to $50 billion per month.   If anything, this planned reversal of QE (quantitative easing) would be expected to increase long term rates, but that has not happened yet.

Bonds achieved modest returns with the US Aggregate Bond Index advancing 1.5% during the quarter and are now up 2.4% for six months.

Equity markets advanced in spite of several uncertainties and concerns including:

  • How fast and how high will the Federal Reserve raise interest rates?
  • How will Great Britain fare in its negotiations over terms to leave the European Union?
  • What impact will the “snap” election which undermined Prime Minister May have in the “Brexit”   negotiations?
  • How will the rising tension between the US and North Korea be resolved?
  • What are the chances for the US passing healthcare and tax legislation and if passed what form will they take?

Returns for key indexes were:

 
 

2nd Qtr

2017

 

1st Half

2017

Dow Jones Industrials index 3.9% 9.3%
S&P 500 index 3.1% 9.3%
NASDAQ 3.9% 14.1%
S&P 400 mid-cap index 1.6% 5.2%
Russell 2000 small-cap index 2.5% 4.8%
Total International, excluding US 5.7% 17.8%
Dow Jones Global Stock index 3.7% 10.3%
Barclays US Aggregate Bond index  1.6 % 2.4%

 

Economic and Market Outlook   The US economy appears healthy and resilient, although economic growth remains sluggish.  The US GDP grew a measly 1.4% in the first quarter, but is estimated to have grown at a 2.9% rate in the second quarter.   Interest rates remain low by historic standards and US unemployment is a low 4.3%.

There are many approaches to assessing stock market valuation. Some show the market to be undervalued while others show it to be overvalued.  One valuation metric, which uses interest rates and corporate earnings, suggests that the S&P 500 is currently 10%undrvalued.  A significant reduction of the corporate income tax rate would make stocks even more attractive.

The earnings of US S&P 500 companies are expected to grow 6.5% for calendar year 2017, which is in line with historic long term profit growth. If US equities are near their fair value, then long term equity returns should be in line with the growth of corporate profits plus dividends paid (currently about 2%).

Most economists expect interest rates to continue to rise, which will reduce the value of existing bonds. This will impact long term bonds more than short term bonds.  If the increase is slow, as expected, it will present a mild headwind for fixed income investors and most bonds (and bond funds) should continue to produce positive returns as interest income more than offsets the loss in value.  However a significant increase in interest rates would likely produce volatility in the stock and bond markets.

Foreign markets have lagged the US for the last six years however both emerging markets and developed markets are now more attractively valued than the US. At this time it does not appear that the US is preparing to significantly increase tariffs which would materially affect foreign markets.

We remain cautiously optimistic for the remainder of 2017. Because of the many political uncertainties here and abroad, it would be prudent to invest cautiously and expect that higher returns will come from outside the US.

Preparing for a market downturn           The US stock and bond markets have been remarkably and uncharacteristically calm in recent years.  Historically, the S&P 500 index suffers a 10% decline once every 12 to 18 months and a 20% “correction” every three years. Yet we need to look back to 2015 when the S&P 500 dropped (temporarily) slightly more than 10% and back to 2011 when it declined 18%.  It typically takes the market four months to recover after a correction, but this can vary greatly.  It is important for investors to be prepared for a market decline at any point in time.  While we are not forecasting one in the near future, it certainly will occur at some point.  When it does, it is important for investors to have realistic expectations and not do anything rash.  Studies have shown that one of the most important things an investor can do is to control their behavior during market downturns. Panicking and selling after a decline can significantly undermine long term returns.  It is helpful to resolve not to do that before a decline occurs since when the markets are dropping it is too easy to let emotions rule.

While market volatility can be uncomfortable, it can also be an opportunity. A market recovery will likely begin at the point of maximum pessimism and the strongest market advances will likely occur early in the recovery.  If investors anticipate the market advances and participate in them and not be influenced by the then prevailing bad news in the media, they will have a decided advantage.

Backdoor Roth IRA    Both traditional IRA’s and Roth IRA’s are subject to contribution limitations based upon taxpayer earnings. However, there are no earning limitations for contributions to non-deductible IRA’s.  And there are no earnings limitations on conversions of non-deductible IRAs to Roth IRA’s.  This opens a “backdoor” opportunity for taxpayers whose earnings are too high for a direct contribution to a Roth IRA to first make a contribution to a non-deductible IRA and then convert this to a Roth (after waiting a respectable period of time).  If the taxpayer has no other traditional IRA’s the only tax that would be due is from any gain on investments in the non-deductible IRA before it is converted to a Roth.   This is something that can be done every year and over time an investor can build up a reasonable sized Roth IRA which will never be taxed.  One caveat is that if the taxpayer has traditional pre-tax IRAs, then IRS “pro-rata” rule limits will result in taxes on the conversion.  However, if the taxpayer’s 401K plan allows, it may be possible to move traditional IRA’s to their 401K plan and then contributing to a non-deductible IRA and converting it to a Roth.


About the author

John Eckel: CFP®, CFA is President of Pinnacle Investment Management Inc. of Simsbury. He has been included in BusinessWeek.com’s list of the Most Experienced Independent Financial Advisors, has been named four times to Worth Magazine’s list of Top Financial Advisors, included twice in Medical Economics list of Top Financial Advisors for Doctors and named twice in JK Lasers list of Top Professional Advisors for Baby Boomers.