First Quarter 2017

Market Review

The year began with the S&P 500 at 2239.  After an increase in the average during the fourth quarter of 2016, the question facing the markets was twofold: would stock prices increase and could bonds hold their ground as the Fed raised interest rates?

During this past quarter, relatively little volatility emerged. Given incidents that were happening both in the U.S. and abroad, this was abnormal. The S&P moved up to a record high of 2395.96 during the quarter, then gave back some ground, closing at 2362.72. This was a 5.5% gain in the average and was well ahead of the gain of 3.3% in the last quarter of 2016.

The first quarter results reflected the desire of investors to purchase large stocks of well- recognized companies. By contrast, the S&P MidCap 400 index was up 3.6% and the SmallCap 600 was up only 0.7%. Last quarter, both Mid Cap stocks and Small Cap stocks outperformed the larger index. This is another clear example of why we need to be broadly diversified. Had an investor used the results of the last quarter of 2016 to direct their portfolio for the first quarter of 2017, they would have overweighed small stocks. Such a decision would have been a financial mistake since small stocks underperformed.

In another example of the need to diversify, we can look at the DJ Global ex U.S. Index. Global stocks have not performed well for some time. For the first quarter, they were up 7.4%. This was better than any U.S. category.  

Fixed Assets

When we look at fixed assets we consider

cash equivalents, U.S. Treasury instruments (bills, notes and bonds), corporate bonds including short term, intermediate term and long term bonds. Cash and equivalents generally pay the least but are not subject to wide swings in value because they are readily convertible into cash. Long term bonds, be they corporate or Treasury, are subject to the most extreme changes in value with even small changes in interest rates.

When interest rates go up, the underlying value of bonds goes down. When interest rates go down, as they have been doing for more than 30 years, the value of the bonds goes up. We are now in an environment where interest rates are headed up. If the rise in rates is gradual, then the interest paid by the bonds can help to offset the decrease in the underlying value.

The Dow Jones Company follows 96 recently released investment-grade bonds with a range of maturities. Referred to as the DJ Corporate Bond Index, the interest rate yield on the index at the end of the quarter was 3.198%. The actual total return (increased/decreased bond value plus interest) for the past year was 1.809%. This means that during the past year, with interest rates rising, the bond has had a lower real rate of return than its interest rate. Although this is not what we would like to see, it does mean that the increases in interest rates are not deteriorating the underlying value of the bonds. Increased interest rates are reducing the overall return.

Why Own Bonds?

With stocks doing so well why should anyone want to own bonds?  Bondholders are the first to get their money back if there is trouble. Bonds are considered more secure for this reason. If you add to this the purchase of investment grade bonds, you have added another level of protection. We buy bonds because they are safe and have a steady rate of interest. If you need income, they provide the safest level of income. A year ago, the S&P 500 had a dividend yield of 2.20%. It is now 1.97%. Dividends can fluctuate from quarter to quarter. Bonds pay a set interest rate. In troublesome times, bonds tend to be more stable than stocks.

The FED

The Fed seems to be a constant topic these days. They increased the money supply when the outlook was bleak. They are now tightening up on the money supply. Their method is to increase the Federal Funds Rate. It was increased by 0.25% in December 2015, again in 2016 and then in March of 2017. This brought the rate from 0% to 0.75%. They plan at least two, and possibly three more increases in 2017. These increases will slow down the economy, help reduce the inflation rate, and tighten the money supply. The Fed’s inflation target is 2%, and the rate hit 2.1% in February. They are also planning on selling back into the market some of the billions of dollars in bonds they bought to prop up the bond markets since 2009.

In all these actions, the Fed needs to keep a close eye on the economy and make sure they do not stall it. With full employment, we are likely to see pressure on increasing wages, which can be inflationary. While consumer confidence is at an all-time high since the economic crisis, consumer spending is not picking up much. The savings rate has moved up to 5.6%.

The Economy

With consumer confidence at a high, inflation reaching a more normalized level, corporate spending growing, and investors feeling confident, we are going through a lull in market volatility. This is not just true of the U.S., but appears to be the case in numerous world markets. Emerging markets, which have a far higher level of risk, have been avoided up until recently. Now emerging markets are seeing rapid gains in security values.

Broad diversification seems to be the best way to invest in this environment. You want to own U.S. stocks and bonds, international stocks and bonds, and emerging markets stocks and bonds. The returns on each seem to be shifting widely and constantly. In this market, you don’t want to put all your investment money in a narrow allocation to try to get maximum gains, but do better to be broadly diversified and earn more consistent gains.

Conclusion

We appear to be entering a period where the actions of the Fed, the spending habits of the consumer, and the actions in Washington D.C. will all have a strong bearing on how the economy moves along. Each of the above will be watched by businesses to determine how they will benefit from the changing environment. Their goal is to increase earnings. Increased earnings, over time, should translate into higher stock prices. As mentioned several times in the commentary above, the use of broad diversification should sustain us and give us the opportunity to achieve reasonable expectations going forward.

Ed Mallon

Posted April 17, 2017