The rally in investment assets continued in the second quarter of 2017. All major asset classes earned positive returns for the quarter, and most have posted very strong returns year-to-date.
Growth Stocks Dominate
Domestic stocks continued their rally, led by large-cap growth issues. Smaller stocks and“value” stocks provided positive, but more anemic returns. Today’s market environment is starting to feel like the late 1990s when technology stocks were far and away the market’s top performers. We don’t have the same speculative excess today that existed in the 1990s, but there are some signs that it could be coming.
For example, Amazon agreed to purchase Whole Foods during the second quarter for roughly $13 billion. The day the deal was announced, Amazon stock rose significantly, adding roughly $13 billion to Amazon’s market capitalization, and effectively making the purchase cost-free.
Also, consider the fact that Tesla is valued more highly by the stock market than Ford Motor Co. This is despite the fact that Tesla produces relatively few cars and has a fraction of the infrastructure that Ford has built over many decades.
There are many other examples that growth potential is being prized above all else these days. Valuation is a secondary concern. This could continue for some time, but eventually the relative bargains offered by other market sectors will again be sought by investors, and the sentiment will turn. This occurred at the turn of the century in an ugly manner, as tech stocks crashed down. It is unlikely that we are approaching a similar occurrence, but the longer the divergence between growth and value continues, the messier an eventual correction would be.
International Stocks Rebound
Another market disparity, between domestic and international stocks, is finally beginning to close. For too many years now, international stocks have lagged behind their U.S. peers. The valuations offered by much cheaper international stocks may have finally become too great to ignore, as international stocks have performed quite well this year. Signs that economic and political reforms are finally taking hold also help boost investor confidence in overseas stocks.
REITs Disappoint
Public real estate investments have languished of late. This is not too surprising since REITs generated very strong returns the past several years. With the Fed raising interest rates, higher-yielding investments are likely to come under pressure. REITs remain a strong diversifier, but if interest rates rise in earnest, they could underperform for some time.
Bonds and Alternatives Plod Along
Speaking of underperforming, bonds produced low, single-digit returns. It is likely that this will continue for the next 6 to 10 years. Recent studies we have read indicate that the starting yield on bonds is a strong predictor of their annualized returns in the coming 6 to 10 years. Since the 10-year Treasury yields only 2.4% currently, it is likely bond market returns will be roughly the same as inflation for the foreseeable future. Bonds are still an important risk control in an investment portfolio, but expectations for future returns should be muted.
Alternative investment returns were also somewhat muted in the second quarter. These investments often move the opposite way of the stock market, so it is not too surprising to see modest returns when the stock market has been strong.
Overall, this has been a good year for investors so far. Many are nervous that the stock market has come too far, and that a crash is imminent. We don’t believe that to be the case. A recent study showed that big runups in the stock market are often not followed by market declines. Indeed, it is well known that valuation is not a good predictor of future market moves. Accordingly, we’re sticking to our discipline, and investing in stocks is a big part of that.
We certainly want to buy stocks with lower valuations, and our rebalancing helps ensure that we continue to get exposure to more reasonably priced small-cap, value, and international stocks. We’re at the half way point for 2017, but hopefully the back half of the year looks like the first half.
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