The third quarter of 2017 was one of continued political strife at home, missile launches and increasing tension in Asia, several devastating natural disasters, and efforts by the Federal Reserve to slow the economy. In the face of that, the stock market rose to record highs.
Stocks Post Strong Gains
The stock market, as measured by the S&P 500, rose 4.5% in the third quarter. Mid-cap, small-cap, and international stocks all rose by a bit more or less, but all major markets experienced solid returns. Year-to-date gains are impressive, led by international stocks.
There is certainly no shortage of negative events to point to as reasons for the stock market to falter, and valuations by some measures are near historic highs. However, stocks continue to trend higher, and I believe there is reason to believe the good times could continue to roll.
Interest rates remain low, inflation is tame, burdensome regulations are being relaxed, and corporate profits are rising. That’s the ideal backdrop for stocks. If we hadn’t just notched eight years of impressive gains already, most would think this is a golden age for stock market performance.
Instead, negativity and caution reign. Most headlines and many market strategists suggest that another drop could be imminent. Anything is possible, and a breather for the market wouldn’t be unexpected, but barring a major exogenous event, the economy and capital markets appear poised for continued strength.
The situation is a bit different for the bond market, where lackluster gains are likely for the foreseeable future. That is not a forecast for losses, just anemic positive returns. Bonds are up over 3.1% year-to-date, but it is unlikely that returns of even that magnitude will persist. The Fed has indicated it will continue raising short-term interest rates. It has also embarked on a new policy of “quantitative tightening”. Rather than buying bonds in the open market to create liquidity, as it has done in the wake of the financial crisis, the Fed is now doing the opposite. It will unwind its historically large portfolio of bonds by letting them mature, and not repurchasing a similar amount in the open market. This will take liquidity out of the economy, which the Fed is betting is now strong enough to stand on its own. This is likely a healthy policy, but it could result in rising interest rates, which is bad for the bond market.
Given our dour outlook on bonds, we’ve been talking about using alternative investments as a replacement for bonds to hedge long-term portfolio risk. The third quarter was not kind to our alternative investments (see related article on reinsurance), making our argument look a little foolish. That said, the nature of investing is that every long-term strategy will sometimes experience short-term periods that look bad. So, we may be wiping a little egg from our faces, but we’re not ready to eat crow on this yet.
There is a lot of evidence and theory to support diversifying into investments beyond stocks and bonds. Our timing isn’t always impeccable, but we believe our long-term thesis on alternative investments still holds.
Given valuation disparities between the U.S. and overseas stocks, and the fact that interest rates are likely to rise, we’re taking a look at our stock allocation. As you know, we are far from market timers, and do not make many tactical changes to our portfolios. However, it seems there may be some longer-term structural events unfolding in the stock market. Accordingly, we’re looking at scaling back or possibly even eliminating our allocation to REITs. REITs are now included in major stock market indices, so we would continue to have exposure, just not as much. This would reduce our portfolios’ sensitivity to interest rates, and we could use the proceeds to commit additional funds to overseas stocks, which look poised to outperform domestic equities in the coming decade. We’re not ready to make these trades yet, but our research is underway.
Overall, it has been a great time to be an investor. Short-term volatility will rain on our parade at some point, but the nearby article on Warren Buffett’s stock market forecast shows that a long-term outlook will almost always result in a profitable investing experience.
To Download the complete 2017 Q3 Newsletter please click below.