The S&P 500 finished 2017 by completing an unusual feat. Not only was the index up +22% (total return), but every single month of the year saw positive performance on a total return basis, and in fact, the index is on a 14-month winning streak (Note: the previous record of 15 straight was set back in 1959!). So, as you might expect, volatility was historically low all year, with the VIX displaying an average daily closing value of 11 (versus a “fear threshold” of 15 and a “panic threshold” of 20). But some of 2017’s strength was due to expansion in valuation multiples in anticipation of tax reform and lower effective tax rates boosting existing earnings, not to mention incentives for repatriating overseas cash balances, expansion, and capex.
Sector correlations also remained low all year, while performance dispersion remained high, both of which are indications of a healthy market, as investors focus on fundamentals and pick their spots for investing – rather than just trade risk-on/risk-off based on the daily news headlines and focus on a narrow group of mega-cap technology firms (like 2015), or stay defensive (like 1H2016). And Sabrient’s fundamentals-based portfolios have thrived in this environment.
Now that the biggest tax overhaul in over 30 years is a reality, investors may do some waiting-and-watching regarding business behavior under the new rules and the impact on earnings, and there may be some normalization in valuation multiples. In other words, we may not see 20% gains in the S&P 500 during 2018, but I still expect a solidly positive year, albeit with some elevated volatility.
In this periodic update, I provide a market outlook, conduct a technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and offer up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model also maintains its bullish bias.
Market Commentary:
US stocks were buoyed all year by strong global economic reports, rising corporate earnings, domestic deregulation, and massive global QE generating demand for the relative safety of US assets, resulting in a persistent uptrend with no significant corrections. The S&P 500 closed the year at 2673, so the 3000 mark is a mere 12% higher, which I think is achievable. I also think stocks may finally endure the significant correction that was so elusive last year, but it would mark a healthy cleansing that ultimately leads to higher prices for the next few years – barring any major disruptions from the myriad geopolitical risks, not the least of which is the global credit bubble and the need for careful deleveraging, especially in China (as it also navigates through a fundamental transition from disinflationary state-owned manufacturing to inflationary consumption and spending among its burgeoning middle class).
Looking at ETFs representing various market segments, the S&P 500 (SPY (NYSE:SPY)) was up only +0.7% in December, but some segments did much better. Standouts during the month included SPDR S&P Oil & Gas Equipment & Services (NYSE:XES), VanEck Vectors Steel (NYSE:SLX), iShares Transportation Average (NYSE:IYT), and SPDR S&P Retail (NYSE:XRT). For the full-year, the SPY finished +22%, the Dow (DIA) +28%, Nasdaq 100 (QQQ) +32%, Nasdaq Composite (ONEQ) +29%, SPDR S&P MidCap 400 (NYSE:MDY) +16%, iShares Russell 2000 (NYSE:IWM) +13%, and SPDR S&P 600 Small Cap (NYSE:SLY)+13%.
The year was characterized by strong performance in the Momentum factor at the expense of Value, Quality, and Low-Volatility factors, although Value and Quality kept pace or outperformed after the market’s slight dip in August, when investors noticeably started focusing more on fundamentals. While the SPY was up +22% for full-year 2017, SPDR S&P 500 Growth (NYSE:SPYG) was +28% versus SPDR S&P 500 Value (NYSE:SPYV) +15%. Looking at the sectors within the S&P 500, Information Technology was by far the top performer for 2017 at +40%, followed by Materials, Consumer Discretionary, Financial, and Healthcare, which were all around +22-23%, and then Industrials at +20%. Energy and Telecom were the only sectors to be in the red for the year, although Energy had a nice resurgence late in the year.
Oil closed the year right at $60, and its strength has provided a welcome boost to the US and Canada. Commodities are suddenly perking up, as well, as they are historically cheap relative to stocks. Jeffrey Gunlach of DoubleLine Capital observed, “…the value in commodities is, historically, exactly where you want it to be a buy.”
Emerging markets have benefited, too, including Brazil and Russia, both of which had been languishing in deep recession. India also has been quite strong. Looking at other developed markets, Japan has benefited from new fiscal stimulus added to continued monetary stimulus, while the Eurozone has been boosted by its own continued monetary stimulus coupled with improving domestic demand.
As for China, rather than continuing to grow through manufacturing and exports (and a large current account surplus) by leveraging low labor costs, state-run enterprises, and state support of private business, which is disinflationary, the country’s leadership has been trying to boost domestic consumer consumption and spending (reducing its current account surplus), which is inflationary, while simultaneously deleveraging its dangerous credit bubble. Nevertheless, the World Bank has bumped up its expected 2017 GDP to +6.8% and forecasts only a modest slowdown to +6.4% in 2018 and +6.3% in 2019. My hope is that China can indeed engineer its way through this fundamental transition and deleveraging process without a major disruption to the global economy.
In the US, The BEA’s final estimate of real GDP in Q3 came in at 3.2%, and for Q4, the Atlanta Fed’s GDPNow model is now forecasting 2.8% (as of December 19, down from 3.3% on December 19, but an update is coming on January 3), while the New York Fed’s Nowcast model projects 3.9% (as of December 29). Corporate Profits surged to a new high of an annualized $1.854 trillion, putting the year-over-year change at +10%. Housing has been particularly strong, with some calling it the biggest story of 2017. Investor Sentiment, Consumer Sentiment, and Consumer Confidence (a 17-year high in November!) all remain strong. New Jobless Claims remain near the lows of the economic expansion, so despite hearing a constant storyline about the labor market under attack by robots, AI, and productivity-improving technologies, hiring has still managed to achieve a post-recession high.
The CBOE Market Volatility Index (VIX), aka “fear gauge,” closed the year at a modest 11.04, which is about equal to the year’s average daily closing value. There hasn’t been a significant market correction since February 2016, and VIX has not approached the 20 “panic threshold” since right before the November 2016 election. But low volatility is the historical norm when economic growth is stable and positive, and it is further supported by the healthy market breadth and low sector correlations. IndexIQ analysis showed that the annualized volatility for 2017 was 6.75%, which is second only to 1964 (at 5.24%) as the lowest, while the largest drawdown during the year was 2.80%, which is second only to 1993 (at 2.53%).
The December FOMC meeting resulted in another quarter-point hike, as expected, which was the third such hike in 2017, putting the fed funds rate in a range of 1.25-1.50%. For 2018, the latest Fed "dot plot" projects another three rate hikes, which would bring the target rate to a 2.00-2.25% range. The median long-run short-term rate is 2.75%. Meanwhile, the 10-year Treasury closed 2017 at 2.41%, with the 2-year at 1.88%. So, the closely-watched 2-10 spread continues to flatten, sitting at only 53 bps (the lowest since 2007), which is well under the 100 bps “normalcy threshold,” 101 bps on Election Day, and 136 bps immediately following the November 2016 election.
Rather than steepening as almost all observers predicted, the spread continues to narrow, and in fact, Morgan Stanley has predicted that the yield curve will become completely flat sometime in 2018 with all Treasury yields converging in the 2.00-2.25% range. But I have been saying for quite a while that global dynamics would keep Treasury yields low, so long as the Fed remains slow and cautious in their path toward normalization while other central banks continue QE. For example, 10-year government yields are 0.42% in Germany and 0.04% in Japan, sending global investors into the US seeking risk-free returns on the carry trade, and demand is further supported by aging demographics in developed countries and consistent capital inflows into fixed income funds (largely from 401k and IRA accounts for formulaic strategic allocations). When the 10-year Treasury yield reaches 3.0% again is anyone’s guess, but it appears to me that 2.6% is a yield that has attracted a strong bid. Moreover, the global economy has become heavily leveraged on cheap debt, while investors have increasingly exposed themselves to higher duration at lower yields as their investment capital has poured into fixed income, so all central banks will likely take great pains to avoid upsetting the applecart via aggressive tightening.
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