- Surprisingly strong equity returns for broad market indices; S&P rises for a record 14 straight months.
- Heavily weighted Technology stocks were consistently strong throughout 2017 and gained 37% for the year.
- Energy, and to a lesser extent, Real Estate and Utilities, underperformed.
- Volatility as measured by the CBOE VIX recorded record lows
The Nasdaq 100 and Nasdaq Composite led all majors with gains of 31.5% and 28.2% respectively, followed by the large cap Dow Jones, 25.1%, and S&P 500, 19.4%, the Mid Cap S&P 400, 14.5%, and Russell 2000, 13.1%. The DJIA, SPX, and Composite saw monthly price gains in eleven of twelve months including 71 record-high closes for the Dow. According to the Wall Street Journal, with dividends included, the S&P 500 had positive returns in each month of 2017, the first time since at least 1970. The current 14 straight months of S&P gains has never happened before.
2017 began as a seemingly chaotic year littered with an abundance of market risks and global events that many expected would lead to a sharp decline in equities following the "Trump Bump" ending Q4'16. In reality many pundits got it wrong as stocks were more resilient than ever, climbing wall after wall of worry, with all major indices reaching new highs. The gains occurred amidst a surprising backdrop of record low volatility.
The "noise" started right away on the political front when Donald Trump took the Oval Office and the GOP assumed control of both Houses of Congress in January. Their plan was to first tackle healthcare and the Affordable Care Act (ACA), before then overhauling the tax system, initiating major infrastructure spending, redrafting and/or eliminating long established trade agreements, and meaningfully reducing regulations. Lofty plans indeed. Although failing numerous times to repeal "Obamacare", Trump and the GOP did succeed in eliminating a number of corporate regulations, did not start a trade war, and in late December passed comprehensive tax reform, the first in over 30 years, which not only reduced the corporate tax rate to 21% from 35%, but also included a provision that repealed the ACA's individual mandate penalty.
In the background of the legislative dealings, there were no shortage of sensational political headlines including Presidential tweets, suspected election interference and collusion by Russia, political wiretapping, the firing of the FBI Director Comey, and a special counsel investigation into the President. Geopolitical tensions also ran high with North Korea testing a number of long range ballistic missiles capable of being paired with nuclear warheads, while leaders Kim Jong Un and Donald Trump openly and often exchanged threats. Despite the ominous sounding headlines around a possible nuclear exchange, the market was not derailed. In the Middle East, Saudi Arabia's King Salman made extensive changes to its Royal line of succession with little market impact. In other geopolitical developments Russia and Iran "withdrew" from war-torn Syria. And more recently in the final days of December, major anti-government rallies are actively taking place across a number of Iranian cities with peaceful protesters calling for President Hassan Rouhani and the supreme leader, Ayatollah Ali Khamenei, to step down.
Europe was a surprise to some, with little in the way of debt crisis headlines from banks or sovereign countries in the region. Election results in France, Italy and other countries largely removed the threat (for now) of a breakup of the Euro feared by some Euroskeptics. In fact, many of the European equities markets, helped by European Central Bank QE, had superior returns than those in the U.S. as European economies rebounded. The Euro Stoxx Index 600, a broad based measure of large, mid and small cap companies across 18 countries in the Europe region, rose 22.5% in U.S. dollar terms.
On the policy front the Federal Reserve accelerated its policy normalization by hiking the Fed Funds Rate three times in 2017, 4X including December 2016, and in October it began the gradual process of reducing its $4.5T balance sheet. After one rate hike in 2015 and one more in 2016, 2017 was the first year the Fed raised rates more than once since emerging from the zero bound. The multiple rate hikes, along with expectations for another three to four hikes in 2018, led to a 70bps rise in the 2-year Treasury yield to 1.88%. Conversely the long 10-yr yield declined 4bps in 2017 to 2.41%. The contrasting moves led to a 73bps flattening of the yield curve (10yr-2yr spread) to 52bps. While many have expressed concern that the flattening yield curve is a warning sign of a looming recession, the below chart of the 10yr-2yr spread argues otherwise. Periods of recessions are shaded in gray and show recessions usually occur AFTER the curve goes from negative to positive. Separately and related to the Fed, in early November Donald Trump nominated Jerome H. Powell to chair the Federal Reserve, bypassing Janet L. Yellen for a second term.
Despite the aforementioned risks, events, and the Federal Reserve accelerating rate hikes and embarking on quantitative tightening (QT), markets took it all in stride with all major equity indices recording new highs as market volatility made all-time lows. In November the CBOE VIX Index made its all-time lowest close on record of 9.14 going back to its inception in 1990. One factor in the low volatility: sector correlations. Since the election correlations between sectors have been dropping. In other words, when one sector is up, another is down, suppressing overall volatility. In the years since the financial crisis, high sector correlations meant that stocks in different sectors traded in similar fashion. In 2017, stock and sector selection returned.
In many years the conventional wisdom turns out to be wrong and 2017 proved to be no different. Investors entered the year expecting the post-election period would result in an expanding U.S. economy fueled by infrastructure spending and tax cuts driving the U.S. to outperform lagging global economies. The resulting growth coupled with Fed rate increases would strengthen the dollar, potentially hurting large multinational companies and emerging market economies. Meanwhile, geopolitical concerns and Trump Twitter tape bombs would add to volatility after a mostly quiet 2016.
The table below summarizes some of the expected vs. actual outcomes in 2017.
Many expected outcomes for 2017 never occurred. One example of the market not behaving as expected: on 8/27, North Korea launched a missile over a populated are of Japan for the first time. Safe haven investments like gold and utility stocks rallied. However, the dollar, a primary safe haven currency, declined vs. the yen , the currency of the targeted country, as U.S. stocks rallied to close higher on the day. A similar missile launch on November 28th of an ICBM into space and reportedly able to hit the U.S. if fired on a less steep trajectory had little impact on the market, which was focused on tax reform passage.
Technology Outperformance: Technology has been the clear driver behind the more than 19% gain for the S&P 500. The S&P Info Tech Index gained ~37%, its best yearly performance since the 2009 bounce following the Great Financial Crisis. Performance was helped by companies reporting strong revenue growth, large cap "FANG" stocks, and catapulted by emerging businesses.
One of the most compelling segments in the Tech space are semiconductors, with the Philadelphia Semiconductor (SOX) Index up 39% in 2017. In the past few years semis were supported by the surge in smart phone buying, but the focus has now shifted towards the automotive opportunities for chips. Analyst believe autonomous and smart cars will be the revenue driver for the next five years for the tech space, as cars will have strict mandates for radars, sensors and cameras.
Consumer Strength: The consumer showed strength in the U.S. at year end. Higher-than-forecast consumer confidence (17 year high), continued low unemployment (17 year low), and a slightly larger paycheck helped both online and brick-and-mortar retailers. 2017 saw the largest year-over-year holiday spend increase since 2011, up over 4.9% from last year. The S&P 500 Retail Index returned over 30% in 2017, outpacing the broader S&P 500 Consumer Discretionary Index which returned nearly 23% and the S&P 500 Index which had a total return of 21.8%. Consumer spending accounts for two-thirds of U.S. economic activity and is a key cornerstone to measure economic activity in this country. The strong holiday shopping spend boasts well for Q4'17 GDP.
Financials keep pace: In 2016 the top performing sectors were energy and financials with gains of 23.7% and 20.1%. The S&P Financials Index largely underperformed throughout the first eight months of 2017 but rebounded strongly in the final four months for an annual gain of 20%. The rebound began in early September when the "belly" of the yield curve (2yr - 3month spread) bottomed for the year and began a sharp ascent through December. The belly's steepening was driven by the dramatic rise in the Treasury's 2-yr yield as noted earlier.
Low Energy: Outside of Telecom Services (which consists of only four stocks and will lose its status as a standalone S&P sector in September), Energy was the worst performing group for 2017 despite having the best December performance on Crude's continued advance. Energy declined 3.8% in 2017 after being down as much as 18% in August. The weakness in energy stocks initially appeared to be simple profit taking and mean reversion after a robust 2016, however beginning in late February crude oil (WTI) declined more than 23% over four months' time into late June. Fortunately the YTD low bottomed along a clearly defined support level, $42.50, and from there crude rallied more than 40% to $60 into year end.
The U.S. market saw a robust year but equities in developing nations outperformed domestic stocks. The MSCI Emerging Market Index shot higher by +31% (best since 2009) in 2017, supported by low interest rates, strong earnings and economic growth worldwide. Investors were buying into strength throughout the year, as ETFs that track emerging markets saw inflows 86% of the weeks in 2017. On 12/20, investors doubled down on their bets and poured more than $517M into iShares MSCI EM ETF (EEM), the largest 1 day inflow since August 2016. On the flip-side of the trade, short-sellers have been reducing their bearish positions during the surge higher. According to IHS Markit, shorts have cut $1.63 billion of bearish bets against the fund, which is "less than half the level seen a year ago when the election of Donald Trump as U.S. president had spurred a widespread selloff."
The relative strength of EM to the SPX broke out from a 5-year down trend line, and is now testing the downtrend beginning at its peak in 2010. A move above this major resistance would suggest EM is in the early stages of outperforming large cap U.S. equities.
There were a number of positive developments on the economic front in 2017. Consumer confidence reached a 17-year high while the unemployment rate continued its descent from the heights of the Great Recession to 4.1%. Total existing home sales averaged 5.5 million units each month of 2017. Millennials are now entering the typical age for home ownership and the pace of new home sales recently reached a 10-year high.
In September 2017 the ISM Manufacturing Index saw its highest reading since May 2004, while in early 2018 the economy can look forward to a potential $1T infrastructure spending bill. GDP grew more than 3% in both Q2 and Q3, and Q4 is expected to mark the first time the economy has grown by 3% or more in three consecutive quarters since the bursting of the housing bubble.
Corporate Earnings (Data below according to FactSet):
For 2018 the estimated earnings growth rate for the S&P 500 for CY 2018 is 11.8%. If 11.8% is the final growth rate for the year, it will mark the highest annual earnings growth since 2011 (12.7%). It will also mark the first time index has reported double-digit earnings growth since 2011. All eleven sectors are projected to report year-over-year growth in earnings. The estimated (year-over-year) revenue growth rate for CY 2018 is 5.6%. All eleven sectors are expected to report year-over-year growth in revenues, led by the Information Technology sector.
Based on reports through December 22, 2017, the estimated (year-over-year) earnings growth rate for Q4 2017 is 10.9%. If the final earnings growth rate for the quarter is 10% (or higher), it will mark the third time in the past four quarters that the index has reported double-digit earnings growth.
Also, negative earnings guidance is lower: Of the 108 companies that have issued EPS guidance for the fourth quarter, 72 have issued negative EPS guidance and 36 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 67% (72 out of 108), which is below the 5-year average of 74%.
MID Note: The recently passed tax reform would also be expected to result in higher earnings for a wide range of companies. Companies are updating projections and analysts are updating models to reflect the new tax regulations.
Growth vs. Value
Growth stocks resumed their decade long leadership role by vastly outperforming value 17.5 percentage points in 2017. The Russell 1000 Growth Index gained 28.4% while vs. its brethren Value Index came in at 10.9%. Growth has outperformed Value in eight of eleven years from 2007 - 2017. Prior to that Value outperformed Growth in six of seven years spanning 2000 - 2006. Value's leadership era was during the bursting of the DotCom Bubble followed by a housing bull market and commodity inflation. Today's housing market is in a healthy recovery including New Home Sales reaching a ten-year high in September. Inflationary pressures are beginning to emerge with oil back to the $60 range and base metals coming off a robust year, particularly copper which recorded record consecutive gains in December and finished 2017 near four year highs. Recent passage of the tax reform bill and talks of a $1T infrastructure project in early 2018 should only fuel the positive momentum in the economy and could provide much needed earnings growth to many Value companies. The ratio of the R2K Growth Index vs. Value (RLG / RLV) is at a 17-year high, however a bearish divergence exists in Growth's long term momentum (monthly RSI) which may suggest a change in trend, Value outperforming Growth, in the not too distant future.
Given 2017's surprisingly strong performace, momentum has many pundits projecting a continuation of the same, with growing corporate earnings and low interest rates continuing to fuel equity gains. With the market priced at high multiples, a good deal of positive news is baked into stock prices already. Investors will be looking for 2017's tailwinds (low volatility, low rates, and improving earnings) to continue. A reversal of one or more of these, or a potential economic or geopolitical surprise overseas, could derail equities.
Overall the majority of analysts are positive on their outlook for 2018 in regards to economic activity and earnings growth despite the economy being in the third longest business cycle in over 150 years. Unemployment continues to decline, stagnant wage increases may finally rise given the passage of tax reform as well as the shrinking labor market. Industrial activity and investment are also expected to grow, which combined with wage increases may finally provide inflation numbers in line with the Fed's 2% target. Inflationary pressures weigh on bond prices and should drive the long 10-year Treasury yield above the current 10-month resistance zone at 2.40% - 2.45%. A "breakout" above this zone opens the door for a move towards the 3% level.
Overseas the global recovery has plenty of momentum and relatively attractive valuations. Emerging markets appear to be in the early stages of outperforming U.S. stocks, aided in part by the weakening U.S. dollar. The U.S. Dollar Index (DXY) declined (9.9%) in 2017, its biggest fall since 2003. After bottoming in September, the DXY has spent the last three months consolidating between 91 and 95. After 2017's sharp decline, an extended period of consolidation at weak levels would be welcome news for global equities, as well as commodities, in 2018.
If history is any guide, 2017's robust price action is a good omen for 2018. Last year the Dow Jones Industrials (DJIA) gained +25% for its 2nd best performance in 14 years. According to analyst Ryan Detrick from Nasdaq-listed LPLA Financial Holdings Inc. (LPLA), the DJIA has gained +25% on ten other occasions since 1950. Of that sample, the Dow was higher the following year eight out of ten times, with six in double digits. The average annual gain for those ten years was 12.6% vs. its average yearly return of 8.5%.
The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided "as is" without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
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