2017 Year in Review: Smoothest Ride Ever?

Heading into 2017, many analysts predicted a modest year for investors. Both Goldman Sachs and Credit Suisse projected the S&P 500 Index to rise less than 3%, and it was widely accepted that bond returns would suffer as interest rates inevitably rose. Of course, 2017 will now be counted as both a stellar year for investors and yet another example of the folly of market forecasting.

The S&P 500 posted a total return of 21.8%, its best yearly gain since 2013, and bonds dismissed fears of rising interest rates by gaining 3.5%. The unrelenting nature of 2017’s impressive run is especially noteworthy. For the first time in history, the S&P 500 failed to move up or down 2% from the previous day’s close. The S&P 500 was positive every single month — another first — and has not had a down month since October 2016. The average intra-year decline over the last 100 years is 16%. This year? 2.8%. It’s possible that 2017 was the smoothest ride for investors ever. Given the current environment, the obvious questions are: “Is the market overvalued?” and “When volatility returns, how will investors react?”

Agonizing over the market’s valuation is one of the financial media’s favorite (and most profitable) activities. Since March 2009, the beginning of the current bull run, you’ve been inundated with headlines like these:

“The Stock Market is Overvalued Between 48% and 61%” – Business Insider, July 2011.
“Markets Are Due for a Correction” – CNBC, October 2012.
“Why the Stock Market Will Crash in a Few Months, Then Go Nowhere for Years” – Yahoo Finance, October 2013.
“The Coming Financial Crisis” – Wall Street Journal, March 2014.

A brief Google search will yield thousands of similar doomsday articles, increasing in frequency and despair as the market continues charging higher. The financial media insists that savvy investors can profit from knowing when the market is over/undervalued, based on recent performance, market valuations, and geopolitical and economic activity. The frantic tone is intended to compel investors to action, but a sound investment philosophy dictates a more measured approach. History has proven that it is impossible to predict, with any regularity, what the market will do in the short term. The chart below emphasizes the futility of predicting future returns based on past performance.

What Does a Great 2017 Foretell for 2018?
Probability that the stock market will rise in a given calendar year:

Data: Reflects Dow Industrials' calendar-year performance since 1897
Data: Reflects Dow Industrials’ calendar-year performance since 1897.
Source: www.HulbertRatings.com

In sharp contrast to annual periods, the market is generally predictable over longer time horizons. Using monthly intervals and 15-year rolling periods beginning in 1940, the S&P 500 has been negative only two times – meaning a long-term investor made money 99.8% of the time. Shortening the time horizon to just five years, the index has rewarded investors 87.5% of the time. Simply put, diversified, long-term investors make money in the stock market if they have the discipline and patience to remain invested. We know that this is not an anomaly, but an inherent expectation in a capitalist system. To quote Peter Lynch, “If you’re in the market, you have to know there’s going to be declines. When they’re gonna start, no one knows…the stomach is the key organ here. It’s not the brain. Do you have the stomach for these kinds of declines?”

So, we know we can’t predict short-term market returns. But what about that nagging question: “Is the market overvalued?’” Coming off a great year, and the ninth straight year of gains, it’s a reasonable question to ask.

The geopolitical turmoil in Washington and around the globe has obscured the economic momentum underlying the market’s rise. For example, corporate earnings are on pace for the strongest growth since 2011. And, as shown below, the economies of all 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) are expanding in unison for the first time since the financial crisis.

Global Growth In Sync

Global growth in sync
Source: Organization for Economic Cooperation and Development (OECD)

Further, tax reform is poised to benefit most businesses and consumers. (For more on the implications of the new tax law, see our recent Viewpoint – Tax Reform Legislation: The Update.) And low bond yields continue to boost the relative attractiveness of equities.

On the whole, it’s likely that some areas of the market have stretched valuations while others are fairly priced. Regardless, valuation isn’t a tool for timing the market (nor is anything else). Rather than attempting to make valuation bets, investors with a broadly diversified portfolio can opportunistically rebalance their portfolios, systematically “buying low” as certain asset classes decline and “selling high” as top performers breach upper thresholds. However, capitalizing on rebalancing opportunities requires investors to maintain a long-term perspective when market volatility inevitably returns.

What to Make of the Latest Trends

Two other major storylines from 2017 included the impressive surge of the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google) and the emergence of Bitcoin.

It’s not far-fetched to suggest that a FAANG stock has been mentioned in a front-page story on the Wall Street Journal every single day in 2017. The trend is not unwarranted. After all, the FAANGs were responsible for about one-fifth of the S&P 500’s total return.

FAANG Stocks
Total Returns as of 12/31/17

In addition, almost every American is intimately familiar with FAANG companies, whose products have become part of daily life for many. They’re so pervasive, it’s tough to imagine how any competitor could dethrone them. Rather than trying to predict who, when, or how the FAANG’s meteoric rise may end, it may be more useful to turn to the past. Harry Truman said, “The only new thing in the world is the history you do not know.” Market leaders like Xerox, Polaroid, and Sears were once thought invincible, too. Countless “unbeatable” companies have been ravaged by similar creative destruction. Even those at the forefront of market evolution can endure periods of brutal performance. If you had bought Amazon in 1997, do you think you would have had conviction to hold through four drops of greater than 55% in less than 10 years (including a 94% plunge during the dot-com bubble)? Even if you had the conviction, would you have had the capacity to withstand the hit to your net worth? Individual companies can be explosive and exciting, but overconcentration in them carries uncompensated risk.

Envy is an incredibly strong and destructive emotion when it comes to investing. Charlie Munger said, “Someone will always be getting richer faster than you. This is not a tragedy.” This has never been truer than in the current context of Bitcoin (and other cryptocurrencies). Bitcoin rose nearly 1,300% in 2017, providing affirmation to courageous investors and stoking envy in everyone else. Its rise is impossible to ignore, but difficult to explain.

Conventional investing involves trading cash today for a potentially greater amount of cash in the future. In stocks, your investment lays claim to future earnings of a company, while bonds promise a stream of cash flows, including principal repayment. As a currency, Bitcoin offers the same amount of future cash flows as a $1 bill in your wallet. Just as you don’t expect to receive more dollars in return for keeping the bill in your wallet, owning a Bitcoin doesn’t entitle you to receive more Bitcoins.

Though not a conventional investment, perhaps Bitcoin has value as an alternative to fiat currency. A decentralized digital currency that could be used globally seems like a valuable proposition. But to be used in financial transactions, currency must have a known and stable value. Imagine paying for a sandwich using Bitcoin, and before you’re finished with lunch, Bitcoin jumps to the price of an exotic vacation.

Without an expectation of cash flows or a store of value, Bitcoin’s rise must be attributable to investor envy and fear of missing out. The below (unscientific) polls show how public perception of Bitcoin has changed as its price skyrocketed:

Paradoxically, as its price continues to surge, more people perceive Bitcoin as undervalued. We don’t pretend to know the intrinsic value of Bitcoin. Perhaps in 2018, it will continue its 2017 rise, or perhaps its value will be cut in half — or worse. (Bitcoin has already experienced three crashes exceeding 85% since 2010.) What we do know is that over the long term, market timing and the “herd mentality” have proven detrimental to investors.

It’s easy to lose sight of the benefits of a diversified portfolio when your friend or neighbor is getting rich quick by loading up on FAANGs or Bitcoin. It helps to remember Nick Murray’s eternal truth of equity investing: “One can become wealthy by under-diversifying. It is inexpressibly harder to stay wealthy by under-diversifying.”

Although it’s impossible to predict what the markets will bring in 2018, we can confidently state that blocking out the noise and sticking to a sound investment philosophy remain the keys to long-term investment success. As always, we are here to help you apply the planning, patience and discipline necessary to achieve your financial goals.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser. Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & 2B filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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