Equity performance in the second quarter of 2018 was characterized by a wide disparity of results among different stock market segments. While small companies had robust returns of 7.8%, emerging market stocks suffered a sharp loss of 8.7%. The performance of these two sectors seemed tied to trade and tariff news. Money flowed into small company stocks on the theory they had less exposure to foreign trade than larger multi-national companies. Emerging market companies, especially those that export to the U.S. were deemed to be most at risk to the imposition of tariffs. The Chinese stock market was particularly hard-hit, falling into bear market territory by losing more than 20% of its value since its January 2018 peak. The dollar’s strength against most foreign currencies also hurt the performance of most international investments in the second quarter.
The table below shows the performance of major equity indices for various time periods.
Equity Performance for Periods Ending on June 30, 2018
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||3.4%||2.7%||14.4%||11.9%||13.4%||10.2%|
|Russell 2000||Small U.S. Companies||7.8%||7.7%||17.6%||11.0%||12.5%||10.6%|
|MSCI EAFE||Developed Int’l Markets||-2.3%||-4.5%||4.0%||2.1%||3.6%||0.0%|
|MSCI EM||Emerging Int’l Markets||-8.7%||-7.7%||5.8%||3.2%||2.6%||-0.2%|
|Wilshire Growth||U.S. Large Cap Growth||4.8%||6.2%||19.7%||13.5%||16.2%||11.3%|
|Wilshire Value||U.S. Large Cap Value||2.1%||-0.9%||9.4%||10.2%||10.9%||8.9%|
As shown in the bottom section of the preceding table, growth stocks continued to outperform value stocks during the quarter. (Growth stocks are characterized by higher rates of revenue and earnings growth. Value stocks are less expensive than growth stocks when comparing their key valuation metrics, such as current price to cash flows, earnings, and book value.) This performance trend has been in place for most of the past 10 years, but has been more pronounced over the last year when growth outperformed value by more than 10%. For the first six months of 2018, large growth stocks have generated total returns of 6.2% compared to a 0.9% loss for large value stocks. The growth versus value trend is probably most obvious when comparing stocks that pay no dividends to the stocks with the highest dividends. Many high growth companies do not pay a dividend, as they use a majority of their cash flows to reinvest in their businesses. In the S&P 500, there are currently 86 stocks that do not pay a dividend. These stocks produced average total returns of 13.9% in the first half of 2018, which compares to an average loss of 1.3% for the 86 stocks with the highest dividends.
The stellar performance of growth stocks has been driven by a relatively narrow group of technology-oriented companies. As a group, the largest five companies in the S&P 500 Index - Apple, Amazon, Alphabet (Google), Microsoft, and Facebook – had total returns of 19.3% for the first half of 2018 and accounted for over 80% of the total returns of the S&P 500.
For some investors, the concentration of investment performance in a small number of growth stocks has become worrisome. It looks eerily similar to the market conditions present during the “dot.com era” almost 20 years ago. Defenders of the current growth stock favorites argue that valuations are more reasonable now than in the late nineties. While that might be true, we have some concern that growth stocks are becoming increasingly expensive and that expectations for future performance might be unrealistic.
The economy continued to hum along nicely in the second quarter and most indicators point to sustained growth for the remainder of the year. Real GDP growth could reach or exceed 3% in 2018, which would be its highest annual rate since the current expansion began in 2009. Historically low unemployment levels, low interest rates, moderate inflation, and strong corporate earnings are supportive of a vibrant economy.
According to FactSet Research, analysts are forecasting earnings growth of 20.5% and revenue growth of 7.6% for S&P 500 companies in 2018. Approximately, half of this year’s earnings growth is related to cutting the corporate tax rate from 35% to 21%. Analysts are currently forecasting another 9.7% earnings growth for the S&P 500 in 2019. The price/earnings ratio of the S&P 500 using next 12-month earnings estimates is currently 16.1, roughly equivalent to its 5-year average. By this and other valuation methods, the overall U.S. stock market appears to be reasonably valued. However, as we noted in our comments regarding growth stocks, there are market segments that appear to be expensive.
As always, there are number risks on the horizon that we try to monitor. As we have noted in the past, we view potential government policy mistakes as the most significant risk to the economy and markets. Currently, the Trump Administration’s stance on trade policy is probably causing the most concern. The administration has imposed tariffs on a number of products impacting trade with many of America’s major trading partners. Since a global trade war would likely be disastrous for the world economy, the markets are hoping for a favorable resolution of this issue in the near future. Monetary policy, as dictated by the Federal Reserve and other major central banks, have helped to stimulate world economies since the financial crisis by keeping interest rates low. These central banks are now attempting to unwind their stimulative actions and allow interest rates to gradually return to historically normal levels without damaging economic growth. An interest rate policy misstep could produce a harmful rate of inflation or possibly lead to a recession. The recently passed tax cuts will result in a significant loss of revenue for federal coffers, increasing the federal budget deficit to 4.2% of GDP in fiscal 2018 and forcing the U.S. government to increase its borrowing. As with companies and households, higher leverage for the federal government results in greater risk, especially if the economy weakens or interest rates rise sharply. Risks associated with geopolitical issues, ineffective regulatory policies, cyber security concerns, and climate and environmental problems also have the potential to derail economic growth.
On balance, considering the strength of the economy, the strong growth of corporate earnings, reasonably-priced stock valuations, as well as the apparent risks, we believe equities remain relatively attractive for long-term investors, especially compared to other investment options.
As was widely expected, the Federal Reserve increased its benchmark interest rate by a quarter of a percent to a target range of 1.75% to 2.00% in June. The Fed also signaled that it expects two more 0.25% rate increases by the end of 2018. The yield on the 10-year Treasury bond rose from 2.74% to 2.85% during the second quarter and traded as high as 3.11%. With interest rates rising, the Bloomberg Barclays Aggregate Bond Index, produced a loss of 0.2% in the quarter and a loss of 1.6% for the first half of 2018. We continue to view long-term fixed income investments as unattractive as they will likely have weak performance if interest rates continue to increase. As such, the fixed income investments in our managed portfolios have a relatively short-term average maturity.
We are very pleased to announce that Larry Eakin joined our team at Vista Investment Management in June. Larry comes to Vista with over 20 years of experience as a portfolio manager and research analyst. He previously worked for Federated Investors, National City Bank, Rockhaven Asset Management, and most recently, Guyasuta Investment Advisors. Larry has an undergraduate degree from Clarion University and an MBA from Duquesne University.
We believe Larry’s addition significantly strengthens our organization. Larry will have an important role in the research and analysis of investments which are held in clients’ portfolios. Since we will continue to work as team, he will also be involved in the management of portfolios.
Larry’s hiring comes a little more than four years after Matt Viverette joined Vista. During this period our firm’s assets under management have almost doubled. While Matt has gained considerable investment experience, his major contributions have been in overseeing daily business operations, technology, and compliance.
As a registered investment advisory firm, we are required to have a formal succession plan which describes how our firm would operate with the loss of a key employee. As you might imagine, when I worked alone my succession plan was less certain. With the addition of Matt, the succession plan was stronger, but if something happened to me, it would have been up to Matt to immediately identify and hire a highly experienced investment manager. While I am extremely hopefully that our new succession plan will never be implemented, the addition of Larry assures that if something happened to me, our firm’s operations would continue with minimal disruption. Simply put, if for any reason I am unable to work, I would feel confident in Larry and Matt’s abilities to continue to manage our clients’ assets, including my family’s portfolio. Considering that I don’t plan on going anywhere in the near future, from a practical standpoint, Larry’s addition makes our current research and portfolio management capabilities much stronger as well as helps to support our future growth.
Larry lives in Peters Township with his wife, Tracey, and his two sons, John and Noah.
We sincerely appreciate that our clients have placed their trust in us to help them achieve their financial goals. It is our mission to provide both superior investment performance and service to all of our clients. We are confident that we have a team in place to meet these objectives.
John D. Frankola, CFA
The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.