Another year in the books. 2017 ended with strong equity markets as the eight-year bull market continued to impress. Global stocks did especially well as economic conditions improved around the world. The bond market produced small gains, as it has for the past few years, as the prospect for rising interest rates kept gains in check. The equity markets experienced relatively low volatility, with the best one day gain for stocks during the year being 1.4% back in March, while the worst one day drop was a loss of 1.8% back in May.
We pointed out a year ago that the current economic expansion is one of the longest expansions since World War II. A year later nothing has changed. Economic growth has continued as has new job creation. Corporate earnings remain strong and most measures of economic activity continue to look good. Based on the economic data we are seeing, an economic recession seems unlikely in the upcoming year.
In the bond market, the Federal Reserve raised interest rates three times during the year. In spite of this, interest rates stayed very steady during the year. The yield curve, which is the difference between short rates and long rates, has gotten very flat, which typically is a sign that equity markets may struggle.
Looking forward to the New Year, the biggest concern we have is the current valuation of the U.S. equity markets. Stocks are very expensive relative to earnings right now. This is not unusual for this point in the economic cycle. After long expansions, stock valuations almost always rise, and the longer the economic expansion, the more expensive the markets get. Will stocks continue to rise in 2018? That is impossible to know. Markets can stay expensive for a long time and don’t drop just because they are expensive. However, when a sell off comes, expensive markets will drop more just because there aren’t earnings to support prices. We believe that the longer-term bull market still looks good, so we would be buyers if we do see a stock sell off.
We have become more cautious in the past year as stock markets have continued to set new highs. In many ways, markets like this are the hardest in which to be an investor. The economy is good, unemployment is low, and markets are rising consistently. It is difficult to take money out of stocks in this environment. However, earnings and valuations matter and sometimes there is a disconnect between the economy and the stock market. By almost all valuation metrics, stocks are higher than they should be and we believe caution will be rewarded. As always, please let us know if you would like to receive our updated Form ADV, which is on file with the SEC and contains information about our firm.