Last quarter was something we have not seen since the fall of 2015 – It was volatile and negative. Although it feels good to see the markets moving up quarter after quarter, it is not sustainable or healthy. Virtually all of the major indices we track were down starting 2018. We were somewhat surprised that domestic stocks outperformed both their foreign counterparts and U.S. Aggregate Bonds. Small Capitalization U.S. stocks bested their larger counterparts. Growth stocks considerably outperformed Value stocks during the quarter. Emerging Market stocks had a positive performance. For the quarter, foreign stocks were down 1.53%, while U.S. Large Cap stocks were down 0.76% and U.S. Small Cap stocks were down 0.08%. U.S. Aggregate Bonds were down 1.46% during the quarter. Commodities were slightly down for the quarter, at 0.40%, while Real Estate was the worst performing asset class, down 7.43%.
The first quarter was the polar opposite of what transpired last year. As we mentioned before, 2017 was an anomaly. The first quarter of 2018 was volatile and not unheard of, but the lack of volatility in 2017 was surprising. Last year, there were only four days the S&P 500 Index dropped more than 1%. During the first quarter, we saw six drops of more than 2%. We did not see the S&P 500 Index drop more than 3% at all in 2017. On February 5, 2018, it dropped 4%.
The CBOE Volatility Index is utilized to get a gauge of implied, or future, volatility. We started 2018 with a measurement of less than 10 and closed the quarter at about 20. During the quarter, the Index spiked above 37. The expectation is 2018 should more closely resemble the first quarter in terms of ups and downs than 2017.
There was a lot for the markets to digest during the quarter. The government finally passed a spending bill, and they are sending mixed messages around the world by pivoting on decades-old trade policy. There were geopolitical issues with Russia, North Korea and China. The Federal Reserve (Fed) raised interest rates again, and a host of domestic policy issues.
On March 21, the Federal Reserve (Fed) raised the federal-funds rate a quarter of a percent, which was widely telegraphed. It was the sixth rate hike since the Fed started raising rates in December 2015. They cited economic output has continued to strengthen during the last few months and inferred more rate hikes would occur this year. The market is expecting two more hikes later this year.
Two main levers can be pulled to help the economy along. One lever is monetary policy, which are actions taken by the Fed. The other is fiscal policy, which are actions taken by the government. Currently, they are being pulled in opposite directions. The Fed tends to be more long-term focused, while the government is very dependent on short-term results for re-election purposes. The corporate tax cut that was enacted at the end of 2017 is an attempt to stimulate the economy, during a time where the Fed is gently trying to keep the economy within a certain range.
One of the major benefits of a corporate tax cut is a greater incentive to invest in stocks. All else being held constant if a company pays less in taxes their profitability goes up, which should translate into a higher stock price. While there is a correlation between higher stock prices and economic growth, the real question is will sufficient growth be created quickly enough to pay for the tax cuts? We do not think so, which is a concern facing us in the next couple years. This translates into higher budget deficits during a time where the cost of borrowing (level of interest rates) is increasing.
The geopolitical issues have us concerned too, especially related to a potential trade conflict with China. We are believers in open markets and free trade. We are also proponents of the ability for labor to move freely, and legally, throughout the world. Labor is an input for economic growth, and if it is removed, economic growth will be more dependent on other factors, like productivity. If those other factors are already maximized, a reduction of the labor force will slow economic expansion.
We are hopeful that the talk of tariffs and restrictive trade is just rhetoric, political positioning. There are no winners when barriers to trade are put in place. Moreover, American industries do not have the unlimited financial backing of the government, as many Chinese industries have had historically. Protectionism policies only lead to higher prices, which mean American consumers will be paying more for things.
During the quarter, companies reported their fourth-quarter earnings, and it was another encouraging report. Earnings matter and we have continued to be pleased with the strength of earnings. Although important, earnings are a rear view mirror indicator, and we need to be concerned with what is coming toward us. Corporate earning guidance, which is forward-looking, was strong too. This indicates companies believe they will continue to perform well. This may not impact their stock performance in the short-term, but once market participants look past macroeconomic news, they will focus on company fundamentals, which should be good.
The economy continues to be solid, consumer and business confidence remains fairly strong, companies continue to post good earnings, unemployment is very low, and volatility is back. All of these are reasons why short-term optimism is warranted. You might be wondering why seeing volatility is a good sign – without risk, there can be no return. We need the market swings to create reallocation opportunities. Moreover, pullback and drawdowns are essential. Without them, the market will continue to expand until it bursts.
Despite this being a negative quarter, we continue to expect the markets to finish the year higher than they started. That belief is based on all of the things that are known; What is troubling to all market participants is the unknown. Hence, our belief in adhering to a disciplined investment process, one that focuses on understanding your cash flow needs and personal situation to make certain we have your investment portfolio allocated correctly. Successful investing is achieved by making certain the investment allocation aligns with your financial plan.
Please find enclosed your first-quarter investment report. We appreciate the faith and trust you have placed in us. Please do not hesitate to let us know if you have any questions or concerns.
The Waller Team
The opinions voiced in this letter are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this printing may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risks, including loss of principal. Bond values will decline as interest rates rise and bonds are subset to availability and change in price. There is no guarantee that a diversified portfolio will enhance overall return or outperform a non-diversified portfolio. Diversification does not protect against market risk.
, 2 Morningstar Office: Large cap U.S. stocks as measured by the S&P 500 Index, Medium cap U.S. stocks as measured by the S&P Mid Cap Index and Small cap U.S. stocks by the Russell 2000 Index. Foreign stocks as measured by the MSCI EAFE ND Index and the emerging market stocks measured by the MSCI EM ND Index. Fixed Income/Bonds as measured by the Barclays U.S. Aggregate Bond Index, Barclays Municipal Index, and the Citi World Government Bond Index. Real estate as measured by the Dow Jones U.S. Select REIT Index. Commodities as measured by the Bloomberg Commodity Index. Inflation as measured by the U.S. BLS Consumer Price Index All Urban SA 1982-1984.