2017 Market Report: A Year Beyond Expectations

It’s January again, which means a fresh round of investment advice from publications, pundits and prognosticators who want to help you make a fortune, or at least entice you to follow them on social media. Last year was extraordinary for investors in both US and global markets. The S&P 500 posted its third best year in the index’s history with a gain of 21.83%—and that was middle of the pack.

Who knows what 2018 will bring? For guidance, some investors look to the “January indicator,” the idea that “as goes January, so goes the rest of the year.” If only it were that simple. DFA analyzed January data going back to 1926, and found that “A negative return in January was followed by a positive 11-month return about 60% of the time, with an average return during those months of around 7%.” Looking back a full year, January 2016 is a case in point. It was a real sky-is-falling month, as you may recall, with the S&P 500 shedding -7.93% in the first two weeks before ending the month down -4.96%. Smart people fled the market. But then the market gained 18% between February and December.

Other investors aren’t thinking about the January indicator at all. Instead they’re nervously eyeing all the market-shattering records. But again, according to DFA research, an all-time market high is not a useful predictor of anything. “From 1926 through 2017, the frequency of positive 12-month returns following a new index high was similar to what is observed following months of any level.” Oh well.  

Instead of reading smoke signals, I advise you to maintain a well-diversified portfolio based on your personal timeline and risk tolerance. Worried about a correction? Consider rebalancing. Given the roaring markets of 2017, your equity positions may need trimming. It’s a good time to review your fixed income holdings too. I’m here to help.

Whatever you do, don’t chase returns and don’t chase fads. Speaking of which, last year’s most attention-grabbing story (aside from Donald Trump’s endlessly bizarre tweets) was Bitcoin’s meteoric rise. We’ll dive into this cryptocurrency in a future blog. For now, let’s review the year just ended.

Market summary and data courtesy of DFA

WORLD ECONOMY

In 2017, the global economy showed signs of stronger growth, with 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) all on pace to expand. Economic outlook and the expected impact on future cash flows are among the many variables markets consider when setting prices. Therefore, investors should remember that growth in the economy is not always linked to stock market performance.

 

Equity Market Highlights

Global equity markets posted another positive year of returns in 2017. The S&P 500 Index recorded a 21.83% total return and small cap stocks, as measured by the Russell 2000 Index, returned 14.65%, both above their long-term average return of 11.96% and 11.73%, respectively, since 1979. 

Returns among non-US equity markets were even higher. The MSCI World ex USA Index, which reflects non-US developed markets, logged a 24.21% return and the MSCI Emerging Markets Index a 37.28% return, making this the fifth highest return in the index history.

As the S&P 500 and other indices reached all-time highs during the year, a common media question was whether markets were poised for a downturn. History tells us that a market index being at an all-time high generally does not provide actionable information for investors.

For evidence, we can look at the S&P 500 Index for the better part of the last century. From 1926 through 2017, the frequency of positive 12-month returns following a new index high was similar to what is observed following months of any level. In fact, over this time period, almost a third of the monthly observations were new closing highs for the index. The data shows that new index highs have historically not been useful predictors of future returns.

Global Diversification Impact

Developed ex US markets and emerging markets generally outperformed US equities. As a result, a market cap-weighted global equity portfolio would have outperformed a US equity portfolio.

The S&P 500 Index’s 21.83% return marked its best calendar year since 2013 and placed 2017 in the top third of best performing calendar years in the index’s history. Despite these returns, the US ranked in the bottom half of countries for the year, placing 35th out of the 47 countries in the MSCI All Country World Index (IMI).

Delving into individual countries, country level returns were mostly positive. Using the MSCI All Country World Index (IMI) as a proxy, 45 out of the 47 countries posted positive returns. Country level returns were dispersed even among those with positive returns. In developed markets, returns ranged from +10.36% in Israel to +51.39% in Austria. In emerging markets, returns ranged from –24.75% in Pakistan to +53.56% in Poland—a spread of almost 90%. Without a reliable way to predict which country will deliver the highest returns, this large dispersion in returns between the best and worst performing countries again emphasizes the importance of maintaining a diversified approach when investing globally.

China provides an example highlighting the noise in year-to-year single country returns. After a flat-to-negative return (USD) in 2016, Chinese equities returned more than 50% (USD) in 2017, making China one of the best performing countries for the year.

Currencies

Most major currencies including the euro, the Australian dollar, and the British pound appreciated against the US dollar. The strengthening of non-US currencies had a positive impact on returns for US investors with holdings in unhedged non-US assets. This may surprise some investors given that the US dollar has strengthened against many currencies over the past five- and 10-year periods. However, just as with individual country returns, there is no reliable way to predict currency movements. Investors should be cautious about trying to time currencies based on the recent good or bad performance of the US dollar or any other currency.

Premium Performance

In 2017, the small cap premium was generally positive in developed ex US markets and negative across US and emerging markets. The profitability premium was positive across US, developed ex US, and emerging markets, while the value premium was negative across those markets.

US Market

In the US, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. On a positive note, high profitability stocks outperformed low profitability stocks as measured marketwide.

Although US small cap stocks, as described by the Russell 2000 Index, provided a healthy 14.65% return in 2017, the US small cap premium (as measured by the Russell 2000 Index minus the Russell 1000 Index) was negative, ranking in the lowest third of annual return differences since 1979. However, over the 10-year period ending December 31, the small cap premium was positive.

US value stocks returned 13.19% in 2017, as measured by the Russell 3000 Value Index. While double-digit returns from value are appealing, US growth stocks performed even better, with a 29.59% return as represented by Russell 3000 Growth Index. The difference between value and growth returns, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, made 2017 the fourth lowest year for value since 1979 and pulled the five-year rolling premium return into negative territory.

Even over extended periods, underperformance of the value premium or any other premium is within expectation and not unusual. Over a 10-year period ending in March 2000, value stocks underperformed growth stocks by 5.61% per year, as measured by the Russell 1000 Value and Russell 1000 Growth indices. This underperformance quickly reversed course and by the end of February 2001, value stocks had outperformed growth stocks over the previous one-, three-, five-, 10-, and 20-year periods. Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.

The profitability premium was positive in 2017, with US high profitability stocks outperforming low profitability stocks. Viewing profitability through the lens of the other premiums, high profitability stocks outperformed low among value stocks while underperforming among growth stocks.

The complementary behavior of premiums in 2017 is a good example of the benefits of integrating multiple premiums in an investment strategy, which can increase the reliability of outperformance and mitigate the impact of an individual premium underperforming, as was the case with value among US stocks in 2017.

Developed ex US Markets

In developed ex US markets, small cap stocks outperformed large cap stocks while value stocks underperformed growth stocks. High profitability stocks outperformed low profitability stocks. 

Over both five- and 10-year rolling periods, the small cap premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World ex USA Index, continued to be positive.

Similar to the US equity market, value stocks posted a healthy 21.04% return for 2017 as measured using MSCI World ex USA Value Index. However, growth stocks performed even better with a 27.61% return, as measured by the MSCI World ex USA Growth Index.

The profitability premium was positive in developed ex US markets viewed marketwide. Looking within size and style segments of the market, high profitability outperformed low profitability in all but the large growth segment.

Emerging Markets

In emerging markets, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. Similar to the US equity market, high profitability stocks outperformed those with low profitability.

Value stocks returned 28.07% as measured by the MSCI Emerging Markets Value Index, but growth stocks fared better returning 46.80% using the MSCI Emerging Markets Growth Index. The value premium, measured as MSCI Emerging Markets Value Index minus MSCI Emerging Markets Growth Index, was the lowest since 1999.

Though 2017 generally marked a positive year for absolute equity returns, it marked a change in premium performance from 2016 when the size and value premiums were generally positive across global markets. Taking a longer-term perspective, these premiums remain persistent over decades and around the globe despite recent years’ headwinds. It is well documented that stocks with higher expected return potential, such as small cap and value stocks, do not realize these returns every year. Maintaining discipline to these parts of the market is the key to effectively pursuing the long-term returns associated with the size, value, and profitability premiums.

Fixed Income

Both US and non-US fixed income markets posted positive returns in 2017. The Bloomberg Barclays US Aggregate Bond Index gained 3.54%. The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained 3.04%.

Yield curves were upwardly sloped in many developed markets for the year, indicating positive expected term premiums. Realized term premiums were indeed positive both globally and in the US as long-term maturities outperformed their shorter-term counterparts.

Credit spreads, which are the difference between yields on lower quality and higher quality fixed income securities, were relatively narrow during the year, indicating smaller expected credit premiums. Realized credit premiums were positive both globally and in the US, as lower-quality investment-grade corporates outperformed their higher-quality investment-grade counterparts. Corporate bonds were the best performing sector, returning 6.42% in the US and 5.70% globally, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD).

In the US, the yield curve flattened as interest rates increased on the short end and decreased on the long end of the curve. The yield on the 3-month US Treasury bill increased 0.88% to end the year at 1.39%. The yield on the 2-year US Treasury note increased 0.69% to 1.89%. The yield on the 10-year US Treasury note decreased 0.05% for the year to end at 2.40%. The yield on the 30-year US Treasury bond decreased 0.32% to end the year at 2.74%.

In other major markets, interest rates increased in Germany while they were relatively unchanged in the United Kingdom and Japan. Yields on Japanese and German government bonds with maturities as long as eight years finished the year in negative territory.

Commodities

The Bloomberg Commodity Index Total Return gained 4.71% in the fourth quarter, bringing the 2017 total annual return to 1.70%. Petroleum led quarterly performance. Brent crude oil returned 18.87%, and WTI crude oil gained 15.64%. Grains was the worst-performing complex, with Chicago wheat and Kansas wheat declining by 8.46% and 7.19%, respectively. 

Real Estate Investment Trusts (REITs)

Non-US real estate investment trusts outperformed US REITs. Despite underperforming the broader market, globally diversified REIT investors earned healthy returns.

Conclusion

The year of 2017 included numerous examples of the difficulty of predicting the performance of markets, the importance of diversification, and the need to maintain discipline if investors want to effectively pursue the long-term returns the capital markets offer. The following quote by David Booth provides useful perspective as investors head into 2018: “The key is to have the correct view of markets and how they work. Once you accept this view of markets, the benefits go way beyond just investing money.”