Returns for equity and balanced accounts exceeded their benchmarks for the three months ended December 31, 2017. Given four consecutive quarters of outperformance, significant value was added to accounts for the full year of 2017. Sources of fourth quarter performance were fairly diverse with eight of eleven stock sectors delivering net relative contributions. Investments in banks and software stocks added decisive gains. Analyzing full year performance is a bit more complex.
The Russell 1000 Growth index outperformed its value counterpart by over 16 percentage points in 2017, with much of the fireworks coming from the usual suspects, the FAANGs. We owned more than our fair share of these stocks but also added additional value with investments in the leading Chinese internet franchise and a semiconductor design firm on its way to dominating the emerging field of artificial intelligence. Nonetheless, our portfolio’s barbell structure means that growth stocks tell only part of the story for 2017. Significant value was added by concentrations in banks, HMOs and select transportation stocks. On the negative side, we were hit earlier in the year by operational setbacks at an oil and gas exploration company which was subsequently sold.
We added exposure to the more economically sensitive side of our portfolio during the quarter. Purchases were made in retailers and chemical manufacturers. Additionally, we moved to overweight the energy sector after gaining conviction that world-wide oil inventories would decline and OPEC was likely to extend production discipline. So far so good but the OPEC issue will need to be reexamined closer to the Saudi Aramco IPO, scheduled sometime in the second half of 2018. Within the sector, we exclusively purchased companies that we deemed to be “pledgers”. In other words, managements committed to prioritizing shareholder returns (dividends, stock repurchase and debt repayment) over unbridled production growth.
Turning to the outlook for financial markets, much attention has been focused on the new tax law. However, it is important to remember that economic activity was already accelerating across the world. It appears that the depression-like mentality lingering after the Financial Crisis is gradually coming to an end. In short, normalization. The tax law hastens this process both directly and indirectly.
Putting aside its components, the net of the tax law represents economic stimulus from good old-fashioned deficit spending, ranging from 0.3 to 0.5 percent of GDP. We are not going to attempt to guess the multiplier effect because economists can never agree on its measurement even after the fact. Remember, “all else” is never equal in the real world. Anecdotes of large corporations giving one time bonuses may not sum to much but are likely to goose consumer psyche.
There will be significant impact from some of the targeted changes in the tax code. As an example, the new code allows full and immediate depreciation of capital spending for the next five years. Coupled with a lower corporate tax rate, this creates significant incentive for business investment compared to the prior regime of multi-year depreciation. As shown below, capex is one of the last depressed sectors of the economy:
The reduction in the corporate tax rate is conservatively estimated to directly add five percent to S&P 500 profits. Tack on another percent if a third of potential repatriated cash is used for buybacks. Pragmatically, much of this is discounted in stock prices, but remember that the new tax rates will be with us for a long time so the net present value is quite large.
The outsized gains produced by equities in 2017 have created angst with almost daily alarms being raised citing, (take your pick): a bubble, over-valuation or euphoric sentiment. We do not subscribe to the thinking that stocks are overvalued just because they are up or that the environment changes as we turn the calendar to a new year. Let’s remember that Alan Greenspan coined (not the bit type) the term “irrational exuberance” three years and over 100% before the market peaked. Our work shows that, while at the upper end of the historical range, equities remain appropriately valued in the current interest rate environment. The chart below demonstrates that the S&P 500’s earnings yield remains above 10-Year Treasuries even factoring in a rise in interest rates.
We view this as more of an earnings driven market with no recession in sight. That is not to say that there is no risk to stocks. The market has not pulled back by five percent in over a year which is a risk in and of itself. However, trading moves like this are likely to be ephemeral unless accompanied by significant deterioration in fundamentals.
Previous letters detailed our conviction that interest rates secularly bottomed in mid-2016. In short, our argument centered on cumulative economic growth since the Great Recession and the exhaustion of aggressive monetary policy. Since rates rarely stay flat for long, we are likely approaching the uptrend phase. This is being pushed at the margin by the tax law accelerating domestic growth and rising oil quotes bringing back the whiff of inflation. Additionally, a step-up in wage growth is overdue. However, the pace of rising interest rates should be muted by continued excess liquidity creation from overseas central banks. We have and intend to continue reducing duration in fixed income assets.
While we have not heard anyone predicting 2017-like returns for this year, it doesn’t mean that 2018 cannot be a fine vintage. In fact, so far the grapes are ripening quite nicely.