As the third quarter came to a close, stock markets continued to seemingly defy gravity. US stocks finished the quarter at an all-time high, while broadly-diversified international stocks continued their 2017 trend of delivering the best results of any major asset class. The S&P 500 rose 4.0% during the quarter … international stock markets outperformed their domestic counterparts with a 5.4% advance.
Also consistent with the first half of the year, defensive assets during the third quarter delivered a much more subdued performance than stocks. Fixed income markets and Real Estate Investment Trusts (REIT’s) both were flat, as gradually rising interest rates lowered valuations just enough to essentially offset interest and dividend income.
All of which brings us back to the central question we posed in the July management report: are risk assets in general, and US stocks in particular, overvalued? After all, if the question was relevant in July, three additional months of strong performance only makes this question even more pressing now. And as was the case then, an argument can still be made supporting both sides of the debate.
The factors suggesting stocks are overextended have been widely-chronicled. Perhaps most often cited is the fact that the current US bull market is now approaching its ninth anniversary, which statistically is well above average. Nevertheless, bull markets rarely end simply due to “old age” … instead some negative catalyst creates an inflection point, from which markets begin a bear market cycle.
A list of potential negative catalysts could include: rising interest rates orchestrated by the Federal Reserve; an unexpected spike in inflation; a slowdown in the growth of corporate profits; or any number of international “flashpoints” (with North Korea and the Middle East being the most likely).
Opposing the theory that stocks are overvalued, stock market “bulls” marshal a number of arguments of their own. Most compelling is the fact that, for the first time in many years, we are witnessing a synchronized expansion of the world’s major economies. This is most apparent in Europe, but China is also staging a strong recovery from a recent profit recession. Even Japan’s economy, which for several decades has suffered little or no growth, is now producing increasingly positive results.
The “bulls” also point out that, while interest rates are moving up, the pace has been and is expected to remain very gradual. This persistently low interest rate environment will provide an ongoing economic stimulus, as corporate and individual borrowers continue to leverage their investment in capital and financial assets.
The combination of low interest rates and steady economic expansion offers reassurance that American companies can maintain healthy profit growth. Finally, although admittedly a bit of a “wild card” at the moment, a successful effort by Congress to pass legislation lowering corporate taxes will further bolster profits and help support stock valuations.
As we noted last quarter, both sides of this debate can make a persuasive argument. This inherent uncertainty means we must design investment strategies and manage client portfolios with the ability to a) continue to participate in the ongoing market rally, while b) also offering a meaningful measure of asset protection when the markets experience an inevitable pullback. We achieve this balance with a variety of tactics which have proven effective over time.
The most important element is the broadly-diversified asset class allocation strategy that serves as the foundation of client portfolios. By spreading investments across several major asset classes, we reduce portfolio volatility and lower risk. In addition we always ensure that any funds that are intended to meet short-term financial needs aren’t exposed to market risk.
Finally, and this is critical, we adhere to a very disciplined schedule of re-balancing among the asset classes in order to periodically realign the portfolio with the client’s basic investment strategy. This analysis has typically been conducted at least four times a year, but in response to the extended bull market in stocks we now have added a mid-quarter review of portfolio asset class allocations … a significant focus of Rampart’s client emphasis will be devoted to this effort between now and year end.