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The Vitality of Valuations

Financial markets showed more of the slow, steady returns in the second quarter of 2017 that we saw in the first, as prices rose for stocks and bonds without much volatility. Valuations for domestic securities have gradually become somewhat elevated, in absolute terms, which raises the question of whether dangerous complacency has become prevalent. We can never ignore price tags, but a few factors ease our concerns. For one, valuations appear more sensible when considered as part of the big picture than they do at first glance. Policymakers’ interests ultimately align with our own, in favor of the health of the economy and markets. Finally, a transition in economic dynamics could support the continued extension of the cycle.

The second quarter delivered decent returns all around, which become fairly appreciable when compounded on a solid first quarter. The S&P 500 Index returned 2.9 percent, with little volatility, bringing it to 9.2 percent on the year. The All- Country World Index extended its mild outperformance with quarterly and year-to-date returns of 4.7 percent and 11.9 percent, respectively, as European and emerging-market stocks continued to lead the way upward. Bond prices also rose, with the Barclays US Aggregate Index returning 1.6 percent for the quarter, and 2.5 percent for the year so far.

On Point July 2017

The overall lack of drama, in the form of exceptional volatility or speculative fervor, is notable, considering that the valuations of many securities have become somewhat full over time, but understandable with some context. The S&P 500 overall is priced at 17.5 times projected earnings, which is close to the high end of the last 15 years’ range, albeit nowhere near the levels of the dot-com bubble. Corporate financial health is a far cry from that time, as companies are much more profitable as a whole, and, in contrast to the peak years of the housing bubble, accounting profits are matched by underlying cash flows. Therefore, higher prices are not unjustified.

Interest rates also remain quite low, which provides two-fold support for valuations. First, low bond yields make stocks relatively attractive. Stock dividend yields are still not all that far behind the yields on longer-term, high-quality corporate bonds, and dividends stand to continue on and grow higher into perpetuity, if the payers are chosen well. Second, corporations can borrow at low rates relative to the growth opportunities in the broader economy. So while market prices have come a long way, their rise does reflect real fundamental underpinnings and not pure speculation.

Of course, interest rates are not as low as they used to be, and may be heading higher, but the abatement of this tailwind does not spell disaster in and of itself. The Federal Reserve System’s Federal Open Market Committee (FOMC) raised their target for the federal funds rate a quarter percentage point to a range of 1.00 to 1.25 percent at their June meeting. However, the FOMC has made very clear that it prefers to conduct the hiking process very gradually, which is why it began well before inflation has risen above its two-percent target for any enduring period of time. Because inflation has proven to be so persistently mild, the FOMC can afford to move patiently and observe the lagging effects of each small rate- rise, rather than rush to contain spiraling prices without the ability to monitor constricting effects on growth.

In spite of the well-documented challenges, fiscal support of the economy could well arrive to offset its diminishing monetary counterpart. While hopes for a sweeping legislative agenda from the new administration have diminished, the Republican Party is broadly unified on the idea of lower taxes. Presidential approval numbers bode poorly for their chances in the first midterm elections next year, which consistently deliver a backlash to new administrations regardless. As that prospect approaches over the next year, legislative success will become increasingly vital to the party. Regardless of the outcome on their healthcare reform efforts currently underway, some amount of fiscal stimulus appears likely, barring a complete breakdown.

The geopolitical environment continues to be challenging, but that could be said for most of the time period post September 11, 2001. While North Korea continues to capture the headlines, the Middle East should also intermittently add to headline risk as both Syria and Qatar continue to be instability flashpoints in the region. Headline risk looks to be the greatest challenge to investors, but headlines could easily spill over into a much more serious situation if words actually turn into actions.

Lastly, the FOMC has broadly telegraphed its intention to begin the tapering of its balance sheet in earnest in the latter half of 2017. While the size and scope of the world’s central banks balance sheets have never been remotely close to this size before, neither has the world seen the results of a tapering of such a magnitude that is beginning to take place. Expectations are for an orderly draw down over an extended period of time, but with anything that is a “first”, we will be closely watching to see what unknown consequences come to the forefront as the Federal Reserve executes on its plan.

On Point July 2017

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Martin C. McWilliams III, CFA®
AVP, Associate Portfolio Manager

David M. Kirkpatrick, CFP®
SVP, Portfolio Manager

Charles A. Williams, CFP®,CTFA®
SVP, Portfolio Manager

Brian A. Barker, CFP®, AIF®
SVP, Director of Asset Management