If this market were a song, it would be The Whispers’ 1980 hit, “And the Beat Goes On.”
We have recorded positive returns again in the second quarter as global markets continue to advance. Globally, economic growth (GDP) has accelerated to over 3.25% in the past year according to the Organization for Economic Co-operation and Development (OECD). This has been fueled by a pickup in industrial production, global trade, and investment. All three factors illustrate the economy’s health and signal an increasing risk appetite for investors abroad.
In our Q1 commentary, we discussed our optimism for Surevest clients because we believed we were at the beginning of a period in which globally diversified portfolios would begin to outperform portfolios consisting solely of US stocks and bonds. This has played out again in Q2. I believe this is currently one of the most important factors to understand as an investor. Seeing that most of us are visual people, I wanted to provide a few stats and charts in this commentary for our clients to review that support the move.
International Fueling Growth
FactSet is predicting that the earnings growth rate for the S&P 500 for Q2 2017 will be 6.8%. For companies that generate more than 50% of sales inside the United States, earnings are only expected to grow 4.5%. However, the earnings growth rate is a blazing 11.4% for S&P 500 companies that generate more than 50% of their sales internationally. This differential is largely due to the economic advancement we are witnessing overseas.
International Beginning to Close the Gap
We have witnessed staggering outperformance from the US stock market vs. other countries since the financial crisis (2009 – 2016). The United States was the first country to unleash economic stimulus (e.g., lower interest rates), which ultimately served as a key factor in the outperformance of the S&P 500 vs. a balanced index such as the MSCI All Cap World Index.
While the S&P 500 is a portfolio of 500 US-only large companies, the MSCI All Cap World Index is more representative of the equity component of Surevest client portfolios. The MSCI is much more diversified, containing large company US stocks as well as stocks of globally diversified companies of various sizes, industries, and geographies.
The MSCI All Cap World Index Breakdown
This diversification, while prudent and financially rewarding over the long term, has been frustrating for the past several years. The chart below highlights the outperformance of the S&P 500 during that period.
This divergence between the two indexes was very unusual. Prior to 2009, the previous 7-year period saw both indexes trade in a much tighter range with the ACWI ultimately outperforming.
Highlighting our thesis, this outperformance reversed in Q4 of 2016. As this continues, the MSCI All World index moves to close this gap again, outpacing the S&P 500 thus far in 2017.
Opportunies in the United States Today
We are taking a much more selective approach within the US markets for our clients today. We are overweighting sectors that are undervalued with positive momentum. We are also investing in stock-specific stories that we believe will have a competitive advantage and the ability to break away from the general market.
The S&P 500 currently is valued at a forward P/E (price to earnings ratio) of 17.6. That means investors are paying $17.60 for every dollar earned by the average S&P 500 company. This is not extremely expensive, yet the price of these stocks is above both the 5- and 10-year average P/E of 15.4 and 14.0 respectively. This indicates to us that selectivity is required.
We are encouraged that over the past few quarters, our research has begun to pay off. As the market becomes more expensive, investors are finally paying attention to individual companies instead of investing in the entire index. I believe one good example of this is Avalon Bay (symbol AVB), which is a stock we own for many clients. Avalon Bay is an industy leader in Class A apartment buildings in high-barrier-to-entry markets such as San Franciso, New York, and Washington, DC. The REIT sector and real estate in general may face headwinds if interest rates rise. Traditional REITS will more than likely underperfom as rates increase. Apartments are different, though. As homes become less affordable, a greater demand for high quality rentals arises. Also, unlike long-term office space leases, apartment leases are short (6-12 months), giving apartment owners the ability to increase rents quickly as demand and rates begin to rise. This situation fundamentally provides a backdrop for this type of real estate to outperform the REIT index. If you look at the following chart, you will see this playing out as AVB has begun to separate from the index, compared here against the Vanguard REIT index ETF.
In regards to international markets, we are casting a wider net as we find greater opprtunities abroad. Almost all foreign markets are now trading at a discount to US stocks.
Europe is currently trading at a P/E of 16.6, Japan at 15.45, and emerging markets at 12.45.
When you dig a bit deeper, you find even greater opportunity. For example, small Japanese companies look very attractive. Japanese small-cap companies have pristine balance sheets with cash hoards (21% cash to market cap compared to 5% of US Companies). Small Cap Europe also trades cheaper than large caps at about 14.6 times earnings. As European economies improve, we believe these small caps will be the greatest benefactor.
In short, while there are areas of overvaluation, we are optimistic about the future because the markets have latched back onto a respect for diversification, risk management, and selectivity. All three are factors we believe create an environment we thrive in.
As always, we appreciate your confidence and will continue to work daily to secure your family’s future.
P.S. While everyone is euphoric over the FAANG stocks and Netflix earnings, I’ve raised some concerns about projections going forward on CNBC ASIA last night. Check out the clip if you get the chance.
Robert J. Luna, CIMA
CEO & CIO