Covenant Weekly Market Synopsis as of May 26, 2017

May 30, 2017

Equity markets remained resilient in a week of potentially negative market-moving headlines: a terrorist bombing in the UK, a downgrade of China’s credit rating, and a Federal Reserve announcement for plans to begin reducing its balance sheet later this year. Domestic stock indices such as the S&P 500 and Nasdaq ended the week at record highs after advancing 1.5% and 2.1%, respectively. Year-to-date, the S&P 500 is up 7.9% (ex-dividends), but 5 stocks are responsible for more than half of the year-to-date gains in the S&P 500 (see Market Internals below). Developed international equity markets tacked on modest gains for the week, but remain about 1% ahead of domestic stocks month-to-date (up approximately 2.5%). Emerging (+1.9%) and Frontier Market (+1.1%) equity indices moved higher, pushing YTD gains to 18.4% and 13.9%, respectively. Interest rates on US Treasuries ticked higher on the week, but yields on the long end of the curve (10-year and 30-year bonds) remain lower on both a month-to-date and year-to-date basis. As of Friday, the yields on the 10-year and 30-year bonds were 2.25% and 2.91% (as compared to 2.44% and 3.07% on January 1, 2017). In the commodity complex, precious metals rose, while copper and crude prices declined, with WTI Crude closing the week at $49.87 per barrel. The VIX Index (a measure of expected S&P 500 index volatility) fell below 10 again last week (vs. a long-term average of 20), highlighting investors’ beliefs that the road ahead will continue to be smooth.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.


Q1 GDP Update: The estimate of real, annualized GDP output was revised up from 0.7% to a better than anticipated 1.2%. Despite the upward revision, Q1 growth was still weak, just not as weak as originally believed. Corporate profits for the first three months of the year fell by 1.9% quarter-over-quarter, but were 3.7% higher than one year ago. The variance between a quarterly decline in corporate profits and the high number of companies that beat consensus earnings estimates in the first quarter may seem irreconcilable. However, share repurchases (financed through cheap debt) have reduced the total number of shares outstanding. Hence a company can have lower total earnings while still reporting improved earnings on a per share basis as there are fewer shares over which to spread those earnings (for a more detailed explanation see Weekly Synopsis March 31st). Consumption growth was revised up to 0.6% (from 0.3%), but still contributed less to quarterly growth than at any point in the last two years (see chart below). On the other hand, business investment growth (as a % of GDP) was the best it has been in the last 9 quarters, and was revised higher to 11.4% annualized, from 9.4%. Thus far, second quarter economic data has been mixed suggesting that the Q2 GDP growth may not be as strong as anticipated by the market. This coming week will be data heavy with income, consumption, PCE Inflation, and May payrolls providing a clearer picture of the current state of the economy. Though we expect Q2 growth to exceed 2.5%, we do not see any evidence that the economy is on the cusp of sustainable, accelerating growth. Our baseline forecast is that the economy will remain “good, but not great” with annual, real GDP growth averaging 2% – 2.5%.



Market Internals: According to Bespoke Investment Group, just 5 stocks are responsible for more than half of the year-to-date gains in the S&P 500. Apple, Facebook, Amazon, Microsoft and Alphabet account for 4.6% of the 7.9% percentage-point gain in the S&P 500 year-to-date. It is also worth noting that “growth” stocks are dramatically outperforming “value” stocks thus far this year. Within the S&P 500, growth stocks have gained 12.9% year-to-date, whereas value stocks have moved higher by a mere 2.2%. The divergence between growth and value stocks, along with index gains largely resulting from the performance of only 5 stocks, makes this a challenging environment for active managers except for those focused on momentum investing styles.


Lower performance, higher returns?: The torrid pace of gains exhibited by growth stocks (and the five stocks listed above in particular) can cause anxiety amongst some investors. “FOMO”, the Fear Of Missing Out, is a powerful emotion and can result in poor investment decisions as investors buy what has gone up recently.  It is worth remembering the adage that successful investing is a marathon, not a sprint. On a longer timeline, a disciplined and diversified investment strategy can lead to dramatically improved performance, even if that strategy “underperforms” over certain time periods. For example, since 1928, the S&P 500 has produced annualized returns of 9.3%. Though investors have had to contend with multiple drawdowns of 50% or more, those investors that hung in there were rewarded. Sadly, most investors did not realize those gains. A preponderance of academic research shows investors tend to sell at market lows and buy at market highs, greatly reducing their portfolio’s performance. One of the most striking examples of this phenomenon is Peter Lynch’s Magellan fund. From 1977 – 1990, the Magellan fund generated compounded growth of +29%, but research by Fidelity revealed the average investor in the fund lost money(!!!) as market volatility caused investors to both sell and buy the fund at the wrong time.

By contrast, diversifying a portfolio can lead to lower overall volatility, an improved investment experience and improved investor performance. Charlie Biello, director of research for investment advisory firm Pension Partners, provided evidence of the efficacy of this approach. He shows that a more stable portfolio that captures 65% of the upside of the S&P 500, and limits losses to 31% of the market’s downside, outperforms the index in the long run. This diversified “Stable” portfolio generated annualized gains of 12.9% since 1928, or more than 3.5 percentage points per year on average than a buy-and-hold S&P 500 strategy. The table below highlights the change in value of a hypothetical $10,000 investment in the two portfolios.



Over the 90-year period of the analysis, the Stable portfolio generated gains nearly 1,700% higher than the S&P 500. This same Stable portfolio would likely be criticized as underperforming over the last several years vs. a concentrated S&P 500 investment. Yet, history is on the side of this strategy outperforming in the long-run. The bottom line is that successful, long-term investors don’t succumb to the siren-call of FOMO and maintain a disciplined investment approach.

Be well,