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Investment Letter

3rd Quarter 2017

October 1, 2017

Laissez les bons temps rouler - let the good times roll -  a slogan usually reserved for the Mardi Gras season, but very appropriate these days as investors enjoyed another period of prosperous returns in 2017.

The Dow Jones Industrial Average (a price weighted index) continued its steady march higher during the quarter as the index set twenty new all-time closing highs before finishing the quarter at 22,409.45 points and posted a total return of 15.45% through September 30, 2017.  The S&P 500 Index (a capitalization weighted index) ended the quarter at an all-time closing high of 2,519.36, and recorded a 2017 year-to-date (YTD) total return of 14.24%.  These two indices are often used in the media and publications to illustrate the performance of not only the large-cap segment of U.S. equities, but the broad U.S. stock market.  However, there is an important distinction between the two.  A price weighted index uses the price of each individual stock in the index to determine the overall proportion.  The higher the share price of a stock, the more influence that stock has on the index.  The DJIA is comprised of 30 large and well-known U.S. companies, but the top 10 holdings in the index are responsible for over half the index’s weighting.  The alternate method of using a capitalization weighted index allows the index components (stocks) to be weighted based on the total market capitalization of each individual part.  Therefore, larger sized companies carry larger weightings in the index.  In the S&P 500 Index, the top 10 holdings represent approximately 20% of the index’s weightings.  While the S&P 500 index is a better overall measure of the U.S. stock market, the DJIA is a popular market evaluation tool.


The table below recaps the 3rd Quarter and YTD performance of major market indices:

Asset Class

Index

3rd Qtr. 2017 Total Return

2017 Total Return

Cash

BofA/ML Three-Month U.S. Treasury

0.26%

0.57%

U.S. Bonds

Barclays Intermediate-Term Treasury

0.34%

1.56%

U.S. Large Co. Stocks

S&P 500

4.48%

14.24%

U.S. Small Co. Stocks

Russell 2000

5.67%

10.94%

International Stocks

MSCI EAFE (net div.)

5.40%

19.96%

Real Estate

DJ Select Real Estate Securities Total Return

0.38%

1.75%

   Source: Morningstar

 

Domestic small cap stocks and international stocks were included in the market’s success story.  The Russell 2000 Index hit an all-time high at quarter end and the MSCI EAFE Index performed well.  In addition to the solid quarter performance, these indices posted double digit total returns year-to-date. 

U.S. economic conditions continued to be supportive of the current eight-year expansion.  See the economic indicators below for additional information.

 

GDP

3.1% Growth (annual rate) – 2nd Quarter 2017

 
 

Inflation

1.7% CPI (less food and energy) and 2.2% CPI (all items)

year-on-year September 2017

 
 

Interest rates

No increase. Federal Funds Rate 1.00 - 1.25%

 
 

Jobs

Unemployment at 4.2% (lowest since February 2001); Drop of 33,000 non-farm payroll jobs in September. First significant job loss since 2010 - likely due to Hurricane Irma and Harvey impact.

 
 

Manufacturing

U.S. Manufacturing expanded.  New orders, production, employment, and supplier deliveries were stronger; Inventories contracted; Price increases indicated higher raw material costs.

 
 

Business Spending

Private non-residential investment trended upward; New durable goods orders increased 1.7% in August

 
 

Corporate Profits

2nd Quarter 2017 - U.S. corporate profits remained strong;

S&P 500 Earnings per share = $30.51

 
 

Housing

New home sales decreased 3.4%; Housing starts declined 0.8%; Existing home sales shrank 1.7%; Building permits increased 3.4%; MBA fixed 30-yr mortgage rates = 4.12% 

 
 

Consumer Spending

Disposable income remained strong; Consumer Confidence declined slightly; Retail Sales declined but total vehicle sales increased; Personal spending edged up; Durable and nondurable spending increased; Savings rate = 3.6%.

 
 

Energy

Oil price (West Texas Intermediate) = $51.67/bbl – 9/29/17; Gas Price (U.S. average regular unleaded) = $2.55/gal – 10/02/2017

 
 

 

The September statement from the Federal Open Market Committee (FOMC) confirmed the economy was growing moderately and the labor market continued to strengthen.  Despite the severe hardships and storm related disruptions from hurricane Harvey, Irma, and Maria, the Fed did not expect the course of the national economy to be materially altered.  Gradual adjustments to monetary policy should support a moderate pace to economic expansion and further improvement in labor markets.  The Committee also anticipated slightly higher inflation due to higher prices for gasoline and some other items in the aftermath of the hurricanes.  In view of the current economic conditions, the Fed decided to maintain the target range for the federal funds rate at 1.00% to 1.25% and assured their stance on monetary policy remained accommodative.[1]

The Fed’s policy normalization plan starts in October.  The strategy is to gradually reduce the amount of mortgage-backed and Treasury securities on the Fed’s balance sheet by approximately $10 billion a month to a maximum of $50 billion a month by the end of 2018.  Scheduled bonds will mature each month without reinvesting the proceeds, and the reduction will continue until it has reached a size desired by the Fed or the program is halted in the event of a material deterioration (recession) in economic conditions.

International economies continue to improve.  Broad-based growth in the Eurozone was supported by advances in business activity and manufacturing.  Japan’s stronger economy was driven by improvements in private consumption and business spending despite softer exports. China’s economic growth rate remained strong, but economic concerns (deleveraging and rebalancing) continue to raise questions about growth sustainability.  Emerging markets expanded further due to stronger global economic conditions, higher demand for technology related goods, positive earnings, and a weaker U.S. dollar.

Our outlook for the domestic economy is still optimistic.  We anticipate a slow and steady pace for economic growth.  Inflation should remain around the Fed’s two percent target rate, and the labor market should continue its movement toward full employment.  Manufacturing, corporate profits, and consumer spending are areas where we expect additional improvement.  We are concerned over the recent decline in housing activity, but we remain confident that favorable economic conditions exist for a housing market rebound.  Short-term fluctuations in oil prices could be more frequent due to global inventory and output levels, but we believe prices should stay around the $50/bbl range for an extended period.  Over the next year, we expect a rising rate environment from the Fed.  We believe a December rate hike is most likely, and we also think 2018 could see two to three additional rate increases.  The Fed’s policy normalization plan will probably contribute to the rising rate environment.  The severity of the impact should be minimal until later next year or if the Fed decides to accelerate the reduction timeline.  The prospects for tax reform are more favorable, but it is still too early to predict if the White House and Congress can work together to develop an acceptable proposal.

The international outlook is encouraging.  Economic conditions continue to improve and are becoming more widespread across Europe and Asia.   Lenient monetary conditions and supportive polices are promoting stronger growth, and we expect international markets to outpace domestic markets during the remainder of 2017.  While we anticipate divergences in financial outcomes, improvements in fundamentals and attractive valuations should help enhance financial performances in developed and emerging markets. 

We are mindful of the potential risks to the domestic and international economies.  The fading Trump economic boom (health care, tax reform, and infrastructure spending), political gridlock, tight monetary policies, restrictive trade policies, immigration, China’s growth, BREXIT negotiations, and escalating geopolitical tensions (North Korea for example) are challenges that could negatively impact economic prosperity around the world.  As always, we remain watchful!

October 19, 2017 will mark the 30thanniversary of the “Black Monday” stock market crash, a day in which the DJIA dropped 508 points or a negative 22.61% (the biggest one-day percentage drop on record for the DJIA).  Fast forward thirty years and the same percentage decline would be equivalent to a 5,100 point drop.  While we don’t anticipate an event of this magnitude, it is important to note that markets are cyclical, and swings in the markets can be short or long.  It usually does not take long for markets to fall, but the recovery can be drawn out.  As an example, look at the last three recoveries in the market.  The crash of 1987 took approximately 18 months to fully recover; the recovery that started in 2002 lasted 49 months; and the most recent recovery that started in 2009 endured 37 months.

Investors have enjoyed a long run of positive momentum in domestic equities.  From March 9, 2009 through September 30, 2017 (102 months), the price of the S&P 500 Index has increased 272%.  Sooner or later, the current market expansion will end.  The successful long-term investor prepares for these types of events by adhering to a disciplined investment process that includes a diversified asset allocation strategy based upon a tolerance for risk and need for return.

As I have often stated, our investment philosophy remains based on the fundamentals.  We believe it is time---not timing---that matters most.   History shows us that turbulent moments in financial markets are unavoidable, but the prudent investor is rewarded by staying the course.

With the end of the year rapidly approaching, it is time to complete any last minute year-end tax planning strategies.  The list below provides some items to consider:

 

·         Gift appreciated property.

·         Contribute the maximum amount to retirement plans.

·         Make charitable donations.

·         Defer income and accelerate deductions.

·         Manage investment gains and losses.

·        Bunch itemized deductions (medical and professional fees/expenses) to exceed the adjusted gross income (AGI) floor.

·         Check estimated tax payments to avoid underpayment penalties.

·         Take required minimum distributions (RMDs) by the deadline

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust.  Please contact me if you have any questions or if you would like to discuss the tax planning strategies above.

With kindest personal regards, I am 

Very truly yours,

 

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.


[1]Source: Federal Reserve System, FOMC statement, September 20, 2017.

https://www.federalreserve.gov/newsevents/pressreleases/monetary20170920a.htm

 

 

 

 

 

 

 

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