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2017 First Half Update

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We are halfway through 2017, and it’s been a good six months for stock markets at home and abroad.

Year to date, international stocks have enjoyed the highest performance, with emerging markets showing double digit returns based primarily on the falling dollar, which was down over 5% year-to-date.  Since most emerging market countries peg their currency to the dollar, when the dollar falls, their currency falls and the companies in those countries being primarily exporters enjoy higher net earnings due to the falling exchange rate.

In terms of the US stock market, large cap companies significantly outperformed small cap companies and growth stocks outperformed value stocks during the first half of the year.  You can see a summary of first half returns in the image above.


When we examine the month of June, the tables turned on the first half winners.
U.S. small caps made up for their relative weakness earlier in the year by having the strongest returns, significantly besting large cap stocks.  Growth stocks were thumped by value stocks while international stocks were mixed in June, with developed-market stocks down and emerging markets up.  You can see these returns in the image above.

Bonds are positive for the year but they experienced a negative return in June as yields rose late in the month.

The most striking thing noted during the first half of the year is the low level of volatility in the markets. June had zero days on which the S&P 500 moved by more than +/-1%. Such movement has happened on only four days this year, which is a material contrast to the volatile first half of 2016.


The image above is a graph of the VIX Volatility Index since the year 2000.  The VIX is the red line and the S&P 500 is the blue line.  You can see the inverse relationship between the two indices – the VIX typically leads the S&P 500.  A low level on the VIX indicates complacency in investors – a high level on the VIX indicates fear in investors.

There was only one other time since 2000 that the VIX has been at 10 or below and that was leading up to the 2008 crash.  This image does not say we will have a crash, but rather it just flashes a warning sign that investors have gotten too complacent and they are not prepared for a correction.

The eight-year bull market we have seen in the stock market since the March 2009 post-crash bottom is getting long in the tooth.  Many of the things that you saw in the first half of the year are typical of aging markets that are readying for a correction:

·    The low economic growth we have seen in the face of rising interest rates pushes investors toward growth stocks that have earnings growth in spite of weak economic times, and growth companies do it with little debt to be impacted by rising rates;

·    Investors favor less volatile large cap companies as they see markets moving toward a top over more volatile small cap companies; and

·    Complacency settles in with investors who have gotten used to markets drifting higher and they do not sell when valuations are high.


The image above compares the Fed Funds Rate (the overnight lending rate controlled by the Federal Reserve) to the S&P 500 Index.  The Fed Funds Rate is in black and the S&P 500 is in blue.  This graph is again from 1998 forward and I wanted you to see the relationship between interest rates and stock prices.  The oldest date for Fed Funds Target Rate in my data service is 1998, but I think you can see the relationship between rising and falling Fed Funds Target Rates and the S&P 500 Index.

Again, there is nothing in this chart that says a correction is imminent.   However, the relationship between rising rates and an eventual correction in stock prices is pretty clear.

We have written to you many times that as valuations on companies move further from their averages, risk increases within stock portfolios.  As risk increases, the prudent thing to do is to employ classic risk management techniques, like increase liquidity in the portfolios and, cull the weakest companies from the portfolio, and book profits on winning positions.

We have been using each of these strategies and feel we have adequate liquidity on hand in preparation for the next correction so that we can be a buyer when others who did not prepare for the correction are forced to sell at lower prices.  Remember, investing is not a linear activity like earning interest on a certificate of deposit.  You want to buy companies when they are low priced and sell them when they are high priced – that does not happen within the constraints of a 12-month calendar nor are the starting points nor ending points clearly delineated.

Greed often leads people to hold onto companies too long and miss a selling opportunity in the hope or assumption that prices will go ever higher.

Unfortunately, with rising interest rates, tepid corporate earnings, slow economic growth, and valuations that are above the 95th percentile, now is the time to be prudent before prices come under pressure so that we can be aggressive buyers when the opportunity presents itself.