[Investment Quarterly] Cryptocurrencies and Other Things on Our Mind

Cryptocurrencies and Other Things on Our Mind

As the calendar has turned to 2018, and the investing world hopes and wonders for a repeat of 2017, here are a few things that are on our minds as we embark on the new year.

Bitcoin Frenzy

The magnitude of the bitcoin movement in 2017 was remarkable. Viewed in the context of other significant historical increases in financial markets/assets (e.g., gold in 1979, tech stocks in 2000, and housing and equities during the Global Financial Crisis), the gains look outsized. The digital asset traded from a low of $789 early in the year to a high of $18,674—a 23-fold increase (Display). To put that into perspective, the S&P 500 traded from a low of 295 to a high of 1,527 in the decade prior to the tech bubble (a 5x gain in 10 years).

The move itself and the frenzy surrounding it make comparisons to other bubbles inevitable. While consistent data is difficult to find and verify, it appears that “Tulip Mania” from the early 1600s had a move that was comparable in degree, where people were even willing to sell property just to purchase tulip bulbs; although some charts show it happened over a period of four years.

So what are our thoughts on bitcoin? Like everything else in the investing world, price and timeframe matter greatly when allocating capital. Digital assets and blockchain technology appear to be here for a while, but just as with the evolution of the internet, there will be winners and losers, regulatory considerations, and a process of price discovery.

Without opining on the current “value” of bitcoin, we believe it would only be appropriate for those who have money with which to gamble. While bitcoin is called a currency, it is emphatically not remotely similar to a reserve currency, and shouldn’t be considered as such.

Swimming Against the Tide

I recently read an article on the proliferation of the use of data analytics in sports and how it has diminished the edge of the early adopters (think “Money Ball” and the Oakland Athletics). The same can be said of the investing business, that there are many professional investors looking for the same opportunities for alpha.

The ability to use modern technology to quickly and efficiently exploit market anomalies, coupled with the increase in assets in passive strategies, has seemingly reduced volatility, shortened periods of volatility and increased the difficulty for asset managers to outperform market benchmarks.

Three quick thoughts come to mind here:

Historically, investing has been a mean-reversion endeavor: if we wait long enough we will see prices and returns move back toward the mean. There have been other periods where passive investing has outperformed and volatility has been reduced. But, as day follows night, these periods have receded, although the timing and length of such episodes is impossible to predict.
Mean reversion would argue that some of the things that have been out of style in recent periods have the opportunity to exceed expectations going forward. Most of us have long-term goals (e.g., retirement, charitable endeavors, providing for our children/grandchildren), yet focus on short-term and recent investment results. Many alternative strategies have underperformed return expectations (which is different than benchmarks or portfolio roles) but appear to be headed into an environment more favorable to their mandates. For instance, reinsurance strategies are coming off one of the most difficult years in history, and market rates have hardened to the benefit of capital providers; global reversal of easy monetary policy could present opportunities for trend-following strategies; and greater dispersion in equity performance would generally benefit active management, including equity-based hedged strategies.
Finally, it’s worth noting that if alpha is becoming a rarer commodity, in order to achieve differentiated (better-than-market) returns, you need to think and position it differently. Cap-weighted passive investing will provide “market” returns. Re-weighting equity allocations (i.e., international versus domestic) is one way to attempt to beat the market; active management is another. It can also be avoiding either panic or euphoria and paying attention to valuations and managing risk. Food for thought.

Good News?

The stock market delivered a pleasant surprise in 2017, with gains greater than
the long-term average (versus the S&P 500). We can attribute this to a variety of reasons, but one of them surely has to be that the economy continues to improve and appears to be on a more solid footing. This improvement is visible in a variety of indicators: unemployment at 4.1%, consistently strong readings from the manufacturing sector, year-over-year leading indicators are still positive, and even the fact that inflation is increasing moderately. Recently passed tax reform and continuing deregulation are trends that also appear to be pro-growth.

It’s important to remember that better economic conditions don’t always translate to a strong equity market. The commonly held perception that the stock market is an efficient discounting mechanism hasn’t always held true. However, a stronger economy and tax reform could translate to better earnings, which would also be a positive for the markets.

This needs to be balanced against the fact that equity valuations by almost any measure remain above average, and the U.S. Federal Reserve and the unwinding of its balance sheet, as well as any potential action on rates, are a wild card. While predicting market performance is at best a guess, the stronger data and business-friendly environment appear to suggest that the current conditions argue against a 1999 or 2008 type of market event.

Bill Hornbarger
Chief Investment Officer

Market Recap

The fourth quarter topped off a rather unprecedented year for equity markets as equities recorded double-digit gains with historically low levels of volatility—despite geopolitical tensions, domestic political infighting and natural disasters.
U.S. equities, as measured by the S&P 500, are currently in the longest period without a 3+% correction, with the last drop of that size back in November 2016.
Additionally, for the first time on record, U.S. equities delivered positive returns in every single month of the year.
Emerging-market equities finished the year ahead of U.S. and developed international equities, benefiting from a weak U.S. dollar, a rebound in corporate earnings and a rally in tech.
Even though valuations may seem elevated, there may still be some room to run given earnings and macroeconomic growth trends, though heightened volatility from recent levels would not be much of a surprise.
Longer-dated Treasuries continued to lead those with shorter maturities, tightening the yield curve to its flattest level since the Global Financial Crisis (GFC).
The Republican-led Congress was able to pass a tax reform bill at the end of the year, with a significant reduction to the corporate tax rate and a reduction in most individual tax rates.
Although the tax bill should improve the cash flow available to companies and the net income to individuals, it will take some time for all the ramifications to become clearly realized.
Over the year, we continued to see a synchronization of global economic growth and improvements of employment. As a result, many central banks have begun to modestly tighten monetary policy.
The U.S. Federal Reserve (the Fed) voted to raise the federal funds rate in December to a target range of 1.25%-1.50%, noting that the labor market has continued to strengthen, and economic activity has been rising at a solid rate.
Policymakers plan to raise rates three more times in 2018 and twice in 2019. They also raised their expectations for economic growth in 2018, expecting the economy to grow at a slightly faster rate of 2.5%, compared to the previous forecast of 2.1%.
President Trump nominated Fed governor Jerome Powell to take over when current Fed chair Janet Yellen ends her four-year term on February 3rd; however, it’s unlikely that Powell will materially alter the probable path of the Fed rate increases.
Outside of the U.S., the European Central Bank announced in October that it would reduce its monthly quantitative easing purchases down to 30 billion euros, from January through September of 2018. Also, the Bank of England increased interest rates in November for the first time since 2007, noting that further rate increases are likely to be dependent on Brexit negotiations.

Leading Economic Indicators

The leading economic indicator index continued to increase in the fourth quarter, ticking higher in both October and November (December results won’t be released until the end of January).
For November specifically, the positive contributions from ISM new orders, consumer confidence and the financials components more than offset the negative contributions from weekly initial claims for unemployment and building permits.
Over the previous six months, strength among the leading indicators has remained widespread.

Employment

The employment picture in the U.S. is healthy, with jobless claims near record lows and unemployment at 4.1%.
Although the recently reported increase in payrolls of 148,000 was below consensus expectations, there shouldn’t be as much of a call for alarm since it remains above the overall growth of the labor force.
A metric that will be tracked more closely in the near term will be wage growth, which has been sitting only slightly above inflation, most recently at 2.5% year-over-year.

Business and Consumer Confidence

Business and consumer confidence remained at elevated levels, both suggesting economic growth will continue well into next year.
Consumer confidence has been boosted by a few factors, including the job market, stock market and fiscal reforms.
Manufacturing is likely to get a boost in 2018 from the $1.5 trillion tax cut approved by the Republican-controlled Congress in December.
Overall business spending has surged in anticipation of the corporate tax cuts (falling to 21% from 35%) and, in a separate report by the U.S. Department of Commerce, construction spending rose to an all-time high near the end of the year.

Equity Performance

Similar to the majority of the year, it was a great quarter across the board for equities.
For the first time on record, U.S. equities recorded positive returns in every month of the year.
Emerging markets finished the year like they started, leading both the U.S. and developed international stocks, benefiting from a weak U.S. dollar, a rebound in corporate earnings and a rally in tech.
Excluding the benefits of currency, although still recording strong returns, international developed equities finished the year trailing both the U.S. and emerging markets as they were not able to keep pace in the latter part of the year.
Growth stocks finished well ahead of value stocks given the weakness in the energy sector for much of the year and the general “risk on” investor appetite.
The sectors recording the best performance in the final quarter of the year included consumer discretionary, technology and financials; the worst performers included utilities and health care.

Trailing 12-Month and P/E Ratio

Similar to the past quarter, even though U.S. equities recorded strong returns during the quarter, the S&P 500 price/earnings (P/E) ratio showed only modest movement as corporate earnings growth actually outpaced market values.
While the P/E ratio is definitely above the historical norm, as long as earnings continue to rise with economic growth, there doesn’t seem to be any fundamental trigger, at least in the near term, signaling a large sell-off.

Valuation Blend

Using our four-factor blend, the valuations for all but one of the equity-market segments finished higher at the end of the year, with U.S. small-cap growth sitting as the richest relative to its own history.
The segment showing a decline in its valuation relative to history was U.S. small-cap value; however, this was simply a result of strong earnings reports during the fourth quarter.
With the large drop in its valuation, U.S. small-cap value now sits with developed international equities as the cheapest relative to other equity asset classes. With that said, both remain well above their historical average.

Fixed–Income Sectors

Although credit benefited from the general risk-on investment environment during the final quarter of 2017, and for the majority of the year, many fixed-income investors still expressed some skepticism with their outlook, providing fodder for the outperformance of longer-dated U.S. Treasuries.
Credit prices have been buoyed by a combination of generally improving credit metrics, few debt-funded mergers and acquisitions or shareholder-enhancement programs, and the market’s expectation that tax revisions will bolster credit strength.

Yield Curve

The shape of the yield curve compressed to its flattest level since before the 2008-2009 GFC.

Corporate Spreads

In the credit market, investment-grade spreads tightened in the past quarter, while high-yield credit spreads have widened.
Although there was a slight divergence between the two spreads, both have tightened significantly year-to-date.

Please note, these materials were prepared for informational purposes only and do not take into consideration your individual circumstances. This is not an offer to purchase/sell securities. Past performance is not indicative of future returns. Alternative investments possess features and risks distinct to the individual investment vehicle, and any decision to invest in such vehicles should be made based on your individual circumstances in consultation with appropriate financial professionals.