As 2017 draws to a close, equities continue their march higher. The cautious optimism that we discussed a year ago has transitioned to into exuberance for stocks. Strong corporate earnings, easy global monetary policy, and tax legislation in the U.S. have been driving forces supporting the bullish momentum in stocks throughout the year.
Calm and Easy
In addition to the strong year in returns, we have experienced gains with historically low volatility. The chart below shows how the price changes in both the S&P 500 and the yield of the U.S. 10 year Treasury Note are at historic extremes going back to the 1960s. Any dot in this chart that is in the lower left corner means there have been little in the way of price changes. Simply put: it has been extraordinarily calm out in investment land and investors have not had their resolve tested in some time.
Calm Before the Storm?
One narrative that has been recurring in the financial press recently is that we are likely in the beginning stages of a market “melt up”. The implication being that melt ups are usually followed by melt downs. While this is easy to say, getting the timing right of when the melt up will transition into the melt down is the hard part. The economic backdrop suggests that we may have some way to go before a correction occurs. The drivers mentioned above all suggest that the upward momentum can continue as long as corporate earnings improve and we are able to avoid things like trade wars and/or military conflicts. Unexpected rising inflation and economic disappointment in China are also risk factors.
The psychology in the investment cycle is best illustrated by the cycle of market emotions. This is a chart that goes back decades and attempts to explain why investors historically have bought their investments high and sold them low.
One of the reasons we experience this cycle is recency bias. The stock market is one of the few places where buyers get excited to buy when the prices go up and become more reluctant when prices fall. So if there is an over-riding theme to 2017, it is the transition of investors in aggregate from being optimistic toward euphoria.
Our investment process is what we use to navigate this environment. Since attempting to predict or time the market, can be extremely costly we use our process to make the most prudent investment decisions we can. Put simply this process is first to diversify our holdings, maintain a long term perspective and finally to be sure we are rebalancing our risks as necessary.
As always, please contact us with any questions. Best wishes in the New Year!
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Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels.
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