Q2 Quarterly Review: Making Heads or Tails of Ongoing Market Growth

Over the past quarter, the US economy has continued its slow but steady growth trajectory. The stock market is up 8% for the year to date, and we continue to see signs of confidence in the economy’s direction.

In our Q2 review we explain why you shouldn’t confuse stability with predictability or try to time the market, and why our view of the US economy and markets remains consistent for now.

Suppose we flip a quarter three times and each time, it comes up heads. What does that tell us about the next flip?

Some might draw the conclusion that the coin is rigged in some way, and the next flip will also be heads. Others fall prey to the gambler’s fallacy and bet on the opposite, believing tails are “due.”

But the fact is, we can’t know what the coin will do after just three flips. A perfectly fair coin lands heads three times in a row about once in 8 sets of tosses. So if the coin is rigged, three flips is too small of a sample size to tell. As a result, our best guess should remain at 50% heads.

It’s not all that different from what’s going on in the current market environment: the US has been experiencing a long stock market boom, and many international markets are doing quite well—but does that mean we know what will happen next? Have we seen enough data to change our current investment strategies?

The short answer is, probably not. Let’s take a closer look at why, as we work to separate the signal from the noise.

 

Chugging right along

We previously noted that, though its growth has been modest, the US economy has been steadily improving, with gross domestic product (GDP) up 1.4% in the first quarter. Unemployment reached a 10-year low in May, and all major U.S. banks successfully completed stress testing, alleviating concerns that the financial sector is undercapitalized. Then, in June, the Federal Reserve Bank nudged its benchmark interest rate a quarter point higher, to 1.25%, further signaling confidence in a strengthened economy. There are plenty of signs that consumers, too, are feeling good about the economy: restaurants are full of patrons, and airports and roads are full of travelers.

 

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(Chart illustrates the year-to-date price performance of VTI, an ETF tracking the total US stock market, as of July 10, 2017; source: Google Finance)

In Q2, the US stock market continued to rise, up almost 8% for the year to date. Even better for investors, the market has enjoyed 258% gains in the S&P 500 since March of 2009.  So, how much longer can we expect this good fortune to continue?

Although the current bull run has been long, it’s not recordbreaking in length or return. Since 1926, US investors have enjoyed 11 bull markets (periods that follow declines of 20% or more). The current market boom still trails the 1990s dot-com bubble in both length (113 months) and total return (417%).

Right now, inflation and interest rates remain low, despite the fact that we are near full employment. Through gentle nudges, the Fed can tighten monetary policy to raise interest rates while still encouraging economic growth.

As a result, short-term interest rates have crept up, yet long-term rates have not moved appreciably. That means bond prices haven’t fallen for long-run fixed income investors, either. The yield curve is flattening and we are watching that closely. Continued low unemployment should drive wage increases, and combined with a growing economy, this should move inflation toward the central bank’s long-run target.

We also still expect the Republican-controlled federal government to make an effort to reduce capital gains taxes. Tax cuts are important to their conference and could be positive for investors. A tax amnesty bill on repatriating corporate cash could follow tax reform.

Growth should continue, but the future is unpredictable. Given how little has changed over the last few months, our view of the US economy and markets remains consistent. It’s nearly impossible to time the market—and empirical evidence suggests it is better for investors to simply ride the waves than to try to enter at the bottom and exit at the top. A diversified investment strategy continues to be your best bet.

 

Abroad, a similar story

 Economic growth continues slowly and steadily in developed countries in a similar trajectory to the US. Developed market equity returns are up 12.6%  and are outpacing the US in the first half of the year. This upward trend is encouraging stability, especially in markets that are hungry for predictability.

 

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(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of July 10, 2017; source: Google Finance.)

Following recent elections in France and Britain, major European markets are on the upswing. Since the Euro credit crisis, the Eurozone has grown steadily, now at a 1.9% growth rate. At the same time, unemployment, which hit a high of 12.1% in major European economies, has fallen to 9.1%.

And while over the last twenty years, the Japanese economy struggled to gain traction, growing its GDP just 0.7% per year, now their GDP growth rate has almost tripled the long-run average at 2.2%, while the Japanese market benchmark, the Nikkei, is close to three-year highs.

These signs and others point to consistent growth and improved returns for developed markets. Furthermore, because developed markets have trailed the US stock market in bouncing back from the global recessions in 2008, international equities may have significantly more room to advance.

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(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of July 10, 2017; souce: Google FInance.)

Emerging stock markets have been the top performing asset class this year, up 14%. This sort of global economic growth is encouraging, though commodity prices continue to lag. Down the line, this could weigh on emerging economies that rely on the export of raw materials. However, as developed economies continue to expand, their demand for raw materials and imports from emerging economies will grow as well.

 

So are we getting a clear picture?

For the last several years, and especially in the last few months, investors have enjoyed steady returns in their portfolios. US and international equity markets are seeing double-digit annual returns, and bond yields have held firm even as the Fed increases short-term rates.

Though the US’ eight-year bull market run feels like a long time, it is important to remember that it is still a relatively small sample. Plus, it is nearly impossible to accurately predict market behavior, and research shows that early exits from bull markets or late entries following bear markets create significantly worse long-run returns than a buy-and-hold strategy that rides the waves.

 

We continue to recommend a strategic, globally diversified portfolio that is aligned with your preferred risk tolerance and personal time horizon. If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.
Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.