Following is a letter written by one of our VWS pros and sent through the Wall Street community/client base on February 1, 2018:

2017 was a surprisingly good year for almost every market around the world, especially given the global and political underpinnings. The S&P 500’s total return was almost 22% in 2017, followed by one of the best January’s on record with a gain of 4%. Let’s keep in mind a one-month gain of 4% annualizes to 48%; after a 22% gain in 2017, it would be an understatement to say that the market got ahead of itself. Average annual stock market returns are between 9-11%.

At the same time, the S&P 500 hasn’t retreated 3%, either in a single day or over several days, since early November 2016. That is the longest period of calm in history, shattering the record from the mid-1990s. How about the last time we had a 5% correction? June 2016…it’s been a while, and a good ride. All good things come to an end, but we believe this will bring on another good thing – the opportunity to buy lower. Here’s how some key benchmarks pertinent to your portfolio performed:

TOTAL RETURNS: 2017 2016
S&P 500 (U.S. Large Cap) 21.82% 11.92%
Russell 2000 (U.S. Small Cap) 14.63% 21.21%
EAFE (Developed International) 25.69% 1.59%
Emerging Markets 37.51% 11.52%
Barclays 1-5 Yr US Govt/Credit 1.27% 1.56%
Barclays CA Muni Short 1-5 year 1.61% 0.07%
Citi High Yield (taxable) 7.05% 17.77%
Barclays High Yield Muni 9.69% 2.98%


Starting with President Trump’s January inauguration, the US markets were full of hype, hope, and fear. With the promise of new border walls and a tax plan, no one could have expected such a dearth of volatility. The stock market rarely moved more than 0.5% either way, while the majority of days were tiny gains. Hopes of a corporate tax cut propped up the stock market through the first quarter. A stable economy and an EPS bounce from the 2015-2016 dip replaced the hope of corporate tax cuts through the summer.

Much of the EPS bounce was due to a weaker dollar. Against a common basket of currencies, the dollar was down 7.5% in 2017, its first decline since 2007. Around 30% of the S&P 500’s total sales, and 40% of profits, flow from abroad.

Global uncertainty was constant with terrorist attacks and threats looming from North Korea, Russia, and the Middle East. Investors were able to limit pullbacks to single digit percentage points by fearlessly buying. This pushed the Dow Jones Industrial Average to a record of records – closing at more than 70 record highs during 2017. As mentioned in the WSJ:

After eight years of solid returns, investors have become accustomed to buying stocks after even small pullbacks, gaining confidence that the market will rebound and continue its run higher. Corporate profits have been strengthening and the Republican tax overhaul is expected to further boost earnings at many firms. More broadly, economists say growth across the U.S. and globally is hitting its stride after years of a fits-and-starts recovery.

During the last few weeks of the year 2017, the previously highly anticipated tax bill was pushed through the House and Senate before they could go on another vacation…or shutdown. The momentum from this bill started 2018 with record stock market closes. To continue this momentum through 2018, we not only look for earnings growth, but better than expected growth to drive higher stock prices. Wall Street analysts are forecasting that cumulative earnings per share for the S&P 500 will jump by 11% in 2018 and another 10% in 2019. The share of corporate profits has outgrown wages and salaries though – with just 43% of GDP accounted for my wages, well below the long-term average of 47%.

A correction in this measure is good and bad news. Lower corporate profits would also mean more money going to the US consumer in the form of wages. Consumption still accounts for more than 2/3 of GDP so any stimulation here could promote animal spirits in an economy which has longed for greater inflation for a few years now.

Over the past couple years, one of, if not the only criticism of US economic health was the weak sign of inflation. Lack of inflation produces fears of deflation – where prices of everything fall and still nobody can afford anything, aka recessions/depressions. Last week we saw the strongest sign of wage growth since recovering from the Financial Crisis. The exact opposite of deflation. Now that the stock market had a fantastic run of low volatility and steady earnings growth, it seems like we forgot about this fear and flipped to the exact opposite. The markets have replaced deflationary fears with a fear of inflation, fed rate hikes, and whatever else the talking CNBC heads make up day to day. Speaking of, a 1000 point drop with the Dow at 25,000 is a big difference from 1000 points when the Dow was at 10,000. Let’s keep that in mind and think in percentage terms, because we care about percentage returns when it comes to your portfolios.

While wage growth was taken as a bad sign last week, this means workers are finally making more money. This increase in paychecks should very well stimulate the economy with consumer spending. Stocks might be slightly overvalued and due for this correction, but in the good ol’ USA, money in people’s pockets tends to be spent. Consumer spending is the greatest component of GDP, so we wouldn’t say there is much to worry about. Any pullbacks in the market should be taken as a buying opportunity, given the strength of earnings growth in companies and economic data.

The VIX, a gauge of investor fear, had an unbelievable year in 2017 when it closed above 15 just 7 times. Expect lower returns given the economic backdrop. Let’s look back over the past 70 years to see how stocks performed each time the unemployment rate was less than 4.5%…

Unemployment Rate One-Year Return
Less than 4.5% 1.3%
All periods 7.6%
Greater than 7% 11.2%


Chris Low’s comments on short-term equity fluctuations (stocks and bonds, and Fed speeches this week):

The short-run future of equities likely depends on the short-run future of bonds. We wrote about rising yields in the Economic Weekly. At this stage, the key is feedback between stocks, bonds and the economy. As weak links break, yields will establish the top of the new range and calm will return. Fed officials, too, will have an opportunity to calm traders. Chairman Powell is to be sworn in today and will likely have something to say. James Bullard will discuss monetary policy tomorrow. Four Fed Presidents, including Dudley, speak on Wednesday. Three more speak Thursday. Hopefully they will be mindful about averting further market chaos.