The first quarter of 2017 was a good one for equity performance across the board. The S&P 500 was up 6.1%, small cap stocks were up 2.5%, and the technology heavy NASDAQ index was up 9.8%. Foreign stocks performed even better with the MSCI EAFE Index of developed international stocks up 7.3%, and the MSCI Emerging Markets index up 11.5%. Bonds were the laggards by comparison, with the Barclays Aggregate bond index up only 0.8% over the same period.
Despite all the talk of heightened political uncertainty, volatility continues to be unusually restrained in the markets. For the quarter, the VIX Volatility Index experienced its second lowest quarterly average on record, and the Dow Jones Industrial Average experienced its lowest average daily change since 1965. This has been an extended period of exceptionally low volatility.
Towards the end of the quarter we saw a rotation out of sectors expected to benefit from increased fiscal spending, decreased regulation, and reduced corporate taxes. Financials and industrials, for example, lost some of their post election momentum, while more growth oriented sectors like technology that rely more on non-US revenues regained leadership. Apple, the world’s most valuable company with a market cap of $759 billion, was up nearly 25% in the quarter while Goldman Sachs was down -3.8% over the same period.
Over the past few months international stocks from developed countries performed better than US domestic stocks, and emerging markets performed even better still. This could be the beginning stages of a longer-term shift toward more favorable international performance. As you can see in the long-term chart below, domestic and international stocks were somewhat correlated for a very long period of time. In recent years, there has been a significant divergence as investor preference for the perceived safety of domestic stocks has led them to surge ahead while international stocks have lagged.
Source: Fidelity Investments
We think this wide divergence is unlikely to be permanent. Over time, we expect the gap to close as international stocks in both the developed and emerging markets begin to perform relatively better than domestic stocks, and the two markets begin to converge again. Of course, even if our expectations on convergence are correct there is still great uncertainty about timing. Most likely it will be measured in years rather than months, and it will proceed in fits and starts rather than in a straight line. Nevertheless, we believe the current environment presents a potential opportunity in overseas equity markets.
Using Nobel Laureate Robert Shiller’s valuation method, international stocks are 36% below their long-term average value while U.S. stocks are 81% above their long-term average value. This disparity is what’s driving the divergence between domestic and international stock performance. Over time we would expect these markets to move toward their long-term averages. Even a partial “reversion to the mean” could produce a relative tailwind for international stocks and a relative headwind for domestics.
On administrative matters, we have enclosed an explanation of material changes to our ADV Brochure filed in February, and a separate letter which highlights several issues relating to the custody of assets at Schwab. Please let us know if you would like a copy of the full ADV Brochure. Also, please let us know promptly of any significant change in your financial circumstances that would require revisiting your investment objectives or re-evaluating the management of your assets.
We are delighted to announce that Michael Masters has become an equity partner in the firm bringing the total number of partners to seven.
2017 marks the tenth anniversary of our firm! We feel a profound sense of gratitude as we begin to celebrate our first ten years in business. We are very thankful for the wonderful families we have been so fortunate to work with over the past decade. We remain committed to building an organization that will provide enduring value to the families we serve, and the communities in which we live for generations to come. Without you, this would not be possible.
As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm. We are grateful for the opportunity to work with you and your family.
Nicholas Hoffman & Co.