Another year goes by, and it’s time for another Market
Review. This guest post by Dimensional Fund Advisors' Bryan Harris reviews how
global stock markets went against the predictions in 2017 and how difficult it
is to guess which countries or asset class will do best in
any given year. Ultimately, there is great wisdom in diversifying your
investments broadly across countries and types of assets and remaining disciplined
for the long term.
 |
Bryan Harris
Dimensional Fund Advisors |
At the beginning of 2017, a common view among money managers
and analysts was that the financial markets would not repeat their strong
returns from 2016. Many cited the uncertain global, economy, political turmoil
in the US, implementation of Brexit, conflicts in the Middle East, North
Korea’s weapons buildup, and other factors. The global equity markets defied
their predictions, with major equity indices in the US, developed ex-US, and
emerging markets posting strong returns for the year.
The broad global advance underscores the importance of
following an investment approach based on diversification and discipline rather
than prediction and timing. Attempting to predict markets requires investors
to not only accurately forecast future events, but also predict how
markets will react to those events. The 2017 markets were a good reminder that
there is little evidence suggesting either of these objectives can be
accomplished on a consistent basis.
Instead of attempting to make predictions about future
events, investors should appreciate that today’s price reflects the
expectations of market participants and information about future expected
returns. The following quote by the late Merton Miller, Nobel laureate,
describes this view:
“Everybody has some information. The function of the markets
is to aggregate that information, evaluate it, and get it incorporated into
prices.” —Merton Miller
The chart above highlights some of the year’s prominent
headlines in the context of global stock market performance as measured by the
MSCI All Country World Index-Investable Market Index (MSCI ACWI IMI). These
headlines are not offered to explain market returns. Instead, they serve as a
reminder that investors should view daily events from a long-term perspective
and avoid making investment decisions based solely on the news.
World Economy
In 2017, the global economy showed signs of stronger growth,
with 45 countries tracked by the Organization for Economic Cooperation and
Development (OECD) all on pace to expand.
1 Economic outlook and the
expected impact on future cash flows are among the many variables markets
consider when setting prices. Therefore, investors should remember that growth
in the economy is not always linked to stock market performance.
2017 Market Perspective
Equity Market
Highlights
Global equity markets posted another positive year of
returns in 2017. The S&P 500 Index recorded a 21.83% total return and small
cap stocks, as measured by the Russell 2000 Index, returned 14.65%, both above
their long-term average return of 11.96% and 11.73%, respectively, since 1979.
Returns among non-US equity markets were even higher. The
MSCI World ex USA Index, which reflects non-US developed markets, logged a
24.21% return and the MSCI Emerging Markets Index a 37.28% return2, making this
the fifth highest return in the index history.
As the S&P 500 and other indices reached all-time highs
during the year, a common media question was whether markets were poised for a
downturn. History tells us that a market index being at an all-time high
generally does not provide actionable information for investors.
For evidence, we can look at the S&P 500 Index for the better part of the
last century. From 1926 through 2017, the frequency of positive 12-month
returns following a new index high was similar to what is observed following
months of any level. In fact, over this time period, almost a third of the
monthly observations were new closing highs for the index. The data shows that
new index highs have historically not been useful predictors of future returns.3
Global Diversification Impact
Developed ex US markets and emerging markets generally
outperformed US equities. As a result, a market cap-weighted global equity
portfolio would have outperformed a US equity portfolio.
The S&P 500 Index’s 21.83% return marked its best
calendar year since 2013 and placed 2017 in the top third of best performing
calendar years in the index’s history. Despite these returns, the US ranked in
the bottom half of countries for the year, placing 35th out of the 47 countries
in the MSCI All Country World Index (IMI).
Delving into individual countries, country level returns
were mostly positive. Using the MSCI All Country World Index (IMI) as a proxy,
45 out of the 47 countries posted positive returns. Country level returns were
dispersed even among those with positive returns. In developed markets, returns
ranged from +10.36% in Israel to +51.39% in Austria. In emerging markets,
returns ranged from –24.75% in Pakistan to +53.56% in Poland—a spread of almost
80%. Without a reliable way to predict which country will deliver the highest
returns, this large dispersion in returns between the best and worst performing
countries again emphasizes the importance of maintaining a diversified approach
when investing globally.
China provides an example highlighting the noise in
year-to-year single country returns. After a flat-to-negative return (USD) in
2016, Chinese equities returned more than 50% (USD) in 2017, making China one
of the best performing countries for the year.
Currencies
Most major currencies including the euro, the Australian
dollar, and the British pound appreciated against the US dollar. The
strengthening of non-US currencies had a positive impact on returns for US
investors with holdings in unhedged non-US assets. This may surprise some
investors given that the US dollar has strengthened against many currencies
over the past five- and 10-year periods.
However, just as with individual country returns, there is
no reliable way to predict currency movements. Investors should be cautious
about trying to time currencies based on the recent good or bad performance of
the US dollar or any other currency.
Premium Performance
In 2017, the small cap premium4 was generally
positive in developed ex US markets and negative across US and emerging
markets. The profitability premium5 was positive across US, developed
ex US, and emerging markets, while the value premium6 was negative across those
markets.
US Market
In the US, small cap stocks under-performed large cap stocks
and value stocks under-performed growth stocks. On a positive note, high
profitability stocks outperformed low profitability stocks as measured market
wide.
Although US small cap stocks, as described by the Russell
2000 Index, provided a healthy 14.65% return in 2017, the US small cap premium
(as measured by the Russell 2000 Index minus the Russell 1000 Index) was
negative, ranking in the lowest third of annual return differences since 1979.
However, over the 10-year period ending December 31, the small cap premium was
positive.
US value stocks returned 13.19% in 2017, as measured by the
Russell 3000 Value Index. While double-digit returns from value are appealing,
US growth stocks performed even better, with a 29.59% return as represented by
Russell 3000 Growth Index. The difference between value and growth
returns, as measured by the Russell 3000 Value Index minus Russell 3000 Growth
Index, made 2017 the fourth lowest year for value since 1979 and pulled the five-year
rolling premium return into negative territory.
Even over extended periods, under-performance of the
value premium or any other premium is within expectation and not unusual. Over
a 10-year period ending in March 2000, value stocks under-performed growth
stocks by 5.61% per year, as measured by the Russell 1000 Value and Russell
1000 Growth indices.
This underperformance quickly reversed course and by
the end of February 2001, value stocks had outperformed growth stocks over the
previous one-, three-, five-, 10-, and 20-year periods. Premiums can be
difficult if not impossible to predict and relative performance can change
quickly, reinforcing the need for discipline in pursuing these sources of
higher expected returns.
The profitability premium was positive in 2017, with US high
profitability stocks outperforming low profitability stocks. Viewing
profitability through the lens of the other premiums, high profitability stocks
outperformed low among value stocks while underperforming among growth stocks.
The complementary behavior of premiums in 2017 is
a good example of the benefits of integrating multiple premiums in an
investment strategy, which can increase the reliability of out-performance and
mitigate the impact of an individual premium under-performing, as was
the case with value among US stocks in 2017.
Developed ex US Markets
In developed ex US
markets, small cap stocks outperformed large cap stocks while value stocks
under-performed growth stocks. High profitability stocks outperformed low
profitability stocks.
Over both five- and 10-year rolling periods, the small cap
premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World
ex USA Index, continued to be positive.
Similar to the US equity market, value stocks posted a
healthy 21.04% return for 2017 as measured using MSCI World ex USA Value Index.
However, growth stocks performed even better with a 27.61% return,
as measured by the MSCI World ex USA Growth Index.
The profitability premium was positive in developed ex US
markets viewed market wide. Looking within size and style segments of the
market, high profitability outperformed low profitability in all but the large
growth segment.
Emerging Markets
In emerging markets, small cap stocks under-performed large
cap stocks and value stocks under-performed growth stocks. Similar to the US
equity market, high profitability stocks outperformed those with low
profitability.
Value stocks returned 28.07% as measured by the MSCI
Emerging Markets Value Index, but growth stocks fared better returning 46.80%
using the MSCI Emerging Markets Growth Index. The value premium, measured as
MSCI Emerging Markets Value Index minus MSCI Emerging Markets Growth Index, was
the lowest since 1999.
Though 2017 generally marked a positive year for absolute
equity returns, it marked a change in premium performance from 2016 when the
size and value premiums were generally positive across global markets. Taking a
longer-term perspective, these premiums remain persistent over decades and
around the globe despite recent years’ headwinds. It is well documented that
stocks with higher expected return potential, such as small cap and value
stocks, do not realize these returns every year. Maintaining discipline to
these parts of the market is the key to effectively pursuing the long-term
returns associated with the size, value, and profitability premiums.
Fixed Income
Both US and non-US fixed income markets posted positive
returns in 2017. The Bloomberg Barclays US Aggregate Bond Index gained 3.54%.
The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained
3.04%.
Yield curves were upwardly sloped in many developed markets
for the year, indicating positive expected term premiums. Realized term
premiums were indeed positive both globally and in the US as long-term
maturities outperformed their shorter-term counterparts.
Credit spreads7, which are the difference between
yields on lower quality and higher quality fixed income securities, were
relatively narrow during the year, indicating smaller expected credit premiums.
Realized credit premiums were positive both globally and in the US, as
lower-quality investment-grade corporates outperformed their higher-quality
investment-grade counterparts. Corporate bonds were the best performing sector,
returning 6.42% in the US and 5.70% globally, as reflected in the Bloomberg
Barclays Global Aggregate Bond Index (hedged to USD).
In the US, the yield curve flattened as interest rates
increased on the short end and decreased on the long end of the curve. The
yield on the 3-month US Treasury bill increased 0.88% to end the year at 1.39%.
The yield on the 2-year US Treasury note increased 0.69% to 1.89%. The yield on
the 10-year US Treasury note decreased 0.05% for the year to end at 2.40%. The
yield on the 30-year US Treasury bond decreased 0.32% to end the year at
2.74%.
In other major markets, interest rates increased in Germany
while they were relatively unchanged in the United Kingdom and Japan.
Yields on Japanese and German government bonds with maturities as long
as eight years finished the year in negative territory.
CONCLUSION
The year of 2017 included numerous examples of the
difficulty of predicting the performance of markets, the importance of
diversification, and the need to maintain discipline if investors want to
effectively pursue the long-term returns the capital markets offer. The
following quote by David Booth provides useful perspective as investors head
into 2018:
“The key is to have the correct view of markets and
how they work. Once you accept this view of markets, the benefits go way
beyond just investing money.”
—David Booth
The small cap premium
is the return difference between small capitalization stocks and large
capitalization stocks.
The value premium is
the return difference between stocks with low relative prices (value) and
stocks with high relative prices (growth).
Bloomberg Barclays Global Aggregate Corporate Option Adjusted Spread.
Source: Dimensional Fund Advisors LP.
Sources:
Frank Russell Company is the source and owner of the
trademarks, service marks, and copyrights related to the Russell Indexes. S&P
and Dow Jones data © 2018 S&P Dow Jones Indices LLC, a division of S&P
Global. All rights reserved. MSCI data © MSCI 2018,
all rights reserved. ICE BofAML index data © 2018 ICE
Data Indices, LLC. Bloomberg Barclays data provided by Bloomberg. Indices are
not available for direct investment; their performance does not reflect the
expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results.
This information is provided for educational purposes only and should not be
considered investment advice or a solicitation to buy or sell securities. There
is no guarantee an investing strategy will be successful. Diversification does
not eliminate the risk of market loss.
Investing risks include loss of principal and
fluctuating value. Small cap securities are subject to greater volatility than
those in other asset categories. International investing involves special risks
such as currency fluctuation and political instability. Investing in emerging
markets may accentuate these risks. Sector-specific investments can also
increase these risks.
Fixed income securities are subject to increased
loss of principal during periods of rising interest rates. Fixed income
investments are subject to various other risks, including changes in credit
quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest
rates, cash flow of underlying real estate assets, supply and demand, and the
management skill and creditworthiness of the issuer.
Dimensional Fund Advisors LP is an investment advisor
registered with the Securities and Exchange Commission.
