2017 turned out to be a much better year for investors than many, including myself had predicted. Last year, I commented that the biggest threat to the markets was valuation, with the S&P 500 trading at 21.3 times earnings, and 17.6 times forward earnings, noting the ten-year average was more in the 14 range. I even went so far as to say “…lofty equity returns appear unlikely at current levels, meaning more subdued returns can be expected on a go forward basis.”
Turns out I was wrong. The S&P 500 gained nearly 22% in U.S. dollar terms, MSCI EAFE Index was higher by 25.6%, and the S&P/TSX Composite Index gained more than 9%. Canadian bond investors also saw gains, with the FTSE/TMX Universe Bond Index gaining 2.5% in a year where the Bank of Canada raised its key overnight lending rate twice.
Our Model Portfolios were all in positive territory over the year, with the Conservative Portfolio gaining 1.5%. the Balanced Portfolio rising 4.0%, and the Growth Portfolio increasing by 10.1%. For a detailed review of the portfolios’ performance and risk reward metrics, you can download our standard monthly portfolio report here. Additional detail can be found in these reports generated by Morningstar. A summary report can be downloaded here, while the more detailed report can be downloaded here.
While markets rallied higher throughout the year, the rally wasn’t as well balanced as the headline numbers would have you believe. The first half of the year was largely dominated by higher beta, growth names like the FANG stocks (Facebook, Amazon, Netflix, and Google) while the more quality, value names lagged. In the final quarter of the year, we saw a bit of a rotation into the more value focused names as markets started to again focus on fundamentals.
As noted above, our portfolios were all in positive territory, however, their defensive positioning was a headwind, as all lagged their respective benchmarks. The Fidelity Canadian Large Cap Fund, and the Mackenzie Ivy Foreign Equity Fund accounted for the lion’s share of the underperformance. In both cases, the quality and value focus of the portfolio lagged substantially in the earlier part of the year, while high cash balances were a headwind in the latter part. With both funds, I believe in the stock selection process used by the managers. However, their propensity to hold significant cash can be a benefit in periods of market volatility, it can also be a hindrance in periods of relative calm.
Looking ahead at 2018, there is no reason to believe it will be substantially different than 2017. Economic growth around the world is in sync and moving largely higher, and inflation remains in check. This provides a decent foundation for equity market resilience. In the U.S., tax reform may provide further earnings support, although there is some debate around whether this has been built into current stock prices now. Still, other economies are much earlier in their business cycle, namely Europe and Asia, providing better potential growth opportunities.
The outlook is strong, but not without risks. Interest rates in the U.S. and Canada are expected to move higher, which will hurt bond investors in the short-term, and may hurt profitability for some highly levered companies. Other risks include fallout from increasingly tighter trade, including the dissolution of trade agreements like NAFTA. This could hurt Canadian companies particularly hard.
Valuations remain near their historical highs, which could see some sharp moves downward, if earnings or growth rates begin to miss expectations. A final worry is many investors have started to forget about the risks of investing, and are looking at investments that are considerably riskier than they appear. Cannabis and cryptocurrencies are just two examples that seem to dominate many of my recent conversations with investors and advisors.
So how do we position for 2018? The first thing I would recommend would be to take a good hard look at your risk tolerance. How comfortable are you with a potential drop in the value of your portfolio? For example, in 2008, our Growth Portfolio was down 24.5%, Balanced was down 15%, and Conservative was down 4.6%. Put those percentages into dollar values and see if you’re comfortable with it. If not, you’ll need to make some changes to reposition your portfolios.
The second thing I would suggest is to not do anything rash. Find your comfort level, and build an asset mix that is in line with that comfort level. There is a very low likelihood of success in trying to outguess the markets, but by being invested in a portfolio that is aligned with your investment objectives and risk tolerance, your probability of succeeding over the long-term is increased substantially. As the old saying goes, it’s all about time in the market, rather than timing the market.