The S&P 500 generated a 3.8% total return in the fourth quarter, fuelled by solid U.S. economic growth, a rebound in corporate earnings, and investors’ optimism following Donald Trump’s election. Small- and mid-cap stocks fared even better, with the Russell 2500 delivering a 6.1% total return last quarter. Meanwhile, a strong U.S. dollar weighed on foreign stocks, resulting in a negative 1.2% total return for the MSCI All Country World Index Ex-U.S.
The U.S. economy picked up steam in the second half of the year. The Bureau of Economic analysis reported that U.S. real gross domestic product increased at an annual rate of 3.5% in the third quarter. This represented the strongest quarterly pace of growth in two years.
Buoyed by this pickup in economic growth, the “earnings recession” also finally came to an end. According to FactSet, earnings for companies in the S&P 500 grew 3.1% in the third quarter, ending the streak of five consecutive quarters of year-over-year declines in earnings.
Furthermore, analysts are projecting earnings to continue to grow in the fourth quarter and meaningfully accelerate in 2017. The analysts’ bullish outlook reflects a consensus view that the new Trump administration will usher in more business-friendly policies, including lower taxes, regulatory reform, and fiscal stimulus.
While the U.S. market is giddy again, we’d encourage investors not to get too carried away. In our view, the market’s valuation is rather full, if not rich. There are still significant risks to consider as well. Trump’s policies may not stimulate as much growth as many investors assume. Inflation may rear its ugly head, perhaps forcing the Federal Reserve to raise interest rates more aggressively. Geopolitical tensions, terrorism, or other wild cards could also spook the U.S. market.
So, we’d recommend keeping a level head and steady hand, avoiding herd-like mentality on both the market upswings and downswings and sticking to your long-term investment plan.
Thinking Beyond 2017, Staying Focused on the Long Run
The start of a new year is a natural time to learn from the prior year and make positive changes in our lives. Our objection is the speculative nature of trying to predict what stocks will do over the next 365 days. Over short periods like this, the market’s fickle opinion can have more influence on share prices than the underlying fundamentals of the business do. Share prices and fundamentals can even move in opposite directions for a period, which makes forecasting over shorter horizons quite challenging, if not maddening.
But as noted by legendary investor Benjamin Graham, in the long run, the market is a weighing machine. Ultimately, a stock price should reflect its intrinsic value, based on its long-term fundamentals. The rub is that this requires considerable patience, not to mention the ability to stomach inevitable short-term bouts of underperformance.
As long-term investors, we simply do not view stocks as wiggly lines on a chart or treat them like trading cards. Rather, we think like owners of a business. When we buy a stock, we are buying a stake in a business whose value will be determined by its long-term earnings and cash-generating power. We are prepared to hold a stock for many years into the future, as long as the intrinsic value of the underlying business exceeds its share price.
