December 8, 2017 – The end of the year is a good time for reflection (once the shopping is done and holiday travel plans have been solidified). As we think back on what this year has meant for financial markets, we can’t help but think that 2017 will be documented—in our memories but also the record books—for the extraordinary market run and lack of volatility. U.S. large cap stocks are up +20% (total return) through the first week in December, and non-U.S. stocks are up 24% in U.S. dollar terms. But beyond this strong performance, consider the following:

  • November was the 13th month in a row that the S&P 500 total return index delivered a positive return. This is the longest stretch of positive performance for the index in the 90 years for which we have data[1].
  • If December ends on a positive note (which 75% of the time it tends to do, thanks to seasonality and “Santa Claus rallies” that often occur into the end of the year), this would be the first calendar year ever in which we have witnessed a positive total return for the S&P 500 in each month.
  • The average level of the Chicago Board Options Exchange Volatility Index (CBOE VIX Index, measuring volatility that is expected or implied by options contracts in the market) was 11 this year, versus an average since 2000 of 20. It breached 16 only once.
  • Realized volatility for calendar year 2017 was lower in only one year during the past 60.

Implied volatility of the S&P 500 (VIX)

 VIX.png

Source: Bloomberg

Data through November 30, 2017

With this context, we observe two conflicting behavioral responses nagging at investors. First is a fear of missing out. After such a strong year, it’s tempting to jump all in, particularly for more cautious investors who may have been underweight risk or holding cash on the sidelines waiting for more attractive valuations. At the same time, a perfectly rational investor may look at the statistics above and conclude that a near-term pullback in equity markets is inevitable; thereby suggesting one should consider reducing risk in anticipation of a correction.

Who is right? Both. And neither. Allow us to explain. The market has shown incredible momentum, which we view as a result of solid earnings growth, robust economic fundamentals, and global central banks that remain accommodative; anticipation of fiscal stimulus and higher corporate profitability are also contributing factors. All of this suggests the equity market strength can continue despite the current run, and investors could end up sitting out equity returns in excess of what may end up being a modest correction.

At the same time, this year was exceptional for its lack of volatility and “straight up” trajectory. We firmly believe this will not continue, especially given higher-than-average equity valuations. Typically, equity markets experience at least one 5-10% pullback during the year. This year the S&P 500 index has seen a maximum drawdown (the biggest drop from peak to trough for the year) of just -2.6%. The only year since 1980 with a similar lack of negative return was 1995. Market corrections are a normal and even healthy part of investing. We would expect some sort of correction over the next 12 months, but this does not scare us and is not motivating us to reduce our equity overweight. History shows us that, more often than not, it is wise to ride out any minor bumps in the road. After all, the average pullback in years where the S&P 500 ended in positive territory was -11%. For investors with the proper mix of risky and defensive assets for their personal situation and a long-term time horizon, sitting on cash or reacting to a pullback by selling into weakness is the worst thing that can be done for long-term growth of a portfolio. This is particularly true if data suggests the economy will continue growing over the next six to twelve months, as we believe is the case today.

Core narrative

Our asset allocation framework is centered on economic fundamentals and analysis of market signals from both a historical and forward-looking basis. This tested and repeatable process gives us confidence to position client portfolios for outperformance over a multi-year market cycle. Despite the risk of a short-term market pullback, we continue to recommend an overweight allocation to equities and underweight to high-quality fixed income, versus our strategic benchmark. In the face of ever-present market uncertainty, we monitor an array of data to anticipate and position ahead of a more sustained equity drawdown—one that is usually accompanied by an economic contraction.

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[1] According to Deutsche Bank.