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Roof Advisory Group: Market View

Solid Results, But Areas of Concern Remain
Market Update

Second quarter market results looked similar to the outcome in the first quarter. Stocks and bonds both posted positive returns. International and global equities again outpaced the U.S. stock market. Also, similar to the first quarter, stocks posted these impressive returns against the backdrop of an almost unprecedentedly low volatility environment. In fact, the S&P 500 Index recorded only one daily decline of greater than 1% in the entire second quarter.

Bonds also turned in respectable performance results in the second quarter. Fixed income performance was aided by a decline in interest rates. Despite two interest rate hikes by the Federal Reserve this year, bonds have performed relatively well for the first six months of 2017. The Barclays U.S. Aggregate Index has posted a 2.4% return through the first six months of the year.

Below is a summary of the second quarter performance results for the major indices we generally review in each quarterly MarketView:

Asset Class Index Q2 Return
U.S. Stocks S&P 500 Index 2.6%
International Stocks MSCI EAFE Index 5.0%
Global Stocks MSCI ACWI Index 4.2%
Bonds Barclays U.S. Aggregate Bond Index 1.4%

Economic Update

Second quarter economic data could best be described as mixed. First on the list of bright spots is strong corporate earnings growth. First quarter corporate earnings grew at an impressive 14% which represents the best growth rate in more than five years. Solid earnings growth is expected for the remainder of 2017 as well. Also, current forecasts for second quarter GDP growth of roughly 3% reflects a measurable improvement over the first quarter’s 1.4% GDP growth rate. Another notable positive is that confidence levels among consumers, small business owners, and corporate executives are hovering around 15-year highs.

Despite the recent tranquil equity market conditions, sky-high confidence levels and a general improvement in economic conditions, weak spots and areas of concern remain. At the top of the list of concerns is the recent disappointing consumer spending data. Given the list of economic positives, consumer spending should be higher. In addition, job growth moderated this quarter. However, given the backdrop of a very low 4.3% unemployment rate and tighter labor market conditions, we view this moderation as more of a natural progression than a harbinger of an economic downturn.

Portfolio Positioning

We maintained a mid-point equity allocation during the second quarter. While we made no changes to the amount of our stock exposure, we did make some shifts to the composition of our stock holdings. We trimmed back a few of our technology and health care stocks which have posted year-to-date returns far greater than the broad equity market as well as their respective sectors. While we still maintain a positive view on these specific stocks, we felt it was a prudent move to lock in some gains and reallocate the proceeds to some other areas. We increased our allocation to international (mainly European) equities where valuations are cheaper than domestic stocks and in our view, there is more room for economic improvement compared to the U.S. We also increased our allocation to growth oriented equities which are being rewarded by investors for their superior earnings growth results.

Within our fixed income allocations, we made several tweaks aimed at reducing our sensitivity to changes in interest rates while keeping our yields or income levels constant. This resulted in reducing exposure to intermediate maturity bonds in favor of short maturity bonds and modifying the composition of our Preferred Stock exposure in order to reduce interest rate risk.

Performance Attribution

Second quarter performance results were solid and well above expectations given our level of risk exposure. We are pleased with the performance momentum and impressive results we have acheived over the past twelve months. Similar to the previous quarter there were numerous positive contributors to quarterly returns. Equity performance was aided by meaningful allocations to the financial, technology, and health care sectors. Exposures to growth oriented stocks and international equities were also beneficial as those asset classes outperformed the broader S&P 500 Index by a wide margin. Fixed income performance was again a significant contributor to overall portfolio returns. Most of our fixed income strategies outperformed the broad bond market with several of our holdings posting quarterly results in excess of stock market returns.

There were only a few notable detractors this quarter. Large-cap value stocks extended their recent run of underperformance with energy stocks posting measurable declines due to the drop in oil prices. However, our security selection decisions in these areas helped to mitigate the overall impacts to portfolio level results.

Closing Thoughts

We thought we would mix it up a bit and end this quarter’s MarketView with some charts that represent some of our reasons for optimism and also some areas of concerns.

Corporate Earnings Growth

Many investors have focused on how or if the new administration’s agenda has impacted the performance of the stock market. However, more importantly corporate earnings growth has turned decisively positive after numerous quarters of declines. And forecasts for future results look healthy as well. This has certainly been a major contributor to the equity market rally and a factor that fits firmly in the reasons for optimism category.

S&P Earnings Growth

S&P Earnings Growth

Historical Equity Market Volatility Review

This is a long-term chart of the “VIX” Index which is a proxy for the volatility of the S&P 500 Index. This index is commonly referred to as the “fear gauge”. Elevated levels represent market uncertainty and significant spikes correspond with periods of investor panic. It is certainly interesting to note how low the fear gauge is currently relative to historical averages. Which begs the question of is volatility more likely to move higher or lower from current levels?

Historical Equity Market Volatility Review

Bifurcated Year-to-Date Equity Returns

Year-to-date equity market returns have been strong, but very bifurcated. Growth stocks (especially the technology, health care and consumer discretionary sectors) have really been the drivers of returns. While Value stocks (especially the energy, telecommunications and financial sectors) have been laggards. These return dispersions do translate into a more optimal environment for active managers.

Bifurcated Year-to-Date Equity Returns

Impact of Interest Rate Increases

The Federal Reserve started the process of normalizing (hiking) interest rates on December 17, 2015 and have increased interest rates a total of four times since then. What has been the impact on the bond market? Not much….

Below is a chart of the yield offered by a U.S. Treasury bond with a 10-year maturity. The chart starts the day before the Federal Reserve initiated their first interest rate hike and shows a yield of 2.3%. At the end of the most recent quarter, the yield was basically unchanged at 2.31%. Point being there are many additional factors other than Federal Reserve decisions that influence interest rates and bond markets returns.

Impact of Interest Rate Increases

Disappointing Retail Sales

We mentioned the recent disappointing retail sales figures. Below is a 5-year chart of the year-over-year change in U.S. Retail Sales. Current levels are not necessarily depressed compared to averages. But we have experienced a noticeable decline from the levels at the end of 2016. Given the improvement in job growth, wage growth, and consumer confidence levels we would expect better results.

Disappointing Retail Sales


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