Many investors were raging bulls at the beginning of 2018, as equity prices vaulted higher. But that optimism faded dramatically as the news flow turned less favorable. Thus far in 2018, what is clear is certain assumptions and patterns that governed markets in recent years have shifted. Equity volatility, which was remarkably low in 2017, has returned, perhaps due to greater uncertainty about inflation, the economy and geopolitics. Rising interest rates mean the yield on 1-Year Treasuries (2.4 percent) is higher than the dividend yield on the S&P 500 Index (1.8 percent) for the first time in years, creating some competition for the stock market (different asset classes react differently to significant changes in interest rates).

While virtually every major asset class made money in 2017, this year U.S. stocks are one of the few investments with a positive return, gaining 6.3 percent as of Aug. 1, as measured by the S&P 500 Index’s total return. In fact, a mixed environment such as this year’s is more normal than 2017 was for capital markets.

Strong fiscal stimulus — sharp tax cuts and spending increases — in the ninth year of an economic expansion is almost unheard of, but it seems to be having a quick effect: Economic growth reached 4 percent in the second quarter, the economy continues to create about 200,000 jobs a month, business investment is firm, and consumer spending is solid. Underpinning the market is robust corporate earnings growth, juiced by large tax cuts and an increase in share buybacks. Of course, as long as public equity markets have existed, there have been cash distributions to shareholders in one form or another, such as through dividends and stock buybacks; this year’s flurry of corporate activity tied to dramatic tax cuts is not a new phenomenon that should cause investors to doubt decades of evidence on security fundamentals, such as the relationship between price-to-book and future returns.

In the first quarter, earnings per share for S&P 500 companies surged 27 percent from the year prior and are projected to have risen by more than 20 percent during the second quarter. Labor markets are so tight — though not all jobs created are of high quality — worker shortages are cropping up in industries such as trucking; at some point, presumably, employers will be forced to share more of company profits with workers in the form of higher salaries. With a backdrop of higher wages and import tariffs, rising energy prices, and some producer capacity constraints, inflation is now ticking up — the U.S. Consumer Price Index, for example, reached 2.9 percent in June 2018, up from 2.1 percent in 2017. In short, it is a positive market underpinned by broadly good economic news, but it is also a mature bull market with downside risk and plenty of potential for volatility; thus, a healthy dose of caution seems in order.

No one knows when the market cycle will end, but we should note U.S. market valuations (S&P 500) are, by several yardsticks, high by historical standards, which implies lower expected returns ahead. As an example, for 10-year market returns by valuation quintile from January 1926 to December 2017, when measured forward, the priciest 20 percent (which would include today’s market) averaged only a 4.3 percent annualized return during the following decade, compared with 15.4 percent for the lowest 20 percent valuation and 9.9 percent for the middle quintile. Valuations can be regarded as more of a market guide than a predictor.

Foreign markets have performed less well, and international equity valuations remain attractive on a historical and relative basis. The average price-to-book ratio of 3.4 for S&P 500 stocks, for example, is twice as high as for stocks in both developed and emerging markets. A global focus is an important portfolio approach for investors who seek to diversify their long-term risks. Indeed, we do not neglect stocks of small U.S. and international companies. Year-to-date, U.S. small caps have returned 9.5 percent, the best performance of any major asset class. (See table for a comparison of returns by asset class in 2018 versus the two prior years.)

MESSAGE FROM THE BOND MARKET

Rising interest rates have reminded investors they can also lose money in bonds, the “safe” part of portfolios. As measured by the Bloomberg Barclays Aggregate Bond Index, the asset class lost 1.8 percent year-to-date to Aug. 1. In the wake of the global financial crisis of 2008, easy monetary policy pursued by the Federal Reserve Board (and the central banks of nearly every developed country) provided additional support for asset prices and contributed to higher debt levels. But now, the Fed’s monetary policy has shifted from one of quantitative easing to quantitative tightening. With inflation and unemployment near their targets, the Fed has raised interest rates twice already in 2018 and indicates it plans two more rate hikes this year, and more in 2019. The central bank is also steadily paring the size of its bulging $4 trillion balance sheet; the great unwind will accelerate from $30 billion a month in second quarter 2018 to $50 billion monthly (the equivalent of General Motors Co.’s market capitalization) in the fourth quarter.

I should note the Fed’s tightening coincides with a dramatic increase in borrowing by the federal government, due to a swelling budget deficit (despite sturdy economic growth) stemming from the late-cycle stimulus of tax cuts and federal spending increases. In April 2018, the Congressional Budget Office raised its estimate for the 2018 budget deficit by $250 billion, to $800 billion, and now projects a trillion-dollar deficit in 2019. While I do not forecast interest rates, clearly the confluence of an acceleration in borrowing (i.e., bond issuance) by the Department of Treasury and the Fed’s balance-sheet shrinkage program (which reduces demand for Treasuries) will create pressure at Treasury auctions that could lead to higher rates down the road.

Gregg Fisher is the founder, head of research and portfolio strategy at Gerstein Fisher, and portfolio manager for Gerstein Fisher Funds. This article was originally published on the Fisher Gerstein website and can be accessed at this link: https://bit.ly/2NRrDJl