• Michael Obuchowski, Ph.D.

Merlin Asset Management Commentary — December 2017

Updated: May 6

Oh, What a Year.

It would be very difficult to complain about equity market returns for 2017 after US, international developed and developing markets all posted strong returns for the year. At the same time, most observers would agree that it was a very difficult year for investors. Historical patterns suggested the first year of a new president to be quite positive for the markets but somehow everything felt different this time – and wound up not being so different in the end.

The unexpected results of the presidential election put into question many investors’ expectations for 2017. It seemed that only those who lived in New York City in the late 80s and early 90s were not surprised by the apparent confusion and lack of direction of the new White House. Over time, it became clear that the daily noise coming out of Washington was going to dominate the 24/7 news cycle, but that it was not going to have much of a short term direct effect on the US or global economy.

The S&P 500’s 21.83% 2017 total return was the highest return in four years and it was the 9th consecutive positive annual return since the market decline in 2008. At the same time, the 2017 S&P500 return ranked only 9th in the last 30 years, so it would be difficult to call this year an outlier. We believe that despite geopolitical uncertainty both domestically and globally, the US equity markets were influenced by trends related much more closely to global economic trends. The most significant trends were continued synchronized global expansion and acceleration of US earnings growth.

Synchronized Global Growth Continues

After the January 5th employment report from the U.S. Bureau of Labor Statistics and Non-Manufacturing ISM Report On Business from the Institute for Supply Management, the Federal Reserve Banks of Atlanta’s GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2017 was 2.7%, suggesting average GDP growth of 3% over the last three quarters of 2017. The New York Fed Staff Nowcast GDP model saw 4Q GDP at 3.97% and Q1 of 2018 GDP at 3.45%, suggesting the strongest Q1 GDP growth since 2006.

The upward revisions to US economic growth will likely result in increases to expectations for global growth, with all of the G7 economies (except for the UK GDP slowdown thanks to the Brexit debacle) expected to show GDP gains for the fifth consecutive year and all of the OECD countries expected to have positive GDP for the second year in a row.

Needles in a Haystack

As always in the beginning of the quarter, we face the avalanche of earnings reports. Over the last several weeks we’ve had an unprecedented number of upward estimate revisions. Some of the rising estimates are based on the improving economy, others on the expected effects of lower taxes or the effect of

foreign cash repatriation by US companies and resulting stock buybacks or possible reinvestment in accelerating growth. As it frequently happens, the widespread analysts’ optimism might prove to be somewhat too optimistic. Lower taxes alone are not going to miraculously improve poorly managed companies or those with business models challenged by technology or the quickly evolving economic environment and consumer preferences. In addition, all these potential effects will be included in investors’ expectations and are likely to be quite different from companies’ own projections.

In addition, after several quarters of price appreciation in a muted economic growth environment, many companies and equity indices seem fully valued. Despite the overall rich equity index valuations, there are also many attractively valued companies that maintained or even accelerated revenue and earnings growth and found a way to function well in the low growth global economy. Unfortunately, passive index funds and factor (or smart beta) ETFs do not have the ability to select only those companies that can continue to execute well in this rapidly changing environment. I believe that, especially in this environment, individual stock selection focused on identifying the most attractive companies will be a necessary tool for managing equity investments.

Other potential problems for equity markets include a meaningful rise in inflation, US withdrawal from NAFTA or WTO, a trade war with China, change to a more hawkish US Federal Reserve’s monetary policy and as always, any unexpected significant global geopolitical turmoil.

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