An unexpectedly strong rally in January and February powered the S&P 500 to its largest quarterly advance since the end of 2015, with the benchmark index rising 6.07% on a total return basis. During the first quarter, large capitalization stocks, represented by the S&P 500, outperformed mid- and small-cap stocks, as the S&P MidCap 400 Index and the S&P 600 Small Cap Index “only” managed to gain 3.94% and 1.06% respectively. The quarter also saw growth stocks substantially outperform value stocks. Given this, it is not surprising that large-cap growth was the best performing style during the quarter, and small-cap value was the worst. On a sector basis, technology turned in the best performance (up over 12%) while energy had the worst performance (down over 6%).
International stocks also enjoyed a strong first quarter. Developed country stocks, represented by the MSCI EAFE Index, gained 7.25% on a total return basis, while emerging market stocks, represented by the MSCI EM Index, rose 11.44%.
While lagging equities, within the U.S., bonds too generated positive quarterly returns, as the Barclays Aggregate Bond Index gained 0.82%. High yield bonds performed particularly well, up over 2% for the quarter.
Q1 Results Explained
The media often refers to the broad stock market rally in the U.S. that began in early November 2016 as the “Trump Rally.” While it is undeniable that the stock market has rallied on prospects for a more business-friendly administration and Congress, it would be a mistake to overlook this rally’s fundamental underpinnings, namely a healthy economy and improving corporate earnings. Indeed, the strong Q1 international stock performance reflects that we are enjoying a synchronized global economic expansion that likely will support higher stock prices going forward.
A good proxy for the health of the U.S. economy is the U.S. labor market, and it is solid, and seemingly improving. As of March 2017, the unemployment rate stood at 4.5%, the lowest level since May 2007 (before the Great Recession began). Average hourly earnings for the private-sector workers rose 2.7% in March on a year-over-year basis, better than the 2% wage gains seen during much of the past several years. In addition to the labor market, the U.S. housing market is strong, and both the manufacturing and services sectors of the economy are expanding. The fact that consumer confidence is at very high levels is no coincidence and certainly helps explain the strong stock performance over the past few months.
The Q1 stock market rally also was fueled by a rebound in 2016 Q4 corporate earnings. According to FactSet, corporate earnings in the fourth quarter grew by 5%, the fastest quarterly growth in over two years. Of course, the stock market looks forward as well, and in that regard, it is important to note that analysts, per FactSet, project earnings for S&P 500 companies to grow by 9% overall in Q1 from a year earlier, with revenue growing by 7%, the fastest pace in five years. We’ll soon know how accurate the analyst forecasts are, but one thing seems clear — 2017 Q1 should see the third consecutive quarter of year-over-year earnings gains after five straight quarterly declines that ended in 2016 Q2. This improvement in corporate earnings, if sustained, likewise should be supportive of future equity gains.
One Final Observation
According to Strategas Research Partners, since 1950 the market tends to experience above-average returns in Q2 and in the remainder of the calendar year following a 5% plus Q1 return. With all the political and geopolitical uncertainty throughout the world, this pattern may be challenged in 2017. In any event, it is something to be aware of.
Mr. McFarland is President and Chief Investment Officer at Pennsylvania Trust.
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