Broker Check

Client Update: 4th Quarter 2016

| February 02, 2017

2016 Client Update

The first quarter of 2016 began with a market swoon as oil dropped below $29.00/barrel and some market pundits hinted at a possible recession.  There was a quick bounce back.  In June, the U. K. Brexit vote caused a brief sell off and then a recovery.  September brought a surprise OPEC agreement to cut oil prices.  November’s election results sparked a strong US equity rally that continued through year end.  Crude oil ended at $53.72.  2016 was a volatile year that ended on an up note for the US stock markets.

Interest rates rose and the result was falling bond prices. The value of the US Dollar increased which hurt international equities.  The 2016 benchmark for developed international equities was 4.5%.  These returns dampened the impact of US equity gains, and moderate balanced portfolios allocated approximately 60% to equities and 40% to fixed income ended up the year with returns in the 7 to 8% range.  Diversification helped investors who worried about the election outcome.  Sticking to a strategy and staying invested paid off.

The rise in equity prices as measured by the Dow Jones Industrials was notable as several new highs were achieved.   It is also noteworthy that just 3 stocks of the 30 in the index account for half of the gains. Goldman Sachs was the big winner at 34% for 2016 and because of its market capitalization (size) it impacted results for the entire index.  The increase in interest rates as measured by the 10 year US Treasury was also remarkable as it shot up from 1.6% in July to 2.6% in December – plus 60%. Shorter duration issues helped manage the risk and market price change in portfolios.

Overall, the US equity market performance was very diverse by asset class.  The benchmark returns for large cap value outperformed large cap growth by a wide margin (14.8% vs 3.2%).  Small cap value outperformed small cap growth by 26% to 11.2%.  Within the overall market, areas like the S&P 500 energy sector were up 24% while healthcare was -4%.  2016 was a classic example of the benefits of diversification that allowed investors to participate in areas that experienced strong price movement.  It also highlighted the benefits of not being over concentrated in an area of the market that under performed.

The market environment made it difficult for even the most seasoned stock pickers to outperform their benchmarks.  If a concentrated portfolio emphasized a particular kind of stock, it likely missed some of the gains from a big winner that skewed the index.

We monitor the important balance and weightings between asset classes. You see this in our quarterly reviews.  We also monitor the management and performance of each of the funds that make up portfolios.  For example, if you own the large cap value holding Vanguard Equity Income, it was up 14.8% for 2016. The Morningstar large cap value benchmark was also 14.8% for 2016.  The widely held large cap growth holding Vanguard Growth Index was up 6.1% vs the Morningstar benchmark of 3.2%. We will let you know right away if any fund that develops a management, performance, or other due diligence issue is subject to a recommendation for its’ replacement. We will contact you if we see stronger investment opportunities or the need to rebalance or raise cash.

There is a long way to go for campaign promises to become realities. Lower taxes, job growth, infrastructure spending, military spending and less regulation are all powerful ingredients in a recipe for earnings growth.  Equities should have a tail wind for 2017 even if only some of these ideas come to fruition. 

Higher inflation and higher interest rates are likely, but keep in mind that these are actually signs of a healthier economy.  Higher mortgage rates will be headwinds to housing but interest rates are still low, and the Federal Reserve will be limited by the impact of the effect of higher rates on US debt service.

Placing America’s interests first will likely cause some friction abroad, but it has thus far resulted in higher consumer confidence and business confidence at home. Canada and Mexico have indicated willingness to update NAFTA.  President Trump’s populist movement may also have encouraged other countries in Europe to follow Great Britain’s lead.  Confidence is crucial for investors.  You may remember that Yogi Berra asserted that “baseball was 90% mental, the other half is physical”.  Yogi also said, “You can observe a lot just by watching”.  Watching the next few quarters of 2017 unfold may see the same kind of market swings and surprises as we witnessed in 2016.

Volatility is also likely because investor expectations are high and stock valuations are high.  The median price to earnings ratio for the S&P 500 is higher now than 89% of historical periods.  For the fourth quarter, the price earnings ratio was 18.7 to 1. Key fundamentals like sales and corporate earnings need time to catch up.  The belief in the implementation of pro-growth policies and a successful transition has 2017 off to a good start, but it will be many months before any tangible results are realized.  We are also mindful that it has been a long time without a significant market pull back and that a surprise event may temporarily derail progress.  We remain cautiously optimistic and expect the economic growth rate and corporate earnings to improve in the quarters ahead.

Comments about the fully valued stock market need to be tempered by the fact that we are now seeing growth pick up and that the alternatives to stocks offer a poor set of opportunities.  The need to outpace inflation is a reality that long term investors cannot ignore.

We look forward to a productive, happy and healthy 2017 for you and your family.

Michael Devine, MSFS, AIF ®/ Becca Cummings, CPA, AIF® / Eric Bleiler, CPA/PFS CFP®