In the end, what can be said about 2016? Unpredictable, perplexing and stunning come to mind. By any reasonable standard, the events of the past year were certainly unexpected, at least politically. At the beginning of 2016, it was not possible to envision a scenario where the UK would vote to leave the European Union and the U.S. would elect Donald Trump as the 45th president. Still, both happened and in hindsight, there were global signals that a populist uprising was at hand.
Even more confounding is that had we known the outcomes of these events beforehand, we would have still struggled to predict direction of the financial markets. A thoughtful investor with early knowledge would most likely have sold stocks and invested in bonds and gold, and they would have been utterly wrong.
The markets in 2016 also endured fears of a China meltdown, the escalation of negative interest rates globally, and the collapse and subsequent rebound in commodity prices, as well as ongoing terrorism and an unprecedented humanitarian crisis centered in Syria.
2016 was the year of “post-truth,” a term Oxford Dictionaries declared as the international word of the year. Post-truth “relates to or denotes circumstances in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief.” Oxford editors estimate use of the term increased by 2,000% in 2016.
Before and After
After losing 5.0% in January, one of the worst starts on record, the S&P 500 stock index finished the year with 12.0% gains, including dividends. So much for the idea that as January goes, so goes the year. The presidential election also gave the markets a distinct before and after feel, as illustrated below.
Five percentage points, or 42% of the year’s total return, came after the presidential election. The influx of post-election funds into stocks reflects expectations for faster U.S. growth and higher inflation in the wake of Trump’s election victory. The accompanying rise in interest rates – long-term Treasury bonds lost 7.4% post-election – also drove up the value of the U.S. dollar, hurting both foreign shares and U.S. companies with larger foreign revenues. Small-cap U.S. stocks, seen as more closely linked to the domestic economy, surged, driving the Russell 2000 index up 13.9% since the election and a market leading 21.3% for the year.
By contrast, the MSCI EAFE index gained just 1.5% with dividends, or 10.5% less than its U.S. counterpoint, the S&P 500. An index of 75% in the total U.S. stock market and 25% in foreign stocks, representing the optimal mix for U.S. investors since 1970, gained 9.5%.* The continued underperformance of non-U.S. equities again begs the question of whether investors should continue to own foreign stocks at all.
The historical data and evidence in favor of broad diversification is still valid. However, there are times when diversification hinders performance, and 2016 was another one of those times. Hindsight will always be 20/20 regarding performance. Investors who overreacted to foreign stocks after they significantly outperformed U.S. stocks from 1990-2009 were sorely disappointed. Diversification works best when executed in the context of a disciplined long-term plan.
We are tempering our foreign allocation but staying invested. Over the last few years, our foreign stock position has declined through a combination of deliberate sales and market action. After their relative under-performance last year, we stand at approximately 18% in foreign shares in our broadly diversified stock accounts. We continue to evaluate opportunities to gradually move back toward longer-term targets. Our goal is not perfect timing but an appropriate balance of return and risk management.
The make-up of our investment in foreign shares is evolving as well. Twenty years ago, the Vanguard Emerging Markets Stock Fund (VEIEX) showed a median market-cap of $4 billion. Today, the average emerging market-cap is close to $14 billion, putting it more in the large-cap category.** In theory, the shift in size along with sector changes reduces the diversification benefits associated with traditional small-cap emerging market funds. Our Vanguard ETF based investments using the FTSE indexes now include more small stock exposure across developed and emerging markets.
The Fixed Side
For much of the year, our shorter-dated bond portfolios lagged the returns of the broad bond market as long-term interest rates continued to fall. Using the bond allocation as a ready source of liquidity and as ballast for stocks, as we do, essentially precludes chasing returns from longer dated bonds. As the tide turned and rates rose quickly post-election, our bond portfolios held up much better than the broad bond market.
Road Ahead
2017 could be equally unpredictable. More elections are coming up in Europe and support for populist candidates is growing, including Marine Le Pen in France. The UK is figuring out how to do Brexit and the markets nervously await more information on what President Trump will, or will not do, once in office. Expect more uncertainty and volatility ahead.
How should investors respond and adapt to a new political world order that often appears more like mob rule than democracy? In 2017, political risk may need to be included along with normal assumptions about economic growth, corporate earnings, and interest rates – fundamentals that historically drive financial markets.
Different from financial risk, political shocks are by nature very difficult to hedge. The best way to prepare is to stay as diversified and flexible as possible. Now is not the time to put too many eggs in one basket, or to bet heavily on any particular industry or sector. Just as important, we believe, is avoiding investments that cannot be easily replaced if conditions change. Not that we have ever favored hedge funds or private equity investments that lock up funds, but now seems like a particularly important time to stay liquid.
We are tightening our exposure across asset classes, with a focus on quality and clearly definable, less correlated risks. High-yield bonds traditionally outperform investment-grade bonds as rates rise, with higher coupon payments tempering the impact of duration. But high-yield securities also bring more credit risk and higher correlations to stocks. Hybrid securities such as preferred stocks, convertible bonds and others, are best avoided.
Bond maturities should remain short and relatively low-yielding in the face of rising rates. There could also be increased corporate defaults if the U.S. Federal Reserve reacts more quickly to raise interest rates to offset reflation policies of the new administration.
While politics could produce some unpleasant shocks in 2017, the resulting market volatility could also deliver investment opportunities, as good companies are often thrown out with the bad.
Allocation Model
Our diversification framework is based on twelve distinct sub-asset categories that encompass a majority of all investable securities. Allocations between growth securities (equities) and more stable assets (bonds and other fixed income) are determined based on individual client requirements for growth and income, long-term financial goals, and personal risk preferences.
What It All Means
While heightened emotions may have driven politics in 2016, investing is best accomplished unemotionally and the results of elections do not change that basic truth. Behavioral errors increase when too much emotion enters the decision process.
A post-truth nihilistic world view could lead to the conclusion that facts do not matter in politics or investing. Almost everyone, it seems, is more than a little distracted with the constant Trump headlines. All the while, the economy is showing resilience, inflation is higher, and commodities are rebounding. Facts, we believe, are still relevant.
As always, we wish our crystal ball could tell you where the stock market is headed this year. We see several potential opportunities and risks, but we really don't know how it will ultimately play out. One of our favorite quotes is from Vanguard founder John Bogle: "If you are sure you are right, you're a damn fool. You may like to be right, you may hope to be right, but to be sure you're right is the formula for investment failure."
The best strategy is to find the right balance of risk and return, extend that insight into a consistent financial plan, keep a close eye on diversification and costs, and stay the course – even when the world, at times, seems to be coming apart. Behaviorally speaking, that's no small challenge. We will work diligently to focus on facts and not let emotions of the time get in the way of your financial success in 2017.
In the next few days, look for our annual report for clients, detailing another solid year of investment performance. As always, please give us a call with any questions or concerns, or to discuss your individual situation.
We wish you a happy, healthy, and successful new year.
Contact us: 865-584-1850 or info@proffittgoodson.com
DISCLOSURES
The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
* Using data from MSCI for the broad U.S. stock market and the All-World Equity Index ex U.S. since 1970 (start of foreign data set), we calculated ex-post Sharpe Ratios, which measure returns per unit of risk, for all portfolio combinations ranging from 100% U.S. stocks to 100% foreign stocks. We found the portfolio with the highest Sharpe Ratio to be 75% U.S. stocks and 25% foreign stocks. This diversified portfolio delivered the highest return per unit of risk over the 44-year period ending December 2014. See PG Portfolio Strategy, January 9, 2015.
** Don Phillips, Time to Rethink Emerging Markets? Morningstar, December 30, 2016