Market Commentary: 4Q 2016

You know that you are deep into a longstanding bull market when you see things like average pedestrians keeping one eye on the market tickers outside of brokerage houses to see when the Dow Jones Industrial Average has finally breached the 20,000 mark. Who would have thought that there was much good to come when the beginning of 2016 got off to such a rocky start, tumbling 10% in the first two weeks—the worst start to a year since 1930? Nevertheless, the markets eventually bottomed in mid-February and began a long, slow recovery. While the U.S. markets suffered a setback in June when the U.K. decided to leave the Eurozone, and endured another hard bump right after the elections, in the end, we were not disappointed.

The final quarter provided U.S. stock investors with impressive gains. The Wilshire 5000, the broadest measure of U.S. stocks, was up 4.54% in the fourth quarter of 2016 and ended the year up 13.37%. It was also a year to remember for investors in small company stocks. The Russell 2000 Small-Cap Index finished the year up 21.31% after producing an astonishing 11% return in November alone.

Unfortunately, rising U.S. equity prices came at the expense of core bond and international stock returns. The overall U.S. bond market gained 2.65% for the year, but that hid a fourth quarter decline of 3.2% as rising interest rates resulted in the worst quarterly performance for bonds in 35 years. Expectations for rising inflation, along with the Federal Reserve’s December decision to raise interest rates, further contributed to falling bond prices. Emerging Market stocks also declined, falling 4.8% in the final quarter. Nevertheless, the combination of portfolio increases and decreases still resulted in better than average returns across the allocations.

Here are the broad index returns through the Fourth Quarter of 2016:

U.S. Large Cap Stocks 12% Emerging Market Stocks 11.6%
U.S. Small Cap Stocks 21.3% Commodities 11.8%
U.S. Real Estate 8.6% U.S. Aggregate Bonds 2.6%
Overseas Stocks 1.5% International Bonds 1.9%

Core bonds are likely to continue to struggle over the next market cycle. The combination of the Fed’s plans for three additional interest rate hikes and an incoming presidential administration that promises to significantly increase spending could mean higher debt servicing costs for both consumers and the government (i.e., taxpayers). Placing a greater emphasis on flexible fixed-income strategies is essential to helping the bond portfolio contribute to the overall portfolio return but it cannot completely remedy the issue. Interest rates are still historically low, where the 10-Year Treasury is now yielding 2.45% versus an average over the last 58 years of 6.15%. The result can only mean lower portfolio returns than has been experienced on average in the last 50 years. Fortunately, inflation is also low and net “real” returns (your portfolio return minus inflation) should continue to fall within an acceptable range over a sufficiently long period of time.

Reflecting again on the financial markets’ rocky start to 2016, it is also important to remember how quickly trends can change. While it is unclear how 2017 will play out, since precise inflection points in market performance are impossible to predict, European corporate earnings and eventually stock prices are poised for recovery and valuations in Emerging Market stocks remain favorable. In contrast, U.S. stocks appear somewhat overvalued and have continued to increase despite their historically high price-to-earnings multiples. As interest rates rise, we may see a weakening in the support that the low rates of the past decade have afforded U.S. stock prices. Corporate tax cuts would likely help support higher prices, but over a full market cycle, valuations tend to matter materially while chasing baseless momentum is a recipe for disappointment. Optimistically, short-term market traders seem to be expecting a robust economic stimulus combined with lower taxes and deregulatory policies that would boost the short-term profits of American corporations. But it is helpful to remember that we are entering the ninth year of economic expansion, making this the fourth longest since 1900, and many economists are predicting a recession within the next few years. The best recipe for portfolio success is broad diversification to help ensure the portfolio has upside potential and downside protection across diverse economic outcomes.

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