Fourth Quarter 2016 Key Takeaways —
Global stocks performed well both in absolute terms and relative to core bonds this year, with U.S. stocks again taking the lead. Large-cap stocks gained 11.8% . This marked the eighth straight year the large-cap S&P 500 Index had a positive return. While streaks of this length have occurred twice before, the market has never had a nine-year winning streak.
Emerging-market stocks were also strong performers, gaining 12.2% for the year. Developed international stocks were the big laggards. They returned just 2.7% in U.S. dollar terms. European stocks did worse, falling 0.4% in dollar terms, although they gained 7.2% in local-currency terms. For the third straight year, dollar appreciation was a drag on European stock returns. The major currency decliner was the British pound. It plunged 16% versus the U.S. dollar, triggered by June’s Brexit vote. The euro fell 3% on the year. Overall, the U.S. dollar index rose around 4% against a basket of developed-market currencies.
For the year, core bonds produced a 2.5% gain, slightly above our longer-term (5 year) expected return outlook for them. Investment-grade municipal bond returns were slightly negative on the year. Though core bond prices got off to a strong start with the 10-year Treasury yield dropping to an all-time low of 1.37% in early July, yields then reversed course, rising to 2.5% by year-end. In the fourth quarter, the core bond index fell 3.2%—its worst quarterly performance in 35 years—due to rising interest rates.
While 2016 wound up being a poor year for treasury and core bonds, it was a good year for riskier fixed-income sectors, such as high-yield bonds and floating-rate loans. These have more credit risk and less interest rate risk.
Alternative strategies turned in mixed performance. The HFR Global Hedge fund index return was just at 2.51%, which is in line with core bond for the year. Our long term assumption is that Alternative Strategies should outperform core bonds.
In our year-end investment commentary, we look back at 2016 as well as ahead to 2017. Several trend reversals occurred in 2016 which leave us hopeful that the portfolios we manage will outperform in the coming years. Our analysis leads us to stay the course, maintaining a focus on our investment discipline, as opposed to trying to forecast economic or political outcomes, which we believe are inherently unpredictable.
Fourth Quarter 2016 Investment Commentary
As we look back at 2016 and ahead to 2017 and beyond, we’ll leave the political discourse and analysis to others and focus our comments on the financial markets. In this commentary, we recap portfolio performance, before speaking to client concerns regarding our investments in foreign stocks.
Fixed-Income: In our balanced portfolios, over half of our fixed-income exposure is in non-core bond funds, including actively managed unconstrained/absolute-return-oriented, flexible multi-sector, and global bond funds. These positions benefited greatly from rising interest rates and added significant value, when compared to core bonds. Gains were in the 5% to 10% range versus 2.5% for the core bond index. Looking ahead to 2017, we think these strategies should again, meaningfully outperform core bonds, although 2016’s returns will likely not repeat.
Larger-Cap U.S. Stocks: Currently, we are underweight to U.S. stocks in favor of non-U.S. stocks and alternative strategies was again a headwind to performance this year (more detail is provided in the following sections).
Smaller-Cap U.S. Stocks: Having benefited from a multiyear period of small-cap under-performance, we unwound our relative underweight to smaller-cap U.S. stocks versus larger-cap U.S. stocks in Q3. We subsequently profited from small caps strong rebound during the remainder of the year.
Developed International Stocks: We started the year with a modest tactical overweight to Europe. After the Brexit vote, we reduced that to a neutral weight, but we were hurt by continued out-performance with U.S. stock versus other regions. This marked the 4th straight calendar year and the 6th year in the past 7 years that the S&P 500 beat the global ex-U.S. index. Since 2008, this is one of the longest stretches of U.S. out-performance on record. U.S. stocks also meaningfully outperformed European stocks.
Emerging-Market Stocks: We were pleased to see emerging-market stocks rebound in 2016. Through the end of October, emerging-market stocks were up 18% on the year (versus larger-cap U.S. stocks’ 6% rise), though they did give back some gains following the presidential election.
Alternative Strategies:Our lower-risk alternative strategies met their performance objectives this year by outperforming core bonds, but they were no match for the double-digit return of U.S. stocks.
Why Do We Still Own Foreign Stocks?
Since the end of 2009, the S&P 500 has returned a cumulative 131%. In contrast, developed international stocks have gained 32% and emerging-market stocks had a measly 1.3% in dollar terms. During most of that out-performance, we were underweight or neutral weighted to Foreign Stocks, but the last two years we have be over-weighted to Foreign/emerging-market stocks. Because of their globally diversified long-term equity allocation, our portfolios have lagged compared to a purely U.S. stock portfolio. While under-performance with foreign stock is trying, we continue to believe, supported by our analysis, in maintaining large strategic allocations to foreign stocks particularly after this prolonged period of under-performance.
Our analysis implies that from current price levels, both European and emerging-market stocks are likely to generate much higher returns than U.S. stocks over our tactical time horizon of 5 years. In our base case scenario, we estimate low double-digit potential returns from European and emerging-market stocks, driven largely by improving earnings growth from still very depressed levels. This compares to our base case of single-digit expected returns for the S&P 500.
While our analysis indicates that we are being reasonably compensated for equity risk in Europe and emerging-markets, U.S. stocks appear fully valued, with a lot of optimism baked into current prices. The level of optimism has accelerated post-election and makes them particularly vulnerable to a negative surprise. We expect the market price-to-earnings multiple to decline in our base case, consistent with U.S. market history, dragging down expected returns. History and investment logic also tell us that high starting-point valuations are a strong predictor of low future returns over a 5-to-10-plus-year horizon. It is this horizon upon which we base tactical decisions. So on a relative and absolute basis, we are moderately overweight to non-U.S. stocks and underweight to U.S. stocks.
Though there are risks to our European and emerging-market equity positions, current valuations suggest these are pretty well—though not fully—discounted. News flow regarding political uncertainties from either rising nationalism in Europe, related economic/breakup risks facing the euro-zone, or the negative ramifications for China’s huge public debt build-up (to name a few big ones), has contributed to their poor stock market performance in recent years. With investors discounting lots of risks and bad news, the news must only be “less bad” for sentiment and stock prices to improve. That typically happens when the market least expects it.
We believe the key earnings growth and valuation assumptions that underlie our base case 5-year scenarios for these markets are reasonably conservative. These markets still face potential shorter-term cyclical downside risk. We do consider more bearish scenarios and outcomes in our analysis, which is why we do not have larger tactical positions to these markets.
However, we believe the overall risk/reward, the combination of the likelihood of certain scenarios playing out and the magnitude of gains or losses across those scenarios, continues to support a modest tactical overweight. Unless or until our analysis suggests making an allocation change, we will remain patient and confident that we will be rewarded, as has been the case historically for long-term value-driven strategies.
As Warren Buffett wonderfully and concisely put it, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” Much easier said than done.
Looking Ahead to 2017
Expert predictions of the future are usually no better than guesses. When it comes to economies and financial markets, there are way too many complex, adaptive, and interactive variables—most of which are consistently unpredictable—to confidently forecast outcomes, at least over the shorter term.
Even if one could know in advance the outcome of many of the important individual variables (such as election results, central bank policy decisions, and currency movements), one would still be likely to make many inaccurate market forecasts. For example, how many experts would have predicted gold would drop and stock markets would rally in the days and weeks after an unexpected Donald Trump election victory?
We don’t bother guessing what financial markets will do next year. An important part of our portfolio risk management process does analyze the impact of 12-month stress-test scenarios. But those are neither forecasts nor predictions. If we had to make a forecast for next year, or any year, it would be this: Expect the unexpected. Prepare to be surprised. Stock markets will be volatile; they will go up and down—probably a lot.
Jon Houk, CFP®