It was an interesting year. The past year proved to be tumultuous on many fronts. It began with a steep double-digit plunge in stock markets and ended with a six-week equity rally. Fears of rising interest rates, news flow surrounding oil prices and production cuts, and the political upsets of the Brexit vote and Donald Trump’s victory in the U.S. presidential election spilled over into financial markets during the year. Equities and bonds experienced intermittent dives; thus the year also saw reversals in several long-running market trends.
U.S. stocks performed well this year with large-cap stocks gaining over 10%. A lot of this gain came after the election and was a surprise to a lot of sophisticated analysts. Many ‘in-the-know’ analysts were anticipating a Clinton victory, so Trump’s victory became unsettling. A possible Trump victory was supposed to bring turmoil to the financial markets because his strategies are untested and his plans uncertain. The year-end rally was surprising on many levels. It should be noted that this rally was contained to U.S. stocks, and many other investment sectors performed poorly, as noted below.
Most investors focus on the U.S. stock reports when they watch the evening news. It’s natural to anticipate that your portfolio should perform in line. However, a defensive and diversified portfolio has many parts that contribute to the whole, and many of these parts performed negatively after the election. It’s as if there was a mad scramble shift to what everyone perceived President-elect Donald Trump will be able to accomplish. (I would like to think I am wise with experience, but maybe I’m just older). I have learned over the decades that there’s a lot of distance between campaign trail speeches and actual implementation of laws, so it’s possible this renewed optimism will be short-lived. I hope not, at least not as far as the equity markets go.
2016 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. This is a smaller portion of our portfolio allocation due to the higher risk of investing in this area.
Developed international stocks were the big laggards; they returned just 2.7%. European stocks did worse. For the third straight year, the U.S. 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 – but were a drag on portfolio returns especially in the last few weeks of the year. Bonds started off the year strong, but were completely hammered after the election (turning in their worst quarterly performance in 35 years) as investors are anticipating higher inflation and interest rates. Many conservative investors were caught off guard and left wondering where they should turn for safety if they want something other than stocks in their portfolio.
In terms of the broader economic environment, the combination of the Fed’s plans for three additional interest rate hikes, an incoming presidential administration, and a Republican-controlled Congress with promises to significantly increase spending and cut taxes could mean higher debt servicing costs for both consumers and the government (i.e., taxpayers). This also means the pump is primed for core bonds to fall further. We are reducing our bond exposure in all but our most conservative portfolios.
Real estate turned in mixed results, but let’s dissect this a bit further.
Real estate that actively trades like stocks and mutual funds (publicly traded) decreased in value after the election in anticipation of higher interest rates.
Real estate that trades privately, performed perfectly in our portfolios with steady dividends and little to no volatility. Private real estate is not priced on the emotions of the daily stock market, but rather it’s priced on recent property appraisals. This is a strong reason we prefer private real estate for our clients. We continue to visit with our clients about moving out of bonds and public real estate and into private real estate in order to play defense. The tradeoff can be less liquidity in the overall portfolio, but we believe some investments in non-liquid real estate are warranted.
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 a measly 1.3% in dollar terms. Because of their globally diversified long-term equity allocation, many portfolios have lagged compared to a purely U.S. stock portfolio. While foreign stocks’ underperformance is trying, we continue to believe, supported by our analysis, in maintaining large strategic allocations to foreign stocks – particularly after this prolonged period of underperformance.
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 projected time horizon of five years. 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 low-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 overvalued, with a lot of optimism baked into current prices. This accelerated in the post-election period, which makes them particularly vulnerable to a negative surprise. We expect the market price-to-earnings multiple to decline, 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 five-to-10-plus-year horizon – which is the horizon upon which we base decisions.
Though there are risks to our European and emerging-market equity positions, current valuations suggest these are well—though not fully—discounted. News flow regarding political uncertainties from rising nationalism in Europe and related economic/breakup risks facing the Eurozone, or the negative ramifications for emerging markets of China’s huge public debt build-up (to name just a few of the 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 projections for these markets are reasonably conservative. These markets could still face potential shorter-term cyclical downside risk. Sometimes an idea can be logical in the long term, but still wrong in the short term as emotions in the markets override everything else. So yes, there are fears about buying international stocks. Americans tend to have more confidence in their home country and are thus biased toward investing close to home. But if the prices are cheaper in other markets, there can still be opportunities. 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.” Admittedly this is much easier said than done at times.
Looking Ahead to 2017
Expert predictions of the future are usually educated estimates. When it comes to economies and financial markets, there are 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 a Donald Trump victory, and then would have predicted gold would drop and stock markets would rally in the days and weeks after his unexpected election victory? Given that we don’t know the details of his plans, only his campaign promises, there are certainly more surprises yet to come.
As we previously indicated, U.S. stocks may be overvalued based on current price-to-earnings multiples. If President-elect Donald Trump is truly able to “Make America Great Again” and corporate earnings skyrocket, U.S. stocks could continue to log gains. Our caution is in two areas: many of his proposals (cutting taxes and increased spending) will substantially increase the U.S. debt, and some of this optimism is already reflected in current stock prices.
It’s tough to estimate what the financial markets will do this next year. We draw from the best research available and accordingly put our best foot forward. If we had one forecast that seems likely, 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. However, in the end the average returns you receive in exchange for this wild ride are better than returns you would gain without utilizing our financial strategies, i.e. holding a well-designed portfolio and following the personal advice we provide. In our minds this process is critical for helping you to achieve your financial goals.
Committed to your successful retirement,
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]