|12 Mo. Change||YTD Change|
|10-yr Treas. yield||2.45%||1.49%||+0.84%||2.27%||+0.18%||+0.18%|
|Fed funds rate||0.50% to 0.75%||0.25% to 0.50%||+0.25%||0 to 0.25%||+0.25%||+0.25%|
(stock indices are before dividends; yield and rate changes are absolute changes)
Even his supporters may concede that Donald Trump’s election was a bit of a surprise. It was unquestionably a surprising quarter for financial markets. Brushing off expectations for a market decline if Donald Trump were elected, the markets reversed by the end of the day after the election. Expectations of loosened regulations sent stocks higher and investors had to jump aboard to avoid missing the run-up, forcing stocks even higher. With dividends included, the Dow was up over 16% for the year (with a greater impact from energy and financial stocks) and the S&P 500 was up over 12%. Interest rates nearly doubled from their mid-year lows and once again the small increase by the Fed in December was a non-event.
For the full year, oil (+45%) and natural gas (+57%) prices were the big gainers with gold holding on for an 8% gain after being up over 25% in mid-year. Energy, financials and telecommunications were the best-performing sectors with health care being the only broad sector to post a negative return. High yield bonds were very strong but investment grade corporate bonds finished up 6% for the year. Brazil was the strongest international market (Canada and the UK were the best develop markets) with Italy and the Shanghai composite pulling up the rear.
The job market continued strengthening, with the streak of weekly jobless claims under 300k stretching to 95 weeks. Unemployment fell to 4.6% and wages were up 2.5% in the third quarter compared to the year earlier. New jobs totaled 2.25 million over the last 12 months and average hourly earnings finally began to show some growth at up 2.5% year over year. Overall, consumer confidence reached a 15-year high after the election as future expectations were particularly strong.
The housing market also stayed positive as new home sales were up over 16% for the year. Building permits for new single-family homes hit a nine-year high and inventory of new homes for sale finally nudged upward but is still below the norm of six-month’s supply. Existing home sales were up 15% from the prior year and hit their highest annualized level in eight years. Inventory of existing homes, though, is down, leading to prices increases of 6.8% compared to the prior year. Foreclosures and short sales were only 4% of sales compared to nearly one-half during the housing crisis. Overall home ownership sat at around 63.5% of households, the lowest since 1994 and well off the peak of 69.2% in 2004.
The Fed’s widely anticipated rate increase was passed by unanimous vote of the Fed committee and was accompanied by a statement that “near-term risks appear roughly balanced”. Fed watchers now expect two or three more 0.25% rate increases in 2017 and possibly three more in 2018 and 2019. Even if all these increases happen the Fed funds rate would barely reach 3%, hardly considered historically “high”. The rate increase was a big factor in the US dollar reaching a 14-year high against a basket of currencies; perhaps not surprisingly, the Mexican peso hit an all-time low against the US dollar following Trump’s election.
The final GDP growth for the third quarter came in at 3.5%, up from 3.2% in earlier estimates and far better than the 1.4% in the second quarter. Consumer spending was solid but softening toward year-end and exports reached their highest level in three years. Business investment turned positive for the final two months but was down 3.5% for the entire year. Services remained strong, with 82 straight months of growth and manufacturing eked out growth overall despite an occasional decline. Inflation increased ever so slightly but core inflation at both the producer and consumer levels remains below 2%.
Looking Forward has in some ways become the most obvious section of these reviews. With control of both houses of Congresses, a vacant Supreme Court seat and an outspoken, unpredictable new president, the Republicans are in position to make broad and dramatic changes to government policies, regulations and practices. But many of Donald Trump’s more populist proclamations are in conflict with other Republicans and he has already softened a number of his more controversial promises.
Geopolitics may end up being of more consequence than the domestic policies of the “first 100 days” of the Trump presidency. Donald Trump appears to be at odds with the US’ current relationships with Russia, China, Israel and other trading partners. These relationships are extremely complex and abrupt changes could be fertile ground for unintended consequences. Russia could be very interesting since the US has just imposed sanctions in retaliation for Russian hacking and Trump has continued to speak admiringly of Vladimir Putin.
Brexit is back in the forefront as the UK is expected to officially begin the two-year clock to fully unwind from the EU by mid-year. Prime Minister May has stated she wants to respect the concerns of all Brits but still intends to forge ahead with Brexit. At the same time, right-leaning candidates are expected to win elections in France and the Netherlands and German Chancellor Merkel is under fire after the terrorist attack in Berlin.
We typically use this space to reinforce our long-term investment horizon and our patience in riding through market volatility. But in all fairness, this refrain can be less than exciting. So, it can also be helpful to talk about what we don’t do as a way to support what we actually do.
Example 1: Last week I spoke to a retired colleague who had sold his fee-only financial planning practice about seven years ago. He had become a client of a financial planner in New York but the distance and time difference had become a problem so he was considering planners in Tucson.
After explaining our approach, he confirmed that it is not for him – he is interested in “beating the market”. Of course, I know that he never really compared his portfolio to any set of market benchmarks and he could not actually say whether he beat the market. His quest to beat the market was driven by a psychological need rather than actual performance. (He is now 83 years old and does not need “market-beating” performance.)
When he’d managed client portfolios he made lots of relatively small investments in lots of actively managed mutual funds with the idea of limiting risk if any one fund hit a rough patch. The aggregate portfolio of all these funds did not differ significantly from the market composition but at a much higher cost. And how were these funds chosen and dropped? They were chosen following a period of strong performance and replaced after a period of poor performance. In other words, betting on past performance, buying high and selling low.
Example 2: The “Heard on the Street” column in the Wall Street Journal “makes calls on markets, corporate strategy and economic policy”. The multiple contributors wrote 1,247 pieces for Heard on the Street in 2016 and Heard’s own self-assessment revealed plenty of hits and misses.
The column became bullish on US banks in mid-year and the bank index rose strongly through year-end on the anticipation of rising interest rates and the expectation of relaxed regulation. On the other hand, a critical analysis of asset Manager WisdomTree was off the mark as the stock rose 15% since the column. Likewise, several columns were on-target regarding specific energy companies but completely whiffed on the price of crude oil as global producers reached several production agreements.
Heard anticipated the positive effects of merger activity on semiconductor stocks but stumbled in consumer electronics. The column correctly exposed accounting problems at one telecommunications firm but was wrongly pessimistic on AT&T. In health care, Heard properly warned that the practice of buying old drugs and raising prices was unsustainable but was also bullish on a big health care merger that completely collapsed and resulted in declines for both firms.
Heard on the Street describes its columns as “deeply reported with a point of view that is well argued”. The column is all those things and it is worthwhile reading, but good luck placing financial bets on the column’s conclusions.
Missing the Point
In last quarter’s review we celebrated the 40th anniversary of the index mutual fund. Mutual fund companies that primarily offer actively-managed funds are not, however, ready to throw in the towel and cede the market to index funds. Marketers for these fund companies are meeting to identify and refine messages that will resonate with investors and slow the stampede to index funds.
One key message is that actively-managed funds can perform better in market declines. This may be true for the portion of a portfolio invested in a specific market area but the diversification of a properly allocated portfolio can serve the same purpose. And those same actively managed funds often lag in rising markets, so any advantage is lost over the full market cycle.
Another challenge is that there are plenty of funds that are guilty of active management’s shortcomings – high expenses for poor performance. It would be a tricky balancing act for the industry to acknowledge this fact but still advocate for investors to choose their funds. Even worse, study after study has shown that a fund that has strong performance over a multi-year period is very likely to become average over the next multi-year period.
The biggest problem, though, is the big picture. More consumers are recognizing that their investment portfolio is but one part of their overall financial life and that they are better served by coordinating all those pieces than by focusing just on their portfolio. Comprehensive financial planning promotes the idea that portfolio performance should not be expected to make up for shortcomings or big mistakes in those other financial areas.
In other words, the fund marketers are trying to focus more attention on an issue that is of declining consequence in the eyes of their customers. If we were talking about cars, the fund marketers are talking about the equivalent of a technically superior transmission, but one that does not necessarily perform as expected under all circumstances. Car buyers are most concerned with whether a particular car will meet their needs, how it looks, its reliability, etc. Only a small number of real car buffs will be swayed by the technical specs of the transmission and that small number is certainly not large enough to support a large part of the market.