Index Performance and Analysis

The fourth quarter, like 2016 itself, opened with uncertainty and selling, and closed with conviction and buying. Markets drifted down in October in nervous anticipation of the presidential election, then rose once it became clear that Donald Trump would be our next president. For the year, the S&P 500 gained 11.9% (including dividends) and the Dow, thanks to a few very strong-performing stocks (see below), was up with dividends 16.5%. Growth stocks were out of favor last year as the Nasdaq lagged the other indexes in rising 7.5%. And the growth-oriented IBD Mutual Fund Index-it provides a gauge of how well the best active managers picked stocks-returned 4%. Bonds, which had been a top-performing asset class most of the year, were punished in the fourth quarter: the Barclays Aggregate Bond Index shed over three percentage points for a gain of 2.6% on the year.

 

Though it was a trying year, stock indexes were able to rally on the possibilities opened up by Donald Trump’s election as president. All major indexes ended the year above their 100 and 200-day moving averages. Multiple new highs were reached last year: the S&P 500 had 18 new closing highs and the Dow closed at record highs 25 times (17 of which it reached after the election). Looks can be deceiving, however, as investors had to endure significant volatility and make wagers on a completely unpredictable future as the election and interest rates loomed over the second half of the year. The Dow dominated headlines as it reached 19,000 in November, a thousand-point milestone of little technical import, though the milestones weigh on investors’ psychology and can encourage a herd mentality pile-on to see the next one reached. Even so, the Dow did not reach the nice round 20,000 number before year end but it did come within just 26 points of it. It should be noted that the Dow is an imperfect index and is not the best benchmark against which to gauge portfolio performance. It is made of just 30 companies (there are over 4,000 publicly traded American companies) and it is “price weighted.” Price-weighting means that the higher-priced a stock is the more it contributes to the overall performance of the index. So a smaller company with an expensive share-price will have a distorting effect on the Dow. This is precisely what happened last year: Goldman Sachs was the most expensive stock in the Dow and it had a gain of over 30% following the election. All told, Goldman alone, hardly the largest company in the Dow, contributed nearly 25% to the index’s performance. You can see that index performance alone-particularly a limited index like the Dow-cannot tell the whole story of the market’s year-long journey let alone the performance of your unique investment portfolio. In all, thanks to the “Trump Rally” stocks finished the year on a bullish note. The resilient market needed only the proper motivation to break out of its holding pattern to the upside, and the pro-business promises of the president-elect did the job.

Unfortunately for investors, stocks weren’t the only asset to have experienced volatility last year. Bonds are commonly thought of as a risk-mitigation tool, a safe haven in which to invest when equity markets get too choppy. We humbly disagree with this assessment and maintain that bonds only introduce a different kind of risk to a portfolio. In the fourth quarter many abandoned the relative ‘safety’ of bonds to take part in the Trump Rally, thereby causing prices to drop quickly as the bond sell-off picked up steam. Rising interest rates and accelerating inflation intensified the selling and demonstrated the unique risks inherent in bonds that investors should be aware of. For example, a popular ETF that tracks an index of mundane intermediate U.S. Treasury bonds returned a negative yearly performance after having been up almost 8% in the middle of the year. This fourth quarter bond market drubbing goes to show that even purportedly “safe” investments can suffer pronounced volatility and lose significant value for a portfolio.

2016: Resilient Markets Endure

The most important lesson of 2016 was a familiar refrain within the investing community: that past performance is no guarantee of future results. The future is unpredictable and it is even more so when generation-defining world events occur. 2016 markets were surprising, bewildering, encouraging, and, to reiterate a theme we have stressed in this space through the year, resilient. At first investors scrambled to sell as unanimous expert opinion was that our fragile economy could never absorb the shocks that it had to undergo from political disruptions worldwide. But the world didn’t end and many indications showed a firming economy underneath all of the noise. The resilient market survived the disruptions and give us reason to be hopeful for 2017.

You will recall that 2016 kicked off with the worst opening week ever for the stock market. The situation looked dire until we finally found a bottom in mid-February. A host of factors snowballed into the early sell-off: Chinese currency devaluation, oil falling to a price we haven’t seen in over a decade, and the perceived powerlessness of central bankers to do anything effective about these things and others. By the end of the first quarter, though, investors found their footing by doing some domestic introspection. They reconsidered the American economy and came to the realization that the sky was not falling. The chart below of the S&P 500’s 2016 performance illustrates this shift in sentiment. Note that by the end of March lost ground was recovered and was built upon thereafter, especially after the election.
S&P 500 Price Index 2016, Source: Financial Times

In addition we can see that after the first quarter only two significant dips interrupted the market’s sluggish, volatile climb. The first came in late June when Britain voted to leave the European Union. This was the first major event to culminate representing the rise of populist-nationalist fervor. The professional commentariat, not to mention the Bank of England and the united British political establishment foretold devastation and depression as a result of their less-cosmopolitan countrymen’s vote. For a day and a half this seemed prescient. But, again, these markets are resilient. The week after the momentous vote, Britain’s large-company stock index recorded its best performance in five years, and since Christmas the index has posted a new high every trading day. Manufacturing and home prices have also hit new highs in the wake of Brexit. And here at home, as you can see from the chart above, our markets recovered quickly and have experienced no lasting negative effects.

From that point in late-June the markets drifted through the summer moving hardly at all. Starting after Labor Day the volatility of uncertainty entered investors’ consciences. The Federal Reserve postponed interest rate hikes until after the presidential election-ostensibly because of a soft economy, but the likelier explanation is that the central bank did not want to make a move and disturb markets so close to the election. As it happened, the markets barely took notice when the single rate hike happened in December. The interest rate move news was drowned out by two events that virtually no market watcher saw coming: first, the election of Donald Trump, and second, the market’s reaction to his election.

The Presidential Election and the Market Reaction

It was no secret that the market had baked in a Hillary Clinton win into its pre-election trading numbers. CNBC, two months before the election, led with the headline “Wall Street doesn’t just see a Hillary win, it sees a landslide.” So when the final numbers were tallied and Donald Trump emerged victorious, markets were at first wary. Asian indexes closed down on the news and domestic stock futures were showing a multiple-hundred point drop in the Dow. Economist and New York Times columnist Paul Krugman perhaps allowed his politics to cloud his analysis as he lamented that night, “If the question is when markets will recover, a first-pass answer is never…So we are probably looking at a global recession, with no end in sight.” Conventional wisdom to that point held that a Trump win would shock markets into a correction. After all, the foregone conclusion of Clinton provided the market with the certainty it craves for stability. The wholly unexpected Trump victory wiped this slate clean and introduced not only a newly uncertain future, but also new opportunities for economic growth that hadn’t even been contemplated under a Clinton presidency.

By the morning after Election Day investors had determined that a Trump presidency would be good for markets and the economy. Instead of a mass-hysteria sell-off, investors bought back into stocks and then continued to buy some more. The table at left shows the performance of different indexes from Election Day through the end of the year.

You will notice that while the big company stock indexes (the S&P 500 and the Dow) performed well, they were outpaced by small company and especially financial stocks. These two category’s outperformance reflects investors’ broad bets on what we might expect from the Trump administration these next four years. First, a main theme of Trump’s campaign was putting the brakes on globalization and focusing our economy inward. Investors are hoping that these “America First” trade policies will redound to the benefit of small companies whose profits depend less on foreign trade than do those of larger companies. Next, financials-long the laggard in this post-recession near-zero interest rate world-may receive some support as rates rise and if Trump follows through on promises to erase excessive regulation.

Generally speaking, there is a newfound optimism about the impending Trump presidency and what it may mean for the economy. In spite of political naysayers like Krugman and the rest predicting disaster, the American people are reexamining the fundamentals of the markets and are finding them conducive to investment and growth. A look at the daily dollar flows into ETF investments (see chart at right) before and after the election confirms this optimism.

Employment has picked up, interest rates are gradually leveling, and the Trump-instigated forecast of lower taxes and relief from business-constricting regulation have combined to make the prospects for 2017 much brighter than they once had been.

Interest Rates and Oil Normalize

Interest rates and the price of oil retreated from their roles as market-movers last year. Investors seemed to collectively understand that though both indicators are helpful to ascertain a limited perception of the economy, neither of them provides a complete picture. And neither of them warrant the extremes to which the market went in its analysis of each. Investors became literary critics in decoding every last word of the Federal Reserve’s press releases and minutes. For a while the price of oil could tell you whether or not the stock market went up or down. Finally this irrational behavior and correlation broke down last year as investors turned back to the basics: are companies making money and growing, are consumers and businesses spending money, and what might the government’s policies mean for the economy going forward.

The Federal Reserve raised the federal funds target rate by .25% in mid-December to a range between .50 and .75%. Markets reacted by dropping the day of the announcement but just as soon shrugged off the news and rose again. This latest hike was the Fed’s first in a year and only the second in ten years. Chair Janet Yellen struck a confident tone in the accompanying commentary, stating that the rate hike, “should certainly be understood as a reflection of the confidence we have in the progress the economy has made.” As explained below, employment is near full and inflation is almost at the Fed-desired 2% rate (November’s rate came in just shy at 1.7%). Though the Fed has a history of being overly optimistic in its forward-looking plans of action, there are good economic reasons to believe that there may be more than a single rate hike in the coming year.

The price per barrel of oil fell as low as $26 last year. Following this, observers realized the selling had been overdone and the subsequent rally in oil and energy stocks made the energy sector the best-performing within the S&P 500. OPEC finally reacted to the price collapse in late-November as the battered cartel agreed on a production cut. Member states will cut production in 2017 by 1.2 million barrels per day in an effort to get prices back into an economy-sustaining level. Prices settled just above $50 per barrel at the end of the year, a level at which most American shale producers can profit but not one with which third world OPEC members can maintain their non-diversified economies (e.g. Venezuela and Libya). The questions for 2017 therefore are whether OPEC can enforce the production cut among its members-easier said than done; as former Saudi oil minister Ali al-Naimi admitted about cuts, “we cheat”-and if better-compensated shale drillers can make up for the lost OPEC barrels. Also an open question is whether there is demand enough to keep oil prices rising in the first place.

Key Economic Indicators

Gross Domestic Product

Our economy grew at a rate of 3.5% for the third quarter. This is the highest quarterly reading since 2014 though there are worries that this number may just be 2016’s outlier-a single quarter of growth that heightens expectations but is not persistent and cannot be built upon in succeeding months. With three quarters worth of data now accounted for the average annual growth rate for 2016 is just under 2%, a poor number that is in-line with the sluggish recovery since 2008’s recession. Estimates for the fourth quarter are modest (in the 2% range) and we will likely maintain yet another annual growth rate of around 2%.

President-elect Trump has stated that he hopes to raise this annual growth rate to 3.5% through business-friendly tax and regulation-cutting policies. Mr. Trump has his work cut out for him: the last time our economy grew over 3% was over a decade ago, in 2004. However, if wage growth and consumer sentiment (see below) are any indication, it would appear that the country is on its way and people are hopeful that the regime change in D.C. will rouse the economy out of its “secular stagnation.”

Employment Situation

156,000 jobs were added in December and the unemployment rate notched up slightly to 4.7%. All told 2.2 million jobs were added in 2016, a weak gain to be sure, but this may be more reflective of employment being practically full. The unemployment rate, after all, has fallen back to pre-recession levels:

Unemployment Rate
2003-2016

You can see in the graph above that unemployment peaked in the immediate aftermath of the recession (the shaded area) and has fallen steadily since. Importantly, wage growth was up 2.9% for the year, healthily outrunning inflation and perhaps signifying a warming economy.
Consumer Sentiment

The University of Michigan Index of Consumer Sentiment recorded its highest reading since 2004 for the month of December. The reading-98.2-is well above the non-recessionary year average and is a marked improvement over the beginning of last year. The sentiment of the American consumer may seem a trivial statistic against other hard and fast economic indicators but we must recall that consumption-getting and spending-accounts for two-thirds of gross domestic product. So a reasonably confident, optimistic consumer we take to be a net-positive for the economy. People tend to spend more freely when their spirits are up and vice versa. Whether or not this heightened confidence is justified is beside the point; the mere fact that consumers are feeling good about the economy is in itself good for the economy.
Looking Forward and Investment Strategy

We stated in these pages last year that the market exhibited a resilience that needed just the right catalyst to set it off. The improbable election of Donald Trump seems to have been the catalyst investors were searching for. Even though markets had priced in the stagnant status quo of another Democratic administration, the last moment populist triumph was a game changer. Investors perceive, rightly or not, a pro-business attitude from the White House and policies reminiscent of Ronald Reagan: tax cuts, cutting red tape and the regulatory bureaucracy, and entitlement reform. While we are hopeful for investment performance this coming year we are always realistic. To belabor a point, past performance is no guarantee of what will happen in the future. We are optimistic about 2017 and believe we have the right set of tools to help tackle this unique market. We turn then to our investment strategy for this coming year.

Target Volatility is our quantitative “strategic” solution. Instead of your typical strategic buy and hold portfolio, Target Volatility portfolios rebalance at predetermined intervals based on a mathematical analysis of fund price movement. Target Vol portfolios sustain controlled participation in the markets (instead of sitting on the sidelines in cash) because we are able to put a ceiling on the amount of volatility a portfolio may experience. Conservative investors therefore have the opportunity to engage with the markets without the fears of being jerked around by extreme unforeseen price movement or of being left in the dust because of a lack of participation.

For more aggressive investors we utilize the latest iteration of our Rank Models. These models trade in and out of securities quickly as they attempt to capture micro-cycle gains within volatile asset classes. We are excited to report that these models are intelligent by being adaptive: our investment management software automatically reanalyzes and fine-tunes the Rank Models every month by incorporating the previous month’s prices into its calculations. This automatic process, a rudimentary artificial intelligence, learns from recent history and then adapts its decision-making based on what it learns. Because stock and bond prices move in trends (however short), this adaptive innovation helps us to make investment decisions based not on what has happened in the distant past but on what is happening right now. With these two tools, then, and along with our classic mutual fund modeling process, we hope to be able to deal with whatever unpredictable scenarios may arise in 2017.

Performance Disclaimer

No investment strategy or methodology can guarantee profits or protect against losses. Investment risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over time. Investment risk is inherent in every individual portfolio and no computer model or modeling program used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling program may not reflect actual risk and return parameters applicable to any particular portfolio or investor. Actual investment decisions made on the basis of a computer generated model or modeling program may be materially different from expected or intended results, and any computer modeling program is subject to errors in the program and system failures at any time.

Sources
http://www.bea.gov (GDP data)
http://www.bls.gov (employment data)
http://www.google.com/finance (index returns)
http://www.sca.isr.umich.edu (consumer sentiment)
A moment of destiny for Britain and Europe, Financial Times, June 22, 2016, https://goo.gl/oQ2iVl.
Federal Reserve Press Release, Board of Governors of the Federal Reserve System, Dec. 14, 2016.
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