Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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2016 Q4 Market Review: A Year of Thwarted Forecasts

This is our review of the markets for fourth quarter and year of 2016. As you know, we do not believe in making forecasts, but we comment on cross currents influencing the markets. As usual, our goal is to look at recent market results, put them in perspective, and see how that experience should set our expectations going forward.

We look at the following topics:

  • 2016 Q4 and Year-to-Date Markets Review
    • Summary of Returns
    • The Markets’ Twists and Turns in 2016
  • What Does all This Mean?
  • Conclusion

2016 Q4 and Year-to-Date Market Review

Summary of Returns

As I write this review of the markets in 2016, some trends from the fourth quarter are already waning. Nonetheless, looking at what we experienced last year may be instructive as we look at the year ahead.

Last year was a tough one for prognosticators and strategists. There were so many twists and turns from a macroeconomic and political perspective that many experts, pollsters and forecasters had their hands full. Those activities are usually fraught with peril, as the error rate is high, but last year seemed worse than usual.

By now, it is old news how wrong the experts were about Brexit and the US election outcome. Not only that, but if they managed to call the Trump victory correctly, they usually got the market’s reaction wrong. Rather than nose diving, the stock market took off and headed for record territory.

Some additional observations from the table of returns, which follows:

  • The 12-month return for the S&P 500 Index of 12.0% was well above the long-term historical average since 1926 of 10.1%
  • In the US, small cap companies led the way, followed by medium-sized companies.
  • Style indexes are not shown, but value trumped growth (pun intended).
  • Emerging markets did well for the year, despite declining after Trump’s election win.
  • Developed markets outside the US rebounded in the fourth quarter, but still turned in a poor year.
  • High quality bonds did poorly, based on an outlook of increasing rates.
  • US Real estate investment trusts (REITs) did surprisingly well, considering their higher yielding nature and a consensus outlook for higher rates.
  • Master limited partnerships continued to benefit from both a firming in energy prices and investors’ hunt for income.
  • Commodities in general did well, with a firming US economy and an emerging consensus of further growth and firming inflation.
  • Despite declining in the fourth quarter, gold held onto positive results for the year.
Market Returns
Market Index December Q4 2016 2016
Stocks        
Large Cap S&P 500 Index 2.0% 3.8% 12.0%
Midcap S&P Midcap 2.2 7.4 20.7
Small Cap S&P Small Cap 3.4 11.1 26.6
Non-US Developed Markets MSCI EAFE 3.4 -0.7 1.0
Emerging Markets MSCI Emerging Mkts. 0.2 -4.2 11.2
US Bonds Bloomberg Barclays US Aggregate 0.1 -3.0 2.7
REITs S&P US REIT 4.7 -3.0 8.5
MLPs Alerian MLP 4.4 2.0 18.3
Gold S&P GSCI Gold Sub index Total Return -1.9 -12.7 7.8
Commodities S&P Dow Jones Commodity Index TR 1.3 3.8 13.3

Sources: AJO Partners, Factset, S&P Dow Jones Indexes

The Markets’ Twists and Turns in 2016

When we see the extremely strong finish for stock markets in 2016, it is worth recalling that it started out in a very rocky fashion, with comparisons to 2008 that were too numerous to count.

Markets later had to deal with the UK’s decision on whether to stay in the European Union. Pollsters predicted the country would remain, but instead we got Brexit, which is still a long-term proposition in terms of its eventual impact. We counseled maintaining your asset allocation through this period, and not making any brash moves. While the markets initially reacted strongly, once they got over the shock, they began to function normally again.

In fact, in the months leading up to the November US presidential election central bank policy produced considerable calm in the markets. In our last quarterly review, we questioned how long the “eerie calm” could last, as an environment where trading volume is low and most asset classes rise together cannot go on indefinitely. But it is impossible to forecast when and how it might end.

When it did end, it was fortunately to the upside. When Donald Trump won the election, stock markets initially lurched downward. Then they turned sharply upward, and the rest, as they say, is history. A consensus view emerged that Trump policies of infrastructure spending, reduced regulation and tax reform would kick start the US economy out of the low growth rate it has experienced since the Great Recession. Rather than deflation, we might need to focus on the potential for inflation, and with it, higher interest rates. The focus moved decidedly from Fed watching to Trump watching.

The only problem with this consensus view is that we aren’t there yet. As I write, Trump will be taking office in a few days, his cabinet still needs approval, and he has already had to revise some policies. Since we have a democratic government, his proposals will be subject to considerable debate, even though we have a Republican majority in both houses and a Republican president. In just the last week, the “Trump trade” has begun to recede, as markets got ahead of themselves. While we may ultimately get to where Trump wants us, the markets may have already fully priced most of that scenario into asset values.

What Does All This Mean?

The unpredictability of last year was a textbook example of why investors need fully diversified portfolios. If one had taken forecasters seriously, a lot of money could have been left on the table or outright losses experienced.

For example, a prospect (now client) came to see me in November, just prior to the election. He was getting to know several advisors as part of his selection process. One had recommended that the client liquidate a good portion of his portfolio on the supposition that if Trump won, it would negatively impact the markets. What did I think?

Long term readers of this newsletter and clients already know how I responded. Extreme changes in your asset allocation are rarely warranted, if you have carefully selected it based not only on your aptitude for risk, but as important, your capacity to bear risk.

Moreover, forecasting in general has a low batting average, especially in the political or macroeconomic realm. These are very difficult issues to fully analyze and get right. Not only that, but one can construct a completely cogent and thorough analysis and yet misread what market consensus really is, or how much is in asset prices.

I responded that the advisor in question could possibly be correct, but there was an equal chance he could be wrong. So to make an extreme change in a portfolio with no hedge in case of a potentially faulty forecast is a risky approach. If there is one thing I have learned, it is how often the markets can fool us. Also, we should avoid building what might be called a “single scenario” portfolio—one that has to have a specific set of conditions met for it to be correct. Instead, it should be as much as possible an “all weather” portfolio, with components that will help it weather different types of markets, since we can never really be certain in advance what may come our way.

So my new client did not liquidate most of his portfolio and is better off for it. We did, however, make some other adjustments based on his unique needs and circumstances.

Conclusion

Last quarter, we noted in that we expected volatility to rise as markets sort things out. Factors contributing to that view were that we were in an election year where the race was hotly contested, and there was some uncertainty regarding Federal Reserve policy.

Now that the election is behind us, things look no more certain than they did last year, despite the market’s reaction to the Trump victory. Now we will really see what the new administration can do, how the economy will fare, what the Fed will do, etc. And let’s not forget factors outside the US—the state of China’s economy, rising nationalism in Europe, and central bank policy outside the US.

Need I say more to make the case for a diversified portfolio?

We would reiterate to make sure you are at your recommended risk level and asset allocation for your portfolio. If you are, then all is well, and you can focus your attention elsewhere. If not, please make adjustments so that you are. And last but not least, if you are not sure, please call and let’s see where you need to be.

Thank you very much for your trust and confidence. We look forward to working with you in 2017. Happy New Year!

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Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.