During the fourth quarter, the financial markets provided another example of the difficulty of predicting returns. At the start of the fourth quarter, U.S. stocks were already at record high levels. As we approached the Presidential election, global stock markets declined as Republican nominee Donald Trump improved his chances of winning. On election night, as it became obvious he was going to win, stock markets around the globe sank over 6% (a rather large amount). The next day, the U.S. stock markets turned on a dime and recovered the 6%, along with Europe. The following day, Asian stock markets recovered their large losses. The election result created a rapid repricing of assets. In the following weeks, U.S stocks gained dramatically, especially small cap stocks, while bond yields moved up sharply from historically low levels (reached in July 2017). As interest rates increase, it acts as a brake on the economy. However, there are numerous periods of positive stock returns during increasing interest rate cycles and as long as the rate increases are not rapid enough to cause contraction, stock returns can increase. Economic indicators continue to improve with solid job and wage growth in the U.S., which bodes well for the continuation of our late stage economic expansion. The primary issues facing expected stock returns are high valuations and rising interest rates (as employment numbers continue to improve, and if there is an infrastructure spending package that comes out of Washington, we could see inflation jump, forcing the Federal reserve to act).
For those who want to dive deeper into our market and economic commentary:
World Asset Class 4th Quarter and Full Year 2016 Index Returns
Fourth quarter index returns were strong for U.S equities and slightly negative for international stocks, while more negative for emerging market and global real estate stocks. For the broad U.S. stock market, the fourth quarter return of 4.21% was well above the average quarterly return of 1.8% (since January 2001). The value and size dimensions of return, which we speak about often as additional factors of return, were very strong during the quarter.
A larger sample of asset class returns shows the strength of small cap stocks and the value bias. The Russell 2000 Value index was up 14.07% in the fourth quarter, well ahead of the broad Russell 2000 Index. Value was also strong in the top 1000 companies by market cap, the Russell 1000 Value index was up 6.68% while the broad Russell 1000 was only up 3.83%. Even is emerging market stocks, value (down 1.1%) was up considerably more than the broad index (down 4.16%). U.S. stocks were much stronger than international, emerging market and global real estate during the fourth quarter.
Full year, 2016 results were very positive for most asset classes:
U.S. stocks were the best performing broad asset class and Emerging Market stocks performed better than International Developed Stocks and Global Real Estate during 2016. For the full year, the value effect was positive in the U.S., international developed, and emerging markets; and small cap stocks performed significantly better than large cap stocks in developed markets. The Russell 2000 Value Index was up 31.74%, well ahead of the broad Russell 2000 small cap index (up 21.31%). The Russell 1000 Value Index was up 17.34%, well ahead of the broad Russell 1000 large cap index (up 12.05%).
Bond markets around the world were negative due to a strong shift up in the yield curve, after the election and from the all-time low yields reached in early July. Here is the large shift up in rates for the fourth quarter and notice the longer end had a larger shift up:
When the yield curve shifts up across all time periods, bonds lose value and the longer duration bonds are going to perform worse. The Citi World Government Bond Index (1-5 years) is slightly ahead of long term government bonds for the year. Notice high yield bonds are up over 17% for 2016, which is another sign of investor preference for riskier securities.
One cannot time markets and typically the short term is just noise. At the start of every year and once again, major financial news outlets were discussing the January effect and how the trend in January sets the tone for the year. There is no empirical evidence to support this theory and we had a great counter example in 2016 when January, 2016 was the worst U.S. stock market start in history and we ended the year with strong stock returns. So far, January has started well for stocks, both in the U.S and internationally. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A DEEPER LOOK
The fourth quarter stock market rally in the U.S. was an extraordinary example of why we stay in the stock markets with our small cap and value bias, because you just don’t know when the outperformance will occur. Well documented historical research shows that U.S. small company stocks have higher average returns than large company stocks; but long periods of relative underperformance and outperformance exist. Small cap stocks had a strong third quarter of outperforming large cap stocks and were at record highs prior to the election; and proceeded to outperform the large cap stock index by 8.6% (a huge margin). Here is the chart of the S&P 500 large cap index in blue and the Russell 2000 small cap index in green from November 2nd through December 31st: (Source: Yahoo Finance)
This is a result of the expectation of business-friendly policies that Congress may implement will likely impact smaller companies more than larger companies. At the same time, the strengthening dollar has a negative impact on large companies’ overseas revenue. However, the rally since the election, which has been mostly contained in the U.S., has been so rapid that it is likely ahead of itself. Investors will need to see follow through from the administration and positive capital spending news from corporations during earnings season, which begins in the second half of January. Financial market research also shows that U.S. stock market performance compared to international stocks is cyclical and currently, the U.S. has outperformed international stocks for 110 months (over 9 years), which is one of the longest cycles of relative outperformance on record. We are watching a number of positive indicators, including a strong U.S. dollar, lower valuations in Europe and emerging markets, economic expansion in Europe and higher inflation expectations, which could reverse this trend. The stronger economic data around the globe has helped the case of lifting inflation expectations so that deflationary pressures are not nearly as strong. In summary, inflation is once again the stronger force in the discussion of a stagflation / deflation scenario.
Economic data in the U.S. and around the globe was positive enough to further reduce expectations of a developed market recession in the next 12 months. However, when stocks climb faster than corporate profits, valuation multiples expand and they were already elevated in most risky asset classes. At the end of 2016, The P/E 10 ratio (price divided by 10 years of earnings) was 27.9, which is a new interim high since the great recession of 2008/9; and a few percentage points from hitting two standard deviations above the historical mean. At the end of the fourth quarter, the S&P 500 P/E ratio was 20.5 for 2016 year-end EPS, compared to the historical average of 17 and if we look at the S&P 500 price to sales ratio, it is over 2 for the first time since 2000 (currently 2.01). Global growth is still low, global debt levels are still very high. We are closely watching growing auto loan and student loan debt in the U.S., non-performing loans in Europe and China and other variable rate debt, which is now more expensive due to higher interest rates. It is wise to be prudent and we will continue to be prudent in our investment committee meetings in the coming weeks. The U.S. stock market has high expectations built in for the new “business friendly” president and our current late stage economic cycle. We will be watching for any catalyst that could cause a significant re-pricing of risky asset classes.