Down over 2,000 points in mid- January to 15,450, the Dow Jones Industrial Average enters 2017 flirting with 20,000.
Down three games to one, the Cleveland Cavaliers won three straight to take home the NBA Championship. Down three to one, the Chicago Cubs came from behind to win their first World Series since 1908. Down over 2,000 points in mid- January to 15,450, the Dow Jones Industrial Average enters 2017 flirting with 20,000.
In many respects, 2016 was the year for exceeding low expectations. In the sports world, we watched the Cavaliers and Cubs fight back after most everyone had written them off. Even the Vanderbilt Commodores, who finished with two upset wins, earned a bowl bid. Outside of sports, there was Brexit, oil at $26 and now back to $54 per barrel, an actually good new Star Wars in The Force Awakens, Bernie Sanders’ improbable run, and, of course, President-Elect Donald Trump emerging from a crowded Republican field of seventeen.
We can’t or won’t speak to the wide range of emotions evoked by the sporting events or the politics. As for the record stock market gains, which few if any predicted, it feels pretty good, especially considering where we were in January. And where many titans of Wall Street (individuals and entities) claimed we’d be due first to the threat of higher rates and oil bust, then Brexit, then a Trump victory.
The chart below graphs the 2016 returns for the S&P 500, MSCI All-World, Russell 2000, and the Barclay’s Aggregate Bond index. The S&P 500 and MSCI All-World indices returned 12% and 8%, respectively. Up 7% through November 8th, the small-capitalization Russell 2000 soared post the election to finish the year with a 21% gain. Higher rates post the election reduced the Barclay’s bond index’s gain for the year to just 3%.
A Tough Act to Follow
How fitting in a year of sports and political upsets for the markets to prove so many prognosticators wrong. We were far from having the gumption to jump all-in at the February or October lows, or on November 8th for that matter. We are pleased, however, to have maintained where appropriate significant client exposure to equities defending them most recently in our October and Election Day commentaries, including making the case for a potential “upside surprise” from the now much anticipated 2017 corporate tax reform. We won’t get them all right, but experience tells us rarely is a broad-brush “sell equities” the appropriate advice for clients.
In the following pages, we share our views on some of the most significant opportunities and obstacles of 2017 and how we’re positioned as a result. Spoiler alert — 2017 will be “unpresidented” [sic] or at least unconventional in many ways. The economic data continues to improve and some level of fiscal stimulus from tax reform and fewer regulations is probable. Yet the pace of the recent rally amidst considerable domestic and international policy uncertainties means we’ve likely borrowed from 2017 returns. At a minimum, we’re in an environment where stock-picking once again matters versus the risk-on/risk off toggle of recent years. Moreover, the growing U.S. valuation premium versus the rest of the world may finally incent investors to look abroad. This could boost lagging international equities, which despite a fast start to the year, have represented dead money for many clients the past couple of years.
The bottom line — this will be an eventful year whether as a result of the political, cyclical, unexpected, or now a heightened bar for the expected. And we are, after all, eight years into a U.S. stock bull market, thirty years into a bond bull market, and an emerging Super Bowl favorite, Dallas Cowboys, are no Cubbies! Even still, “sell equities” is not our call. Instead, we’ll hold some cash and keep exposures at the low-end of target ranges to reduce risks versus attempting to jump in and out of markets. Those who tried the timing approach in 2016 for fear of the unknown can likely attest to the merits of staying on a course consistent with the risks you are willing to accept.
Consumer Sentiment: Out of the Doldrums
Consumer sentiment hit a 12-year high in December. Perhaps it is the “wealth effect” from new market highs, the economic cycle, or universal relief that a long and divisive Presidential election season is behind us. Ray Dalio of Bridgewater Associates might attribute the improvement to early signs of the “animal spirits” he spoke about recently when assessing the potential boost from the prospects of lower taxes and fewer regulations. Whatever the reason, holiday retail sales are projected to be strong up 4% versus last year. This could be the highest level of growth since 2005 and the first year ever to achieve $1 trillion in holiday sales. Amazon is a growing force behind these sales having shipped one billion (yes with a “b”) packages this Christmas/holiday season.
Not all ships, however, have risen with this new retail high water mark. Traditional retail business models are still under assault. In-store traffic is flat to down, and only a few retailers are successfully re-directing lost foot traffic to online activity and even then rarely at attractive margins. Consumer preferences have changed too. Led by millennials and online sharing, possessions are out and experiences are in. Travel stocks have enjoyed this shift. Thanks to record traffic and lower oil prices, airline stocks have performed well. For our most risk-tolerant clients we’ve been believers in the evolution of the sector since 2011. Mr. Buffett’s 2016 purchases of American, Delta, Southwest, and United, which represented a stark about face from years of disdain, has contributed to broader investor interest and recognition of this consumer theme. Of course, not every travel theme looks sustainable. Capital starved during the financial crisis, hotel companies or more specifically their capital partners, are adding rooms at a rapid pace. Some estimates have the upscale new-build pipeline at 22% of inventory. Our hometown of Nashville has more than 11,000 rooms scheduled for construction in the next 12 months. Planning a visit but surprised by the room rates? Check back in mid to late 2017.
Whether for possessions or experiences, consumer behavior remains key to economic activity at approximately 70% of GDP. Housing equity and low interest rates have helped drive improved activity in recent quarters. Yet since September, the fixed rate for a 30-year mortgage has jumped from 3.4% to 4.3%. We’ll be interested to see how these higher rates affect behavior in 2017.
We All Know Where Aleppo Is Now
Libertarian Presidential candidate Gary Johnson made headlines in September when he botched a question regarding Aleppo. The question, which could have referenced a number of trouble spots around the world, highlights how many Americans have tuned out when it comes to international strife. Perhaps as a result, US policy remains in flux and politicians’ answers are nuanced at best for the role of the United States in Aleppo or abroad in general.
Then there is Russia. Friend or foe, one thing is certain. President Trump’s Russia policy will be watched as closely as any peace-time diplomatic relationship in decades. The allegations surrounding Russia’s attempts to influence our elections, and their apparent cyber sophistication, makes 2008 presidential candidate Romney’s concern for our relationship with Russia somewhat prescient.
Europeans will be watching the evolution of the Trump Russia doctrine closely. But, it is far from the only 2017 unknown on the continent. France and Germany will hold elections. All indications are the new leaders will pursue more nationalistic agendas that would further strain the increasingly tenuous European Union. Brexit may well have been the tip of the iceberg, and recent ISIS terrorist activity in France and Germany may be the chunk that breaks the hull. Currency traders seem to have a view given the Euro’s weakness versus the dollar, which has only been exacerbated by recent increases in interest rates in the United States.
The Bully Pulpit Brought to You By Twitter
On election night, market futures initially plunged 5% as a President Trump victory became apparent. By the market open the next morning all was well. Besides clarity around another peaceful transition of executive power from one party to another, markets started focusing on the potential for pro-business policies under a Republican President, who also has majorities in both houses of Congress. Having only months before predicted a “crash,” investor activist and Trump supporter Carl Icahn left the election night party to purchase $1 billion of stocks.
We certainly agree corporate tax reform and a fresh look at Federal regulations, which some estimate represent a $1 trillion a year U.S. economic headwind, could stimulate growth. This is not partisan but economic reality in today’s global marketplace where capital is fluid. What has surprised us is how markets seem to have accepted these reforms (the non-protectionism versions) as a foregone conclusion. Yet if we’ve learned anything about Washington in years past, it is that nothing is easy. In fact, besides possible tax changes via budget reconciliation, which require budget “neutrality,” long-standing and sweeping legislation takes sixty votes in the Senate. The Republicans have 52 seats.
As a result, the first 100 days of the Trump administration in particular are going to be very interesting, and perhaps just about all that matters in determining whether equities hold firm and possibly grind higher, or give back the Trump rally. Thus, we’ll be watching for those Bully Tweets very closely.
Is The Bond Bull Market Over?
In July, the Ten-Year U.S. Treasury yielded just 1.4%. Roughly $13 trillion of global debt yielded 0% or less. Fast forward six months and the Ten-Year is at 2.4% and now just $11 trillion of global debt yields 0% or less. For years, bond investors have enjoyed the capital appreciation from falling rates. In recent months, they were reminded how bond values decline when rates rise. This reality served as a notable drag for balanced-account investors (i.e., those who own stocks and bonds) during the post-election stock rally.
The recent rise in rates has been fueled by improvements in the economic data, including an upwardly revised 3Q GDP estimate of 3.5%. The now finally data-driven Federal Reserve bumped up rates in December and has indicated it plans to increase rates three times in 2017. In addition, interest rates have responded to the potential fiscal stimulus that characterizes much of the Trump agenda, which would prove inflationary.
U.S. Ten-Year Treasury Yields:
For years now, we’ve resisted reaching for yield via longer-dated bonds. As a reminder, a 1% change in rates can result in a 20% decline in a thirty year U.S. Treasury issued at today’s prices. Of course, for investors in need of income doing nothing is hardly a solution. Thus, we continue to opportunistically accumulate five-year and up to ten-year bonds when prices come in and the spread between Treasuries and either corporate or municipal bonds widens. Capping duration reduces the risk if inflation materializes in a meaningful way. But, going ahead with some purchases recognizes the potential of a lower for longer Japan-like scenario, and the demand for U.S. debt among international investors living in an even lower-yield world. The trillions behind this demand will compete with the inflationary pressures in determining when rates return to historical levels.
In October We Pushed Back Against the Idea of a Stock Bubble. So What About Now?
Many market seers were negative on the markets’ prospects earlier in the year only to turn positive as of late. The high profile and generally cautious investor, Stanley Druckenmiller, claimed “the bull market was exhausting itself” in May only to “make large stock bets on economic growth” in November. He has not been alone in shifting his views. So what changed? Put simply, investors’ confidence that the “E” in the Price/Earnings equation will grow has increased. And when investors get excited about the potential for earnings growth the “P” usually moves in advance of the “E.”
Wall Street expectations for 2017 S&P 500 earnings currently stands at $130, which represents 7% growth over 2016. After the S&P 500’s 5% move since November 8, this puts its P/E multiple at 17X compared to 11X in 2011 following the U.S. debt downgrade sell-off and 25X at the height of the 2000 tech bubble. The historical forward P/E average is 16X. These ratios are based on “adjusted” earnings instead of GAAP, which if honored would put the P/E multiple at least 6% higher. This discrepancy fluctuates and is difficult for the purists among us to accept. Yet despite the SEC’s recent efforts to reduce the level of adjustments in company reporting, we acknowledge living in a pro forma world.
Deutsche Bank estimates that for every 5% reduction in the corporate tax rate, S&P earnings increase 4% on a $130 base. A 10% reduction, without regard for the implementation or any economic effects, would boost S&P earnings by 8% for a theoretical 16X 2017 P/E. Clearly, this has been the source of much of the markets’ optimism of late. The fact small-capitalization stocks, which generally pay higher tax rates due to their domestic focus, have greatly outpaced other indices since the election only supports the conclusion.
Many factors influence stock valuations, including the discount rate which increases with higher interest rates thus depressing stock valuations. The corporate tax reform math, however, is simple, potentially significant, and front and center. Thus, we expect near-term market activity will be correlated closely to the size and type of corporate tax reform investors can expect.
If reform is significant and our leaders avoid trying to pick the economic winners and losers via certain protectionist measures, stocks may still look cheap given the earnings boost and options the additional cash flow provides companies. If reform is marginal, and clouded in protectionist politics that can depress economic growth, investors will be disappointed and the “P” will adjust quickly for a reduced outlook for the “E.”
After the tax reform dust settles, we can think more about whether companies focus on “pre-tax” or “post-tax” rates of return when pricing goods and services. A theoretical question now, the eventual corporate management perspective will impact how much of the tax-rate boost ultimately improves company earnings.
Be at war with your vices, at peace with your neighbors, and let every new year find you a better man. Benjamin Franklin
No doubt many of us have made a New Year’s resolution or two. If you haven’t recently, we would encourage you to add to your list revisiting your financial plan and investment goals. We recognize many of our clients have their own resources to determine spending patterns, college savings, charitable gifts, and estate plans, relying solely on us for investment management. But, for those who look to us for a financial plan as well, we would welcome the opportunity to lead you through this exercise. It is included as part of how we serve clients, and could prove a good distraction to actual exercise, which is New Year’s resolution number one for many of us!
The April “Fiduciary Standards” Watch
Another way we serve clients is to disclose all costs and place their interests ahead of our own. These fiduciary standards have always been requirements for registered investment advisors like Woodmont. In 2016, the Department of Labor decided that effective April 2017 these standards will apply to all financial advisors servicing retirement account clients. Amidst continued industry lobbying, there is speculation the expansion set for April could be reversed. Regardless, nothing on our end will change. Woodmont appreciates the trust our clients place in us and will continue to honor that trust with transparency and the alignment of interest a fiduciary standard requires.
Thank you for your continued confidence. Best wishes for a healthy and prosperous 2017, and please know we look forward to discussing your investments and answering any questions you may have.