Data suggests more upside

Coming off a weekend of political disappointment, it’s easy to get caught up in the emotions of it all. As I pointed out, the market was due for a pullback, and it got a reason to. We can “beat a dead horse” and dissect all of the “what-if” scenarios and implications of the failure. But none of this will be fruitful for your investment decisions. We know that pullbacks and corrections are an inevitable part of investing. And once in awhile we get a major decline, usually due to a recession. The key question is does the data suggest a business cycle peak?

The short answer is no.

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Consumer confidence numbers just came out at a high not seen since November 2000.

Small business optimism

Scott Grannis points out that Small Business Optimism has soared post election and is near all time highs.

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Earnings growth is finally back and is projected to be around 9-11% for 2017. This would be the largest annual increase in earnings since 2011. And this doesn’t even factor in the potential for tax reform and repatriation.

And interest rates are still very low. The earnings yield on the S&P 500 is currently 5.59%, while the 10 year treasury bond yield sits at 2.38%. Even the Fed’s overly optimistic projection suggests the real Federal Funds rate won’t even turn positive until another two years or so. So, even though valuations are on the high side and interest rates have risen quite a bit post elections, stocks still present an attractive risk premium.

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An interesting chart to follow going forward is the ten year yield. Post election the 10 year yield has risen on the assumption of pro-growth policies of the new administration. Since then a trading range between 2.3% and 2.62% has been formed. An upside breakout suggests all is clear, while a breakdown suggests that more of the President’s agenda may be in jeopardy.

Time will tell. But for now, things are looking pretty good to me. But I parse this by saying we’re probably closer to the end of the bull market, than we are to the beginning. The stock market and the economy don’t always correlate. We’ve had great performance in stocks over the last 8 years, while the economy largely under-performed. I wouldn’t be surprised if, going forward, we experience a situation where the economy starts to outperform, while stock performance slows down to an eventual crawl.

The great thing about diversification and asset allocation is that we don’t have to be prophetic. We stick to our strategy and re-balance when necessary. It’s that simple, but certainly not easy.

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Don’t fear a market correction…

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Today the market has experienced its largest intra-day decline for the year. There is no doubt that you’ll hear numerous explanations for the decline, from the health care bill, to Dodd-Frank and bank stocks. The truth is that these market corrections are commonplace and they usually come and go without any real rhyme or reason. The simplest explanation for today’s price action is that the market was simply over extended in the short term and was due for a pullback.

The chart above is the weekly chart of the S&P 500. We see that when price gets too far away from the 50 week average, there is oftentimes a reversion to the mean. This is natural and it doesn’t mean the “big crash” is upon us.

It’s been years since the S&P 500 got this far above its 50 week moving average. And in most instances when it gets 10%+ above the 50 week average, a correction usually follows.

Corrections between 5%-15% occur frequently, and it’s almost impossible to time. This is why having an allocation to high quality bonds can have some benefit. As they will generally appreciate and offset some of the decline in stocks, thus limiting the volatility of the total portfolio. This way you don’t need to try to time the corrections, you simply let the diversification benefits hold you over until the dust settles.

This is also a great time to assess your investment strategy based upon your emotions. If today’s actions have you concerned, you may be more aggressive then you can tolerate. After all, we are still only down about 3% from all time highs. So it’s not even an official correction yet. But it’s better to be prepared beforehand, because they don’t ring a bell and let you know the market is topped out and ready for correction.

 

Q4 performance not as good as it seems…

Successful investing involves remaining balanced when market forces tempt us to make major portfolio decisions at inopportune times. Q4 was an interesting transition period and I think investors need to understand the bigger picture to avoid making any reactionary decisions.

We’ve spoken at length about how the Dow hitting a meaningless 20,000 target should not change your approach. The Dow is a broken index with only 30 stocks without broad sector exposure.

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Let’s dive into the Q4 performance. The chart above shows Q4 performance for the major asset classes. As you can see, it’s not nearly as good as the media portrayed it to be. The S&P 500 was up close to 4%, but the bond market fell by an equal amount and international stocks were also negative, due to a rising US dollar.

It’s very possible that a globally diversified portfolio ended the 4th quarter negative.

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If we drill down to the sector performance for the US stock market, we can see that the relative strength came mostly due to Financials, Energy and Industrials. Of course these are the same sectors that have under-performed much of the last five years.  The consumer discretionary (Amazon’s), Technology, consumer defensive and health care sectors all under-performed on a relative basis.

I would venture to say that many investors had more exposure to the sectors that under-performed. So the temptation for investors is to now pile into the thing that has gone up the most. So go all in financials for 2017?

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But before you go there. Take a look at this annual sector performance chart. Can you see any discernible patterns here?  If anything you can see that oftentimes the best performing sector one year turns out to be the worst performing sector the next. So before you go making a major change because of one quarter’s data, remember that change isn’t likely to yield any significant positive outcome.

This all brings me to the main message. The markets can do crazy things in the short term. But the reason why we invest doesn’t change. We don’t invest for one quarter, or even one year, we invest for long term goals while maintaining a certain level of risk.

Unfortunately there is no strategy that works well in every market environment. A conservative allocation will do well in periods of volatility, and under-perform when the stock market is rising rapidly. An aggressive portfolio will work great when the market rises rapidly, but will be very painful during the inevitable downturns.

A balanced portfolio will mean that you’ll usually hate some part of your portfolio each year. But oftentimes that part of the portfolio that you hated last year, will be your best friend the next, as mean reversion runs its course.

Rather than trying to constantly predict what type of market environment we’ll experience each year. It’s best to accept that just like the seasons change, the markets seasons change too. Periods of declining markets give way to periods of rising markets, which give way to periods where the market moves up and down without making any direction (not always in that order).

Investors should be more concerned about what what typically works over time, rather than what is working right now. The truth is that long term investing should be rather boring.

Don’t be surprised if 2017 starts off slow…

No one knows what the market will do on any time frame. As the Dow nears the meaningless 20,000 target, investors will be tempted to overreact and chase the market.

We have to understand that a significant correction (10-20%) can happen at anytime, even with no rhyme or reason. Major market declines (30%+) almost always occur because of an economic recession, but that’s not a given either.

This means that investors should continue to “stay the course” with their investment plans and not react to these moves. The old adage goes “the public loves stocks when they are expensive, and hate stocks when they are cheap”. Do whatever it takes to not fall into this category!

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The S&P 500 has moved about 2% below it’s recent highs as we close out the year. There has been more optimism than at anytime during this 8 year bull market, and that could certainly carry over into 2017. But don’t be surprised to see a slow start to the year.

The S&P 500 has support around 2195, and 2165 would be a 5% correction (most frequent correction size of the bull market). These levels could come into play, if indeed the market decides to take a break to start 2017.

Also January has been a tough month in each of the last three years. SPY returns for January:

2014   -3.52%

2015   -2.96%

2016   -4.98%

No one knows if the pattern will continue or be broken. This is why it’s best to stay away from the prediction department. Especially with your portfolios!

“Animal spirits” shouldn’t have a place in your investments

For those who are contemplating making portfolio changes as a result of this recent rally, ask yourself if you panicked on election night (when the Dow was down 800 points)? Or earlier this year when the market got off to its worse start on record? Or last summer when the Dow opened down 1,000 points?

In other words, the people who now want to chase the market after recent gains, are the same who are first to panic when inevitable volatility hits. This is a result of recency bias, or the temptation to chase gains, even though it hurts much more to lose money than to lose out on making money.

First, let’s put this recent rally into perspective. A 1000 point rally sounds great, but it’s only about 5% when the Dow is at 19,000. It’s important to look at percentage moves, instead of how many points the Dow moves. At 20,000, the daily point swings in the Dow are going to be higher than usual.  Just like the 800 point drop in the Dow on election night sounded worse than it really was (4%), a 1000-1500 point increase sounds much better than it really is. Much of the gains have come from the underperforming sectors of the last few years (Financials, Industrials, and Basic Materials). And as long as we are on the topic, the Dow index itself is flawed and shouldn’t be looked at anyway.

It appears part of the rally is due to an increase in sentiment. Let’s not forget that sentiment was favorable when George Bush, Jr. took office. His MBA and understanding of business was supposed to be very supportive for stocks. The result was one of the worst 8 year periods for stocks in recent history. This isn’t a fair comparison because this time period includes 9/11, a catastrophe no one could ever have predicted, along with two economic recessions. But fast forward to 2008 and the consensus was that Barack Obama was going to be awful for the stock market. The result was one of the biggest bull markets on record.

This is not to draw any conclusions. I’m simply pointing out that sentiment doesn’t always equate to actual performance. Because of one month’s performance, conservative investors now want to become more aggressive. We know that stocks don’t go up forever, and they don’t go down forever either. We’ve been saying for years that things aren’t as bad as they are being described. And as the Dow inevitably trades above the 20,000 level, sentiment may eventually swing too far in the opposite direction.

The reality is that the market has more than tripled over the last seven years. Even though the market is likely to move higher, it’s hard to envision similar performance over the next seven years. In fact I think it’s safe to say it’s more likely we experience a bear market (recession) before the market triples again.

It’s usually best to maintain a balanced approach to investing. Not getting too carried away when things look bad (stocks go on sale) and when things look good (higher valuations, lower dividends, lower expected returns). Focus on those things that you can control, such as keeping costs low and maintaining an asset allocation strategy that suits your risk tolerance and time horizon. And don’t scrap a perfectly good aset allocation just because it underperformed for one month. Animal spirits have no place in your investment accounts!