Client Letter: 2016 Year End Review & Adjustments for 2017Submitted by Alsworth Capital Management, LLC on January 17th, 2017
2016 Year End Review & Adjustments for 2017
The year 2016 proved to be tumultuous on many fronts. It began with a steep double-digit plunge in stock markets and ended with a six-week equity rally. Fears of rising interest rates, volatile oil price, and the political upsets of the Brexit vote and Donald Trump’s victory in the U.S. presidential election spilled over into financial markets during the year. As a result, equities and bonds experienced intermittent dives. The year also saw reversals in a number of long-running market trends. Amid the tumult, global stocks overall ended the year surprisingly strong. U.S. stocks again took the lead, with larger-cap U.S. stocks gaining 11.8%. International stocks returned just 2.7% in U.S.-dollar terms and continue to lag the US market for an unprecedented period of time. The aggregate U.S. bond market gained 2.5% for the year. But that hid a 3.2% tumble during the fourth quarter, as rising interest rates resulted in the worst quarterly performance for bonds in 35 years. Expectations for rising inflation under a Trump administration, along with the Federal Reserve’s December decision to raise interest rates for the first time since August 2015, further contributed to falling bond prices.
Putting the markets’ performance in perspective, we were pleased to see several of our convictions bear fruit, especially against the backdrop of such a tumultuous year. Emerging Markets gained 12.2% during 2016 and were up significantly higher than that before giving back some performance in the final weeks of the year. Within the bond allocation our floating-rate loan holdings also performed well, rising 17.5% and 10.2%, respectively. Our flexible and absolute-return-oriented fixed-income positions notched gains of 8%–11% for the year, far outstripping the bond market index’s 2.5% gain.
In constructing globally diversified portfolios, we know that there will be periods of time when some portions of the portfolio will perform better than others. We hold broadly diversified portfolios to mitigate risk, understanding that we can’t predict the future or know which asset classes will outperform in a given year. We do tactically tilt our portfolios to areas that are trading at lower valuations and we tilt away from asset classes that are relatively expensive. Over the long term, we believe that this fundamental weighting will add value to the portfolio on a risk adjusted basis. While some areas of the markets and our portfolios delivered strong performance this year, others faltered, most notably our managed futures alternative allocation and our European Equity position. We continuously review the thesis for maintaining allocation tilts in our portfolio, so this is not an event that goes ignored. However, we are acutely aware of human behavior traps, such as “recency bias” or giving irrational optimism to what has worked in the recent past. It is behaviorally tempting to abandon positions that have lagged US stock performance in recent years. However, we believe it is important to resist this temptation and stick to our long-term allocation plan of buying when assets are trading low and selling when assets are trading high. Since we can’t predict the timing of these trend changes, we adopt a strategy of making changes to the portfolio incrementally over time.
Where does this leave us? Reflecting again on financial markets’ rocky start to 2016, it’s worth mentioning how quickly trends can change. While it’s unclear how 2017 will play out, we continue to believe European corporate earnings, and eventually stock prices, are poised for recovery from depressed levels. In contrast, U.S. stocks appear overvalued. Among their potential risks are historically high price-to-earnings multiples. Additionally, as interest rates rise, we may see a weakening in the support that low interest have afforded U.S. stock prices. We remain confident that over a full cycle, valuations and earnings matter, while chasing short-term performance is a recipe for disappointment. As US markets have pushed the envelope with higher and higher valuations, we have slowly taken gains and reduced our allocation. We expect to continue to do so and you should expect to see some trading in the coming days to reflect some modest adjustments.
In terms of the broader economic environment, the combination of the Fed’s plans for three additional interest rate hikes and an incoming presidential administration and Republican-controlled Congress with promises to significantly increase spending could mean higher debt servicing costs for both consumers and the government (i.e., taxpayers). We expect that interest rates are likely to continue to trend higher and we will likely continue to migrate out of traditional bonds and into alternative bond holdings as a result.
Yet in acknowledging that the year brings significant uncertainty both for the investing environment, as well as with regard to potential tax law and other regulatory changes, we see bright spots in the form of expected continued positive contributions to portfolio performance from our flexible fixed-income and emerging-market stock positions. If rates do continue rising, we also expect our alternative strategies to perform well as they shift to trend following strategies that benefit from higher rates. In addition, returning to a more normal interest rate environment will be very beneficial to investors relying on the income from their more conservative allocations to fund expenses.
Lastly, we underscore the importance of viewing investment performance from the perspective of long-term financial planning. This broader lens is critical in keeping you on track to meet your overall financial goals and in not overestimating the impact of any one quarter’s, or even one year’s, returns. If you would like to discuss recent market events or have questions specific to your financial situation, please do not hesitate to contact us.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: www.WSJ.com, Morningstar/Ibbotson data, Litman Gregory Research