Client Letter: Emotions, Politics & The MarketSubmitted by Alsworth Capital Management, LLC on April 26th, 2017
First Quarter 2017 – Emotions, Politics & The Market
The buoyant mood that pushed stocks higher through year-end 2016 continued into the first quarter of 2017. Stock indexes were up across the board globally. Emerging-market stocks were the star performers, with double-digit gains. Developed international stocks were up 8% and U.S. stocks were up 6%. Bonds were basically flat on the quarter. This was a positive development considering the recent spike higher in interest rates, which reduces the value of existing bonds that pay lower coupon rates.
The Small Business Optimism Index is running near historic highs, having spiked dramatically after the Presidential election. To give it some perspective, the index was at a low of around 80 in 1980 and again in 2008 after the Great Recession. It historically averages around 95-97 and has been consistently around 95 since 2010. It spiked after the election to nearly an all-time high at 107 and currently sits at 105. Business optimism has historically correlated with a small uptick in hiring and capital investment, though it has been a poor indicator of economic trends and a poor indicator of future stock market performance. None the less, I think it is an important statistic, especially given the significant reversal and spike in the data, which is an outlier in the historical trend. It fits a narrative that I hear from the small business community and it does seem to correlate with recent investor sentiment indicators, which have also been running high. To be clear, these indicators are tracking “feelings” and not hard economic data. In the long run, market prices are dictated by hard fundamental data. In the short run, they can swing unpredictably based on the emotional reaction of human beings. The election result was a surprise to anybody that was following polls, myself included. The resulting market reaction was not predicted by any credible strategist’s and could likewise be called a surprise. It makes sense, in retrospect. Promises have been made to slash taxes, spend $1 trillion on infrastructure projects, eliminate environmental regulations and reduce burdensome (expensive) business regulations. What remains to be seen is if these pledges can be turned into actual legislation and if the resulting deficit spending will boost economic growth.
In the long run, politicians have limited impact on the economy. The economy is a large and complex web of competing interests and the historical data shows very little correlation between changes in political party (executive or legislative branches or any combination) and the corresponding economic growth rates. Stock markets follow economic trends over the longer term, though they are subject to wild swings over the short term. I believe the current political environment is so charged and erratic that the emotions of politics are seeping into the emotions of the short-term stock market more than historical data would indicate. We can’t predict emotions and the political landscape is highly unpredictable at present. As such, we are not making portfolio allocation decisions based on forecasting politics and we work very hard to eliminate “gut feelings” and operate in a data driven environment.
US corporate profits are still relative high and there is no indication of an impending recession. This remains supportive of US stocks, though I would argue that the absolute price levels reflect the uncertain expectation of significant growth from current levels. Across several metrics, U.S. stocks are the most expensive they have been in 50 years, with the exception of the stock market bubble period of the late 1990’s. We don’t believe this time is different. We do believe valuations matter. When stock market valuations are high, the odds are your future market returns will be low. So, we remain underweight to U.S. stocks in favor of foreign stocks, where there are tangible signs of an economic recovery underway in Europe, attractive valuations, and favorable corporate earnings trends in both European and emerging-market economies.
Turning to more defensive assets, we have been well served by our intentional tilt toward “non-core” bond funds in anticipation of rising interest rates. Our absolute-return-oriented and flexible funds collectively beat the investment-grade core bond benchmark’s less than 1% gain, while our floating-rate loan funds matched its performance. We continue to believe we are well positioned to generate returns in excess of the core bond index’s as the U.S. transitions from abnormally low interest rates.
Managed futures and alternative strategies play a key role in our portfolios as diversifiers, generating returns that don’t move in tandem with those of stocks or bonds. Our decision to invest in managed futures was based both on their significant risk-reduction benefits and on our expectations of positive returns over the long term. Of course, these portfolio protection benefits come with tradeoffs that can include periods of short-term volatility. With returns that ranged from modestly positive to marginally negative during the first quarter, our managed futures and alternative strategies funds are performing in line with our expectations and reducing overall portfolio risk. It can be difficult to stick with positions that lag strong returns in other areas of the portfolio, especially when they are showing negative returns. However, this lack of correlation works to our benefit in other periods, when stocks and bonds may be declining. We continue to monitor these positions closely and we are comfortable with their role in the portfolio.
As we head into the second quarter, we are alert to emerging political risks in the United States, whether related to domestic policy or stemming from geopolitical developments. We are also paying attention to European elections and the potential for volatility. It is important to view your portfolio in the aggregate. The only reason we can expect to earn returns in any investment is because we are taking risk by giving up access to our cash in exchange for the expectation of uncertain growth in the value of the investment. There are always going to be areas of the portfolio that outperform other portions of the portfolio. There are always going to be elevated risks in certain asset classes that seem obvious in retrospect. Our job is to diversify the portfolio and weigh the desire for more certain returns with the requirement to accept risk. We can’t predict the future, but we can make informed judgments to balance your portfolio to meet your financial planning needs and risk tolerance. We have enjoyed a nice run in global stock markets and we hope this trend continues. We continue to stick to our discipline of focusing on data, looking out over a five-year time frame and balancing the portfolio with an eye on downside risk. We believe this is the best approach to building and maintaining wealth over time.
If you have any questions or want to update and review your plan, please call us anytime.
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, www.nfib.com/SBOI