December turned out to be a continuation of the November rally in stocks. All the major indices – domestic and international – were up for the month. Bonds continued to suffer in the aftermath of the U.S. Presidential elections as the dollar and commodities remained strong through year end.
|U.S. & International Stock Index Returns|
|S&P 400 (Midcap)||2.36%||18.73%|
|S&P 600 (Small Cap)||3.86%||24.74%|
|Barclays Agg. Bond||2.64%|
|CRB Commodity Index||9.51%|
|U.S. Dollar Index||3.66%|
Source: Morning Outlook January 3, 2017
To the surprise of about everyone the U.S. stock market had more than a very good year in 2016. The Dow, the S&P 500 and the NASDAQ all shook off a surprise of a Presidential election and an interest rate increase to hit new all-time high levels, ending the year up an impressive amount. Global stock markets didn’t fare quite as well, but December turned up, giving hope for a turn of fortunes in 2017.
Looking back at 2016 what we had was a tale of two markets – the first six weeks and then the rest of the year. Beginning on January 2, 2016 the U.S. stock market turned decisively negative based off of bad news coming out of China in relation to their equities markets. This trend stayed in place for six weeks, allowing many to question the validity of the 6+ year move higher which began in March 2009.
After six weeks of market jitters and the S&P 500 finding a bottom around 1820 the stock market turned around and headed higher, ending the year at 2238 (see chart #1). As one would expect the move higher was not straight up. In fact, the year had the feel of a grind, moving sideways or down from the early summer through the November 8th election, when the market caught a bid. A similar path to new all-time highs can be seen in the Dow Industrials (chart #2)..
Interest rates continued higher in December as the 10-year U.S. Treasury yield closed the month at 2.50%, off a peak of 2.60% earlier in the month. After a strong move higher in November the continued strength would not be considered a surprise. What we are left to ponder is where do rates go from here?
We know it’s a fool’s game to try and predict where interest rates will move. Knowing what comes next could make us eventually look foolish; Chart #4 gives some perspective on where rates are relative to the past 15 years, and how to think about what rates may look like in the future. What is obvious is the distinct break above the downtrend line from the 2008 rate peak. For almost eight straight years the trend was down. Over the summer the 10-year Treasury bond hit a low yield of 1.36% before rallying hard to current levels. From the look of the chart we believe there is a reasonable chance of that being the historic bottom of the 35 year bull market in bonds. Time will tell if this analysis is correct.
Our current concern is how the market reacts to the higher rate environment. After a quick spike up in rates over the previous two months a pullback or sideways movement in rates is to be expected. Once the market “rests” for a bit we should know more. If rates stay above the trend line we would then assume that the trend has changed. If on the other hand we see rates fall below the trend line again, the move up was one big market overreaction and nothing has really changed.
Time will tell …
The breakout in U.S. Dollar strength is starting to look and feel real. After a long consolidation period the dollar has quietly continued to move higher, ending the year up 3.66%. Dollar strength is important to markets in a number of ways. For commodities, which are traded in dollars, currency strength tends to keep commodity prices low (at least in dollar terms). For U.S.-based multinational corporations, dollar strength is a headwind for overseas earnings. If the dollar slowly gains strength it is manageable. On the other hand, a big move higher like we witnessed in 2014 would produce a tornado-like headwind for any company with off-shore earnings.
December witnessed more consolidation for commodities. The strengthening U.S. dollar appears to have had little or no effect on pricing. Nothing much to see here.
Looking Back at 2016
In the coming weeks we will be publishing our Stock Market Outlook for 2017. Last January we believed that 2016 would be a year of transition for the markets. Our best idea for the coming year was to rid your portfolio of weak holdings and make sure your asset allocation was in line with your goals and risk tolerance. We saw more volatility on the horizon. Money management equals risk management in our book and after a 200%+ return for U.S. equities we felt the time to take some risk off the table was prudent. The first six weeks of the proved us correct, for at least the first six weeks of the year.
Soon after the market bottomed we began to believe in the stock market. The market reversal in February led us to cautious optimism by the end of the month. By the end of March we were on board. In our March 2016 Stock Market Wrap Up we said the following:
“There’s an old market adage that states that markets can stay irrational longer than you can stay solvent. Stated differently, bull and bear markets can and will go longer than you expect. If you fight the trend because you think you know more than Mr. Market, good luck with that. Such bullheadedness doesn’t usually work out for those without the deepest of pockets.
This is why we just can’t write off these markets. As we look at the bigger trends that feeling inside may be absolutely correct. Or wrong. Only time and markets will let us know. So while it is uncomfortable staying with stocks, assuming low interest rates and commodity prices, and a range-bound U.S. dollar, we have no compelling reason to change course.”
Over the rest of 2016 we remained bullish on equities and more cautious on bonds, particularly after yields had started to move off of the market bottom or 1.36% yield for the 10-Year U.S. Treasury. It was challenging at times to remain bullish, but not as much as you might think. Politics … oh that dreaded word … had a lot of people making assumptions about what would happen post-election based off of a Clinton or a Trump victory. And yes, we do have a variety of political opinions amongst us, when it comes to the markets those opinions are meaningless. What we pay attention to is the markets.
In our October Stock market report we noted the relative strong showing of the U.S. equity markets. September and October were negative, but not by much. Both of these months, by the way, are in general not good. According to Jeffery Hirsch’s Stock Trader’s Almanac 2017 the average monthly return for the month of September since 1950 is -0.5% (page 50) while October is known as a “jinx” month (page 90) because of crashes in 1929 and 1987, along with the 554 point drop on October 27, 1997. That we made it through those two months relatively unscathed felt like a big win at the time (and still does).
So where do we go from here. Not to give away all of our thoughts, we still see equities with a wind at their back. In the short-term markets move on emotions, but over the long haul they move based on earnings. With oil prices higher the energy sector and the industrial companies that service it should earn more. With higher interest rates the banks will be more profitable. And with what appears to be the political desire to decrease corporate tax rates, Corporate America is looking at a bump in earnings. The earnings recession appears to be over, giving stocks a real possibility of a tailwind.
At its December meeting The Fed indicating three rate increases in 2017, helpful to the buyer of bank-issued CDs who should see more interest when they renew their CDs. For the bond buyer we expect it to be a hard environment. When the interest rate on bonds increases the value of bonds will decrease in value. Even though we are not convinced we will see three rate increases in 2017 we do expect to see rates trending at least modestly higher. So as you might expect we see tough sledding going forward for bonds.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com