4th Qtr Portfolio & Market Observations 2016

The old saying, “All’s well that ends well” is certainly apropos for last year’s stock market. The market started out with modest appreciation throughout the first nine months and ended the last quarter with a bang.  For the first 3 quarters of 2016 the S&P 500 Index was up a modest 7.84%, and then went on a tear during the last quarter. We are pleased to report that our client portfolios performed extremely well, outpacing the benchmark for 2016.

So investors say, “Great, but what is the market going to do for me in 2017?” With a new administration in Washington we can only speculate how the economy will respond to new economic policies. What investors are looking for is fiscal policy (something which has been absent these last eight years) that will finally drive the economy forward. This is accomplished through three primary methods:

  • Lowering corporate taxes.
  • Restructuring previous trade deals to be more favorable to U.S. interests.
  • Reducing and trying to balance regulations so they do what was intended and not stifle the economy. More importantly, individuals should not be blocked and eventually defeated by bureaucratic regulations while trying to start and promote small business.

This administration is seeking to enact more business friendly policies and that stance is being well received by investors. Lower corporate taxes and less regulation alone will help corporate America. Trying to get better trade deals involve negotiations, business acumen and true negotiating skills. As the wealthiest nation in the world we will always import more goods than we export, but a lower tariff on our exported goods will directly help U.S. companies.

While there are many positives affecting the stock market, there are also potential negatives. Pressure on some industry groups such as drug companies and the aerospace industry to reduce prices, many of who depend on government contracts, could potentially cause companies to lose market share; thus putting pressure on the price of their stock. Imposing tariffs on imports and bringing back manufacturing jobs from overseas will have an impact on foreign economies. While we want to grow jobs at home, too much pressure on foreign countries will hurt their economies and make it more difficult for them to afford our goods.

So, what do we think the outlook for the stock market is for 2017? We believe, overall, that business friendly policies will work to stimulate opportunities and the economy will improve over the next twelve months, which will be further reflected in the stock market. The economy has a long way to go before it is overheated. While the market has already taken into account some of the better economic outlook, it is our opinion there is further room for stocks to advance. While corrections can occur at any time we believe a major downturn is nowhere near at hand.

As happy as we all are with our 2016 results, we know that policies and actions take time to enact and, while the market is exuberant for now, its temperament can change quickly.

The Markets

Through the last quarter of 2016, the markets were influenced by two major events – the U.S. Presidential Election and the Federal Reserve’s December meeting. Whereas the outcome of the latter was broadly expected, the results of the former were startling to virtually everyone. Both of those events were deemed to negatively impact the market, however, neither of them seemed to discourage investors.

Although stock market futures briefly plunged during election night as the results started to pour in, adding state after state to Donald Trump’s column, the market swiftly turned around and rallied through the end of the year. Stocks posted numerous all-time highs as investors bet that the new administration will spend heavily on infrastructure, cut taxes, and reduce regulations. This newfound optimism allowed the market to take the Federal Reserve’s December interest hike in stride. As a result, after declining through the entire month of October, the S&P 500 Index rallied almost 200 points since the beginning of November, rising by 3.82% for the quarter and 11.95% for the year. The Dow Jones Industrial Average gained 8.66% in three months, bringing its year-to-date advance to 16.50%. The Medium and Small Cap indexes, which are typically more volatile, performed best. The S&P Mid Cap Index added 7.41% for the quarter and 20.73% for the year, and the Russell 2000 Index of smaller companies increased by 8.82% for the quarter and 21.28% year-to-date for 2016. The technology-heavy Nasdaq Composite lagged with a relatively small gain of 1.69% for the quarter and 8.97% year-to-date. The composite’s weaker performance is a reflection of investors’ lack of confidence in the future earnings of some of the fast-growing and highly valued stocks included in the benchmark due to rising long-term interest rates. Rising yields also took a steep toll on the shares of the utility companies, whose high dividend yields became less appealing, making it the worst performing sector in the S&P Index in the last quarter of 2016. Conversely, higher yields along with the prospects of less regulation under the Trump administration helped the financial sector to become the best performer for Q4 after jumping almost 14% in the month of November alone. The typically defensive Consumer Staples and Health Care sectors posted losses in the fourth quarter, with the latter posting the first negative return for the year since 2008.

Outside of the U.S., the markets were negatively affected by the post-election U.S. dollar rally. The MSCI EAFE Index of the developed countries fell -1.04% for the quarter and -1.88% for the year. The MSCI Emerging Markets Index lost -4.56% for the period of the last quarter, which reduced its year-to-date gain to 8.58%. 

Given the post-election growth sentiment and the subsequent rotation into equities, interest rates on fixed income securities rose in a very rapid fashion. The 10-Year Treasury yield increased from 1.63% at the start of the quarter to 2.45% at the finish. As a result, the Barclays Aggregate Bond Index produced a quarterly loss of 2.98% and finished the year with 2.65% gain. 

The Economy 

The U.S. economy has continued to steam ahead with final revisions for the Q3 Gross Domestic Product coming in at 3.5%, up from the sub-par 0.8% and 1.4% for the previous two quarters. Growth has been supported by strong consumer spending, business investments and a pick-up in exports. This quarterly GDP number represented the highest growth since Q3 of 2014, with both the service and the manufacturing sectors expanding. With positive, pro-growth sentiment put forth by President-elect Trump, economists have been optimistic about future growth of our domestic economy.

The labor market continued to tighten, adding an average of 165,000 jobs for the previous three months through November. These gains helped to reduce the national unemployment rate to 4.6%. Jobless claims extended the trend of below 300,000, a streak not seen since 1973.

As the year was coming to an end, consumer confidence looked remarkable. The Conference Board’s monthly Consumer Confidence Index increased substantially in November and December, reaching a 13-year high not seen since the beginning of the Iraq war.

The last quarter also saw a pickup in inflation. Core consumer prices, which exclude the effects of food and energy, climbed 2.1% year-over-year through November, reaching the Fed’s 2% goal.

Given the strong sentiment and the moderate pace of the U.S. economy, the Federal Reserve decided to hike the federal funds rate by 25 basis points during its last meeting of 2016. This move was broadly expected and the attention of the market was aimed at the pace of future hikes. The FOMC put forward the possibility of three rate hikes in 2017 versus a previously suggested two; although the Fed officials strongly emphasized that oncoming tightening will be “gradual”.

Outlook 

After the triumphant end of last year, Wall Street is entering the first quarter of 2017 with a good deal of optimism. Economic signals have looked much better lately compared to a year ago, and the stock market appears to be on a much stronger upward path than it was in the beginning of last year. Following the decline in four consecutive quarters, corporate earnings made the turn from negative to positive, and the jump in earnings growth expected for 2017 helped to ease valuation concerns. We are witnessing rising business, consumer and investor confidence which can be attributed to the more business-friendly proposed policies of the incoming administration.

Donald Trump has already made history in the stock market, as the Dow Jones Industrial Average greeted him with the biggest gain in the first five weeks than any President-elect since 1900. However, come January 20th, we will come to grips with the connection between the campaign rhetoric and the reality. All the commendable ideas such as a corporate tax cut, increased infrastructure expenditure, especially in the form of a private/public partnership as opposed to federally funded spending, and regulatory overhaul definitely point to growth, but the continued pressing of anti-trade and pro-tariff promises could dampen the pro-growth agenda.

We are keeping an eye on the Fed, which could be forced to be more aggressive if inflation or growth heats up enough. We are also following the strength of the U.S. dollar, which could tighten financial conditions and hurt earnings for multi-national companies. However, we share the optimism as it relates to the U.S. markets in 2017 although we do not expect the trajectory of gains to be as ferocious as the one we saw immediately following November 8th, 2016.

In the twenty-plus months leading up to the presidential election, many U.S. markets overall didn’t do much more than earn income and dividends. Subsequent to the election, stocks and Treasury yields surged. Looking ahead, it’s impossible to know how policy will take shape—and how effective it will be. That’s why we believe that the best, sustainable path toward long-term returns is a diversified portfolio that can capture more of a market’s upside and less of its downside.

Dumont & Blake Investment Advisors, LLC
December 31, 2016

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