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Fourth Quarter 2016 Investment Report

Prognostication

2016 may go down in history as the poster child for the axiom that it is impossible to magically predict how the stock market will perform.  Of course, that makes much of the print you read, or gurus you watch or listen to, meaningless.  But don’t take our word for it.  At a presentation at the University of California on April 15, 2003, Steve Forbes, publisher of Forbes Magazine said:

             “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”

Forbes is basically saying most investors would be better off if they covered their eyes and ears when any predictive information on the stock market appears on a screen or in written communication. Contrary to this meaningless daily dribble, our advisors consistently share with clients the empirically proven investment truths backed with financial science from multiple confirming studies and most often from the top graduate business schools.  Yet, when markets become volatile, cracks seem to occur in even the most educated investors’ resolve, which can lead to actions and behaviors that can damage their portfolio’s results, not to mention their stomach lining and/or mental psyche.

In 2016, the broad US equity markets started off with an ugly drop, falling by almost 10% by mid-February.  Who would have thought that by year’s end these same markets would have moved up nearly 25% from that early pullback?  In early summer, Brexit occurred.  During the first couple of strongly negative trading days thereafter, who would have guessed that equity markets would turn and robustly move up?  And finally, as was discussed in last quarter’s report, how many financial experts predicted a Trump victory or the straight-up movement in the US equity markets starting the day after the election?  In fact, the conventional advice was that all three of these events would lead to a continued negative market trend. 

Predicting market moves doesn’t just come from talking heads and internet tweets.  Every active participant, whether a mutual fund manager, genius stock broker or individual retail trader is actually predicting the future when they decide to buy or sell, over or under weight an industry or sector, or make another portfolio decision based on their magical interpretation of the future.

We do know, at the very least, that active mutual fund managers as a group are not very successful at their jobs.  In the most recent analysis of their performance, we see once again the futility of trying to pick an active fund manager who adds value to the benchmark they are competing against.  See Exhibit 1 below.

Note the very poor chances of outperforming a benchmark over the 1, 5 and 10 year periods.  Add the fact that it is virtually impossible to recognize the small percentage of managers that do outperform BEFORE they do it.  Due to this, it becomes nearly impossible to successfully select an active mutual fund that can consistently outperform most market benchmarks over any meaningful time period. 

Even the most reputable sources often guide investors to the wrong course of action.   See Exhibit 2.

BusinessWeek, Forbes and The Wall Street Journal are all highly respected sources of financial news.  Yet, if an investor had followed the sage advice offered at the times shown above, they would have missed some of the greatest bull markets in history. 

Oftentimes investors shoot themselves in the foot without help from any outside source.  This may occur when the market’s recent trends are in contradiction with a properly diversified portfolio.  See Exhibit 3.

For the first time this century, Small Caps underperformed Large Cap two years in a row (2014 & 2015, by a total of about 13%).  When this happens, investors who own a diversified portfolio may feel they own too much of an asset class that is lagging.  They often forget that long term portfolios are built to take advantage of empirically proven facts.

The portfolios that DHG Wealth Advisors manage have a modestly over-weighted position in Small Cap asset classes, precisely because we know that over the long term our clients will benefit from that weighting.  We also realize there will be times during a full investment cycle when Small Caps will underperform.  2016 has done a good job in showing this concept in real time.  For the first 10 months of the year, Small and Large Caps had very similar returns: 6.16% vs 5.82%, respectively.  But add November to the calculation and we see some dramatic differences: 18.00% vs 9.99%, respectively.  That’s an 8% difference in one month!  And that is why we build portfolios for the long term.  We know over longer periods, Small Caps improve returns, but we don’t know exactly when that outperformance will occur.  Unfortunately, no one rings a bell right before it starts.  So we will have periods when there will be some underperformance of certain assets classes that are owned, in the same way that we will have periods when those same asset classes will once again outperform.   

The trick is to be knowledgeable about these situations and continue to follow the plan.  Over time, there will be bull and bear market cycles, Large Cap and Small Cap cycles, Growth and Value cycles, Domestic and Foreign cycles, etc.  We use rebalancing to buy asset classes that have been underperforming and sell those that have been outperforming.  Without even trying to prognosticate the markets, this forces us to buy low and sell high, which is a goal of all successful investors.  No need for tarot cards, crystal balls or palmistry.  We simply stay consistent in monitoring an academically proven investment methodology designed to provide a generous long term reward consistent with the risk level you have chosen.  And it works.  Like magic!

Fourth Quarter 2016 Asset Class Returns

Global equity markets started the 4th quarter on a weak note, pulling back during the final days before the US Presidential election.  But the trend changed on the first trading day after the Trump victory and continued well into December, assuring that all US equity asset classes except Real Estate had positive returns for the quarter.  In a continuation from the 3rd quarter, Small and Value asset classes led the way in performance.  As discussed earlier in this report, the Large Cap cycle in 2014 and 2015 reverted back to Small Cap in 2016, with Micro Caps and Small Cap Value having 25%+ full year returns. 

Value stocks outperformed their Growth and Core counterparts in both Large and Small Caps, as well as domestically, internationally and in emerging market countries. During the 4th quarter bonds were hit hard as the Federal Reserve raised interest rates, putting downward pressure on bond prices.  Real Estate, due to its nature as an equity/income hybrid, suffered pullbacks in both the US and foreign countries.  However, looking at the full calendar year, all equity asset classes including Real Estate showed positive full year returns, making 2016 a perfect example of markets climbing “walls of worry” all year long.

The New Year promises to be an exciting one.  Clearly global investors are favoring US equities, believing in the potential of increasing strength in the US economy and the US Dollar.   This comes from anticipation of potential Trump Administration changes in trade, taxes and business regulation, to name a few.  There are clearly many question marks about when, how or even if many items on Trump’s stated agenda can or will be fulfilled.  But the mad rush for US companies’ stock during the second half of the 4th quarter shows the willingness of global investors to believe increased economic growth for the US is very possible in 2017 and beyond.  This potential higher growth, compared to the backdrop of much slower economies in Europe and other foreign nations, shows the reason for superior US equity asset class returns in both the 4th quarter and full year. 

As always, we remain vigilant in monitoring your portfolio, making sure excessive optimism or pessimism is viewed as an opportunity to rebalance your portfolio if weightings of certain asset classes become too extreme. 

In the meantime, good luck with your New Year’s resolutions.  Stay warm, and enjoy the winter months.  And remember, to an optimist, spring is just around the corner.

Sincerely,

Frederick F. Kramer IV, JD
Co-Chief Investment Officer

Attachments

  1. 4Q2016 Investment Report.pdf 1/5/2017 4:03:58 PM