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Market Commentary 4th Quarter 2016

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2016 was a broadly favorable year for investors.  Virtually all major asset classes posted positive returns with U.S. stocks leading the way.  The S&P 500 posted a total return of 12.0% for the year, and small stocks did even better with the Russell 2000 returning 21.3%.  Small stocks are being helped by a potential corporate tax cut.  They caught fire in the second half of the year after gaining just 2.2% in the first half.  On the international side, after 3 consecutive years of negative returns, emerging markets bounced back to return 11.2% in 2016 while developed international markets barely eked out a positive return of 1%.

Diversifying assets also had a strong year.  After an abysmal year in 2015, inflation hedges were buoyant in 2016 with commodities and gold both coming to life.  Every vehicle we use in that category except managed futures did well last year.  Pipeline MLPs (TORIX and MLPX) rebounded sharply from 2015 with gains of 42% and 36% respectively, while gold stocks did even better.  The REIT index of publicly traded real estate also did well, returning 8.6%. 

This past year will be remembered as a disastrous year for pollsters and pundits.  The first embarrassing gaff of the year for that crowd was the so-called ‘Brexit’, the unexpected vote by UK citizens in June to leave the European Union.  This bombshell created instant volatility in markets around the world, but the initial plunge in markets proved to be just a head fake as most of them (including the U.S.) quickly gained back the losses and more.  Nonetheless, that vote may be signaling increasing stresses in the EU that could lead to its eventual disintegration. 

The second forecaster misstep was U.S. interest rates, which confounded economists’ consensus predictions for higher rates yet again by plunging in June to 1.38%, the lowest level of the last sixty years!  Then, just so prognosticators could save face, rates reversed course for the rest of 2016, and the interest rate on the 10-year bond in mid-December was a quarter point higher than the 2.27% level where it started the year.  Since bond prices fall when interest rates rise, the total return for the year on the municipal bond index was 0.0%, as falling bond prices erased all the bond interest earned during the year.  The picture was a bit better for taxable bonds as the intermediate bond index returned 2.6%.  Our diversification into non-traditional lending such as LENDX and insurance linked securities was very helpful as rates rose.

The third surprise of the year and most humiliating event for pollsters was the upset election of Donald Trump as the new U.S. President with the Republicans surprisingly retaining control of both the Senate and the House.  That shocker propelled the domestic stock market to a sharp gain (and pulled bonds and REITs lower) over the last eight weeks of the year on expectations for stronger economic growth due to business-friendly policies out of Washington such as corporate tax reform, reduced regulation, and income tax cuts. 

Unfortunately, this year’s double-digit gains in domestic stocks came in the face of declining corporate earnings.  So, the valuation of the market, which was already stretched, is now even further above long-term norms.  Furthermore, the low interest rate justification for the elevated valuation is being called into question by the recent rise in rates and the Federal Reserve’s forecast of more rate hikes in 2017.  The market appears to be counting on a surge in earnings in the coming year to justify the gains recorded this past year.    Let’s hope that guess proves more accurate than last year’s forecasts.  Meanwhile, we’ll continue our disciplined strategy.  We know we can’t see the future, but we can identify risks and shape portfolios to meet client goals whatever the future brings.