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2016 Year End Market Update

| December 31, 2016
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2016 Year End Review

 

There were several themes that factored in to our results in 2016:

 

  1. Corporate earnings
  2. US Election
  3. US Economy
  4. Fed

 

Looking forward to 2017, many of these same themes will continue to influence the stock and bond markets.

 

Let’s examine each theme.  But first…

 

Here is how stocks have fared:

 

Here is how bonds have fared:

 

 

 

 

Earnings:

 

As I have mentioned in previous blog posts, stocks typically follow earnings. When earnings increase, stocks typically increase, and when earnings decrease, stocks typically decrease.

 

As you can see from the earnings report below, corporate earnings bottomed in 2009, rose through the end of 2013 and then barely grew from 2014 to 2016.  In 2014, S&P earnings were $116.76 per share. They grew to just $117.97 in 2015, and an estimated $118.69 in 2016.

 

 

This led to a sideways trend for stocks over the same period.  As you can see in the chart below, stocks moved sideways in a very choppy fashion from the middle of 2014 to the middle of 2016.

 

 

So what caused earnings to take a long pause?

 

Oil prices were a major factor.  Below you see a 5 year chart of Light Sweet Crude oil.  Oil prices cratered from mid-2014 to early 2016, nearly the exact same time frame as earnings petered out.  Losses for energy companies were a major drag on US corporate earnings overall.

 

 

In addition, the strong US dollar makes US exports more expensive for foreign countries.  Below you see a 5 year chart of the US Dollar which took a dramatic rise in mid-2014 through early 2015 and has recently spiked again on the heels of the election.  US exporting companies were another major drag on corporate earnings over the last few years.

 

 

Looking forward, oil prices are trending up which boosts earnings for oil companies.  But  a strong US dollar will continue to hurt US exporting companies.  Luckily (?) exports are not a big percentage of the US economy.  So estimated corporate earnings for 2017 are currently estimated to increase to $132.87 per share.  This represents a 10-11% increase in corporate earnings for next year which is a very positive sign.  We have seen the market finally break out of the sideways trend in anticipation of better earnings in 2017 as you see from the chart below.  Stocks have rallied roughly 5-10% over the last 3 months.

 

 

In summary, earnings are finally expected to rise in 2017. However, much of the increase has already been priced in to the market given our rally since the election.  I will discuss this more in the next section.

 

Election

 

The second major contributor to our 2016 results was the election.  Flat corporate earnings and uncertainty heading in to the election kept a lid on stock prices.  Historically election years are not good for the stock market as you can see from the graphic below, far left panel.  What you can also see from the graphic below middle panel is that after elections, and particularly close elections, the market has historically rallied and that is what we saw in 2016. 

 

I will also point out, in the panel below left, that year 3 of the election cycle (2015) would have historically been the best year in the cycle, but that was not the case in 2015 due to poor earnings so these historical examples will not always play out to a historical pattern.

 

 

I think very few people, myself included, anticipated the election results. Polling proved to be flat wrong.  We ended up with a widely disliked Republican President elect and a Republican controlled Congress. 

 

 

Though a Republican President and Republican Congress is historically uncommon, with just 7% of elections giving us this result, the market has historically done well in this scenario.  The historical average annual return with a Republican President and Congress is 15.1% as you can see from the graphic below.

 

Why might the market do well under a Republican President and Republican controlled Congress?

 

First is deregulation, particularly in the financial sector. Though recent efforts to prevent another 2008 like financial crisis led to new laws such as Dodd Frank over the last several years, those laws have limited profits especially for banks.  With the anticipation of financial deregulation under the next administration, we are seeing financial services companies such as banks and insurance companies contributing to earnings for the first time in many years.  What will the long term implications of deregulation be?  We will someday find out.

 

Second is corporate tax reform.  US companies have an estimated $2.5 trillion stashed overseas in an effort to avoid high corporate taxes here in the US.  With a Republican President and Congress, we may get more competitive corporate tax rates and if even some of those trillions of dollars come back to the US, it should be very beneficial for the economy.  Lower taxes for individuals and families would also potentially boost spending, saving, profits, and earnings.

 

Third is infrastructure spending.  Both Trump and Clinton campaigned on the idea that we needed to invest in our infrastructure.  Updating roads and bridges for example will add jobs and boost profits for construction companies.  Where would we get the money?  Well, we would borrow it of course!

 

In summary, themes that may play out include: limiting regulations, borrowing more, spending more particularly on infrastructure, and taxing less at the corporate and individual level.  These themes might be good for the economy short term, but I hate to think about the long term consequences including a spiraling national debt.

 

Economy

 

Our economy continues to chug along at a very modest pace.  Below you see an important chart from Doug Short showing the 4 economic indicators that the National Bureau of Economic Research uses to indicate if we are in a recession.  As you can see from the chart below, most of those indicators, with the exception of industrial production, are trending up.  So we have employment, sales, and income all on the rise which is a good sign.  The modest rate of growth keeps the Fed out of the equation to some extent – more on that in the next section.

 

 

A potential indicator that we are headed for a recession is an inverted yield curve.  This occurs when short term interest rates, which are controlled by the US Federal Reserve, are actually higher than long term interest rates, which are market driven.  As you can see from the chart below, the yield curve (blue line) is still positive, though it is on the decline.  Note that it dipped below zero before each of the recessions going back to the 1970’s (recessions are shown by the grey shaded areas). If we do in fact get 3 interest rate hikes from the Fed in 2017 as anticipated, that could drive this measure downward even further which would not be a good sign. This is something to keep a close eye on since recessions have historically been associated with larger stock market declines.

 

 

US Federal Reserve (Fed)

 

Our last key component to 2016 results was the US Federal Reserve (Fed).  The Fed’s job, under Chair Janet Yellen (and predecessors Ben Bernanke and Alan Greenspan) is to maintain full employment and to control inflation.

 

One of the tools the Fed has to control employment and inflation is to raise and lower interest rates.

 

Lowering interest rates tends to spur borrowing and thus stimulate the economy which can boost employment. We have had very low (near zero) interest rates since 2008 and the Fed has been very reluctant to raise them.  Near zero interest rates are great if you are borrowing money for a car purchase or home purchase.  It’s terrible for savers as you can tell from the interest rate you get on checking, savings, and money market accounts. 

 

The Fed raises interest rates to control inflation.  Inflation means rising prices.  We do not want high inflation as it erodes the value of our savings and income and is particularly damaging for those that are retired.  By raising interest rates, the Fed discourages borrowing.  When interest rates are high, people are less likely to use credit for purchases and the economy slows down.  Companies are forced to lower prices or provide discounts to keep sales going (deflation).

 

Below is a chart showing the Fed Governor’s opinion on where interest rates might be in the years to come.  Each Fed Governor is shown as a “dot”.  You can see that they don’t completely agree on where rates should be, but the point here is that they generally see rates rising in the coming years.  Rising rates are a sign of a stronger economy and don’t generally hurt stocks, but recessions do.  However, rising rates do hurt bonds, especially medium to longer term bonds, and this is a major concern of mine at this point in time.  Eventually the Fed will raise rates enough to trigger a recession which is a year over year decline in our economy.

 

 

Conclusion

 

2016 saw a few key themes influence our results.  These same themes will continue to influence markets in 2017.

  1. Corporate earnings have been flat from 2014 through 2016 and this has led to a choppy flat market since stocks tend to follow earnings. Earnings are expected to rise by 10-11% in 2017, but much of this has already priced in given the stock rally over the last few months.
  2. The Election created a lot of uncertainty and stress which kept a lid on stocks much of the year. Now that we know the results of the election we can anticipate trends such as increases in infrastructure spending. However, there is still uncertainty with the Trump administration and what will actually become policy. For example, the Trump administration’s stance on health care is unclear.
  3. The economy continues to plod along. There are basically no signs of recession and recessions tend to be associated with bigger market declines.
  4. The Fed has been mostly on the sidelines in terms of raising interest rates over the last 2 years. Rising interest rates are a sign of a strong economy and don’t tend to hurt stocks but they do hurt bonds. The Fed has hinted at raising rates as much as 3 times in 2017 as our economy strengthens.  Rapidly rising interest rates may eventually result in recession.

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results

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