Broker Check

7300 Wealth Connect – 12-16

Annual Financial Market Update

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

An Average Year

That’s right, 2016 turned out to be an average year for stocks if you use the large-company S&P 500 Index as your yardstick. Going back to 1928, the average annual return, including reinvested dividends, runs nearly 10% (NY Stern School of Business data). When the year had ended, the S&P 500 rose 9.54%. Throw in dividends and 2016 rose 11.96% (MorningStar). Mid-cap and smaller company shares topped 20%.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC

Of course, these are just averages and returns can vary widely from year to year. Since the bull market began in early 2009 (St. Louis Federal Reserve), we’ve been treated to eight-straight years of positive returns for the S&P 500 Index (dividends included), with six of those in double digits (NY School of Business).

That always leads to the next question – or we near a top? I’ll attempt to provide perspective later in the summary. Spoiler alert – it largely depends on whether the U.S. economy is headed toward a recession.

A look back at 2016

The year finished on a solid note, but 2016 didn’t start out that way.

Falling oil prices, worries about China, an upward lurch in junk bond yields, and overblown fears of a recession took a big toll on investor sentiment. CNNMoney pointed out that the first ten days of the year were the worst start for the Dow in its history – that’s going all the way back to 1897.

To compound the angst, comparisons to 2008 were rife. However, this wasn’t 2008, there wasn’t a subprime crisis that was brewing, and shares touched bottom in early February (St. Louis Federal Reserve).

At the time, stocks were closely tracking oil prices. When oil prices bottomed, so did the S&P 500 Index (St. Louis Federal Reserve, Energy Information Admin.). Not coincidentally, so did the peak in junk bond yields (St. Louis Federal Reserve, Energy Information Admin.).

While tumbling oil prices had raised worries over demand and led to fears a recession might take hold, the reality was quite different – it was about too much oil, not fading demand in the economy.

Shares eventually moved off lows, and the closely-watched S&P 500 Index eclipsed its May 2015 high in July, when the surprise Brexit vote in the U.K. failed to create much turbulence in Europe.

Trump train spurs new highs

New highs experienced by the major U.S. indexes came despite the unexpected victory by Donald Trump. Most analysts believed a brief but violent selloff would ensue if the outsider won the election. Instead, talk of corporate and individual tax cuts, new spending on infrastructure, the repeal of Obamacare, and regulatory reform all served to spark a late-year rally.

The late-year surge in stocks came at the expense of longer-term Treasury bonds and high grade corporate bonds (St. Louis Federal Reserve). Figure 1 highlights the spike in Treasury yields (bond prices and yields move in opposite directions).

Data Source: St. Louis Federal Reserve, NBER Last Date: 12.30.16 Shaded areas mark recessions

Yields have been at or near historically low levels for much of the economic recovery. Very accommodating monetary policies from the major global central banks, low rates of inflation around the globe, a lackluster economy, and yields hovering near or below zero in parts of Europe have all played a role. Still, on a historical basis, Figure 1 illustrates that yields remain low.

The long cycles in oil

Oil is an incredibly important component in our economy. Falling gas prices have been a boon for drivers, but severe cutbacks by oil-related firms have forced layoffs and sharp reductions in expenditures in the industry. Moreover, it has hampered S&P 500 profit growth (Thomson Reuters).

We are witnessing a modest bounce in prices thanks to a recent OPEC decision to cut production. But even at today’s prices, rig activity in the shale producing regions is rising, promising to bring new output.

I won’t venture a guess where prices will end up next year, but as Figure 2 highlights, oil has historically moved in very long cycles. If that holds true this time around, we could see prices remain at relatively low levels for quite a while.

What’s in store this year

As with oil prices, forecasting how stocks will perform this year is dicey. Simply put, there are too many moving parts to the stock price equation, and each of those moving parts can affect one of the other moving parts.

But we can take a stab at some of the tailwinds and risks.

Since WWII, the U.S. economy has had 11 economic expansions, which were interrupted by recessions (National Bureau of Economic Research). At 73 months, the current expansion is the fourth longest, with the longest being 120 months in the 1990s (NBER).

The current recovery isn’t young anymore, but risks for a near-term recession in the U.S. are low. That’s important for investors because Figure 3 reveals that most bear markets, defined as a 20% decline, since the late 1950s were associated with a recession. The one most recent exception – the Crash of 1987.

Data Source: St. Louis Federal Reserve, NBER Shaded areas mark recessions Last Date: 12.30.16

Thomson Reuters is forecasting a return to S&P 500 profit growth in 2017, which would provide a tailwind for stocks. A gradual upward path in interest rates by the Fed would probably be viewed as a plus, especially if it were in response to an expanding economy.

Trump’s election sparked enthusiasm, primarily because he has touted pro-growth policies and downplayed his more controversial ideas. For example, it’s unknown if his tough trade talk during the election will result in dramatic new barriers to free trade or whether his rhetoric is simply a negotiating ploy.

You see, the vast majority of economists would argue that free trade is a net benefit to the U.S. However, “net benefit” is a fancy way of saying that winners exceed losers, but there are still losers.

You and I stand to gain when we buy cheap imports like big screen TVs that would cost more to manufacture in the U.S. Exporters gain access to foreign markets. Since 1990, exports as a percent of GDP have risen from 6% to 13% (U.S. BEA). That creates jobs for Americans and profits for U.S. firms.

But jobs have been lost when firms relocate plants abroad or when U.S. manufacturers can’t compete against lower-cost imports. If Trump were to follow through with threats to raise tariffs, U.S. trading partners could quickly retaliate, sparking trade war. Any heightened uncertainty could create volatility in stocks.

Of course, there are other unknowns. Will simmering problems in Europe or China bubble to the surface, or will unexpected geopolitical issues surprise investors?

What we have seen during this cycle – problems abroad that have not had a material impact on the U.S. economy have created temporary angst but have not killed the current bull market.

Another way to view this – those who have adhered to a long-range view and side-stepped the inevitable gyrations have profited.

Warmest Regards,

Christopher J. Carroll, CIMA®
Founder, Portfolio Manager, and Founding Partner