- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Officer
- Jonathan Strok, CFA - Investment Associate
- Despite volatility, 2016 turned out to be a strong year for equities as the S&P 500® index gained 12%, including dividends. The surprise victory of Donald Trump, along with an improving economy and earnings outlook, helped propel the stock market to all-time highs.
- Investors appear to be pricing in very favorable outcomes for equities. We are skeptical that reality will meet expectations.
- We believe that the risk/reward tradeoff has become more balanced for stocks.
- We see no imminent signs of a recession on the horizon at this point, but we believe that the economy is entering the later innings of the economic cycle.
- Although interest rates could continue to climb near-term, we expect yields to remain low by historical standards for quite some time.
- We continue to expect muted overall returns from both stocks and bonds over the next several years.
It has been said that there are just two emotions on Wall Street: fear and greed. It is tough to argue with this axiom after watching the financial markets in 2016. Fear gripped the markets at the beginning of the year with the S&P 500® tumbling to its worst two-week start to any year on record. In June, Britain’s vote to leave the European Union also briefly rattled global equity markets, only to be followed by a sharp rally in the ensuing weeks. Now greed appears to have taken over with the stock market soaring to new all-time highs following the surprise victory of Donald Trump in the presidential election on November 8.
As we look ahead to 2017, we believe that more volatility is in store for investors. Regardless of the prevailing emotions on Wall Street, we caution investors not to get swept up by them. Instead, we take note of the advice of Warren Buffett to “be greedy when others are fearful and fearful when others are greedy.” With expectations currently running high in the market, we think it is best to exercise a bit of caution. We remain overweight stocks, but less so than in recent years, as we believe that the risk/reward tradeoff has become more balanced.
Indexes Used for Figure 1: U.S. Large Cap Equities – S&P 500 Index, U.S. Small Cap Equities – Russell 2000, U.S. Investment Grade Bonds – Barclays U.S. Aggregate Bond Index, Developed International Equities – MSCI EAFE Index, Emerging Market Equities - MSCI Emerging Markets Index, Commodities – S&P GSCI
The ‘Trump Bump’: Will it Last?
While there were many events that shaped the financial markets in 2016, there was perhaps none bigger than the presidential election. Heading into Election Day, most polls and forecasters had projected Hillary Clinton to win. Most pundits also believed that since the stock market was pricing in a Clinton win, a surprise Donald Trump victory would create uncertainty, which, of course, is something that markets hate. Therefore, we would see heightened volatility and likely a selloff in the markets under that scenario. That turned out to be the case for all of about six hours. Instead of a Trump slump, we have enjoyed a Trump bump that, along with strong economic data and improving earnings, has helped lift the stock market to new all-time highs.
You can count us among those who expected a Trump victory to rattle the markets. We would have been well served to heed the advice of Mark Twain to “pause and reflect whenever you find yourself on the side of the majority.” After a very brief panic, the market soon realized that a Trump presidency and Republican-controlled Congress could actually be a positive for corporate profits – and, thus, stocks – through possible tax reforms, a lighter regulatory environment and a potential increase in infrastructure spending.
Whether or not these catalysts actually manifest themselves remains to be seen. Either way, we are skeptical that the U.S. economy can achieve outsized growth for any sustainable period. While there have been many big promises made, the economy faces some harsh realities. There are structural headwinds such as an aging population that are simply going to weigh on economic growth for quite some time. Additionally, while we view many potential policy changes as pro-growth, we caution that stricter immigration and trade policies could hinder economic growth long term. Additionally, a continued strengthening in the U.S. dollar would also hurt corporate profits, as a large portion of earnings come from overseas.
Moreover, we view Donald Trump’s victory in 2016 as part of a broader rise in populism globally. This was evident earlier in the year with Great Britain’s vote to leave the European Union. Much of the rhetoric from populist candidates have been anti-globalization and anti-status quo. If these trends continue, then expect to see greater market volatility in 2017.
While there are certainly many potential positives for the economy through legislative changes, there are some negatives too. We believe that investors are currently pricing in very favorable outcomes, which, in our opinion, increases the odds of a correction if reality does not meet expectations.
Economy Continues to Improve
Despite fears of a possible recession early in the year, the U.S. economy showed its resiliency and continued to expand in 2016. Yet, as has been common in the post-Great Recession recovery, growth was far from robust. Consumers did the heavy lifting in pulling the economy forward this year, but business investment remained a drag.
Consumption was driven in large part by continued improvement in the labor market. Job gains averaged 180,000 per month in 2016 through November, which was down from 229,000 in 2015 but still solid overall. The official unemployment rate declined to 4.6% in November, marking its lowest level since 2007. The more comprehensive U-6 unemployment rate, which includes all persons marginally attached to the labor force (including discouraged workers), plus those employed part-time for economic reasons, also continued to improve in 2016. (Figure 2) It currently sits at its lowest level since 2008 at 9.3%.
It was particularly encouraging to see these metrics improve alongside a growing labor force participation rate. (Figure 3) The labor force participation rate for 25-54 year olds, which excludes most college students and retiring Baby Boomers, saw its first meaningful improvement this year since before the financial crisis. We remain hopeful that continued tightening in the labor market will translate into stronger wage growth in 2017.
Another positive development for the U.S. consumer in 2016 was a further recovery in the housing market. According to the S&P/Case-Shiller National Home Price Index©, home prices recently eclipsed their peak from 2006. (Figure 4) There are a couple caveats to this data though. First, this is not the case in all parts of the country (location, location, location, as they say). Second, the recovery has been uneven among price ranges. Higher-end home prices have recovered much faster than more moderately-priced homes.1
While the economic recovery has been uneven for Americans, overall, the strengthening labor market, recovering housing market, record-high stock market and low interest rate environment have greatly improved the balance sheets of millions of households. This is evident in improving credit quality metrics. (Figures 5, 6) In fact, we caution that signs of euphoria appear to be popping up in certain areas of the economy, particularly in some real estate markets. We believe these could be signs of the economy reaching the later innings of the economic cycle. However, we see no imminent signs of a recession on the horizon at this point
We are skeptical, however, that the U.S. can achieve outsized growth for a sustained period going forward. As a mature economy with an aging population, strong growth will be difficult to achieve long term. In fact, the last time the U.S. economy cracked annual GDP growth of 3% was in 2005. A key driver of long-term economic growth is productivity, and it has been notably weak since the end of 2010. (Figure 7) Productivity is at least partially a function of business investment, which has been weak too in recent quarters and trending lower. (Figure 8) Perhaps a lighter regulatory environment and a lower corporate tax rate will improve this, but we are not expecting major gains here.
Another important component of long-term economic growth is growth in the labor force. However, with an average of 10,000 Americans turning 65 years old every single day, the overall labor force growth rate will likely remain strained for many years. Potentially stricter immigration policies present a major headwind to the labor force too.
Interest Rates: Diverging Paths
Not only do we expect structural forces to hinder economic growth, we expect them to keep a lid on interest rates as well. While long-term rates have risen sharply since the presidential election, yields are still low by historical standards. Although rates could continue to climb in 2017, we do not expect them to return to their long-term historical averages anytime soon.
Meanwhile, the rising rate environment in the U.S. has been in sharp contrast with most of the developed world, which has helped drive the U.S. dollar to a 14-year high. The Federal Reserve recently announced an increase in the short-term federal funds rate on December 14 for just the second time since 2006. Based on the latest projections from members of its Federal Open Market Committee, the Fed expects to raise interest rates three additional times in 2017. Of course, the FOMC projected four rate hikes in 2016 but raised rates just once.
While our central bank is expected to raise rates in 2017, both the European Central Bank and Bank of Japan are likely to continue their quantitative easing programs in order to drive down both long-term and short-term interest rates. In fact, the spread between U.S. and German 10-year government bond yields recently hit its widest gap on record at more than 2.3 percentage points. (Figure 9) Despite diverging monetary policies, we believe that exceptionally low interest rates overseas are likely to pressure rates here at home.
Nonetheless, the recent rise in interest rates here in the United States has led to a bit of a pullback in bond prices, which is something that bond investors are not used to seeing very often. However, for well-diversified bond portfolios with relatively short durations (i.e. low interest rate risk), the pullback has been relatively moderate. In fact, for long-term investors, higher interest rates are actually a welcome development since it allows for reinvestment at higher yields. That is one reason why we continue to believe that fears of a crash in the bond market are overblown.
Credit spreads, which measure the difference in yields between bonds of different credit qualities but similar maturities, also tightened considerably in 2016 as recession fears from earlier in the year waned. (Figure 10) Given these narrow spreads and that we believe we are approaching the later innings of the economic cycle, corporate bonds do not appear as attractive to us as they have in the past.
Stocks: Be Fearful When Others Are Greedy
The narrowness of credit spreads underscores the current lack of fear in financial markets. This is evident in the stock market too, as price gains this year have been driven solely by expansion in the price to earnings multiple. We feel that current expectations among equity investors are likely too optimistic and expect more muted returns going forward. We have generally favored equities relative to bonds since 2009. We remain overweight stocks compared to our benchmarks, but only slightly, as we believe that the risk/reward tradeoff has become more balanced now.
We also think that market shocks are likely in 2017, particularly given the rising tide of populism around the globe. For all of the market swings we experienced in 2016, perhaps what is most remarkable is that this type of volatility is actually not remarkable at all. The stock market often fluctuates widely in any given year. Since 1980, the average intra-year drop for the S&P 500 has been over 14%, yet annual returns have been positive in 27 of 36 years.2 In 2016, the largest drop was 11%, from the start of the year through February 11. Since then, the index has surged nearly 25%.
However, there is reason to be optimistic about earnings growth in 2017. Following seven consecutive quarters of declining profits, the S&P 500 finally ended its earnings recession in the third quarter of 2016. This was driven in part by less drag from the energy sector as oil prices have rallied in recent months. If oil prices can remain stable, then the energy sector should provide a nice tailwind for aggregate earnings in 2017.
Current estimates for the S&P 500 are calling for earnings “per share” of around $130 in 2017, which equates to 20% growth over 2016 estimates. We believe these estimates are too optimistic, especially given the recent strength of the U.S. dollar. Yet, even at current lofty earnings expectations, the S&P 500 trades at a price to earnings multiple of more than 17, which is a premium to its historical average. (Figure 11) While lower interest rates arguably justify valuations above their historical norms, stocks certainly do not look cheap to us, and we believe that valuations suggest only modest upside from this level. We also note that while earnings could receive a significant boost from major corporate tax reform, the market appears to have largely priced this in since the election.
We continue to believe that international stocks look comparatively cheap to the United States. However, we are not as enthusiastic for their prospects as we have been recently given the potential for continued strength in the U.S. dollar and given a more domestic-focused government agenda. We also note that many international markets, both developed and emerging, face significant structural issues that likely warrant a valuation discount to the United States. For instance, demographic headwinds are generally much worse in international developed markets than here in the United States.
Additionally, the prevalence of stated-owned enterprises and reliance on volatile commodity prices in many emerging economies tempers our enthusiasm there too. Yet, we still believe that the long-term return potential remains attractive, as these issues are already more than factored into the share prices.
We continue to expect muted overall returns from both stocks and bonds over the next several years. (Figure 12) While interest rates have risen since the election, we believe that yields will remain low by historical standards, providing returns below their long-term averages for bond investors. An improving U.S. economy should provide support for stock prices, but with expectations currently running high, we see limited upside for the stock market in the near term.
One thing that you can count on is that the markets will be volatile, as fear and greed will always be driving forces on Wall Street. Whether the prevailing emotion is euphoric or depressed, it is important to remember that the market is there to serve you, not to guide you. An essential component of managing money is managing emotions and remaining disciplined.
1. Lightner, Renee. “Home Values Rebound, But Not For Everyone.” The Wall Street Journal 27 Dec. 2016.
The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the USB-denominated, investment-grade, fixed-rate, taxable bond market of securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass through), ABS, and CMBS sectors. It is not possible to invest directly in an index.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The MSCI EAFE Index is broadly recognized as the pre-eminent benchmark for U.S. investors to measure international equity performance. It comprises the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging market countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.
The S&P GSCI is a widely recognized benchmark that is broad-based and production weighted to represent the global commodity market beta. The index includes the most liquid commodity futures.
Brent oil is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide. Brent is the leading global price benchmark for Atlantic basin crude oils. It is used to price approximately two thirds of the world’s internationally traded crude oil supplies.
The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated monthly. It is included in the S&P CoreLogic Case-Shiller Home Price Index Series which seeks to measure changes in the total value of all existing single-family housing stock.
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.
Moody’s Investors Service provides ratings to securities in order to provide investors with a simple system of gradation by which future relative creditworthiness may be gauged. Moody’s Aaa-rated obligations are judged to be of the highest quality, subject to the lowest level of credit risk. Its Baa-rated obligations are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.
The price-to-earnings ratio is a valuation ratio of a company's current share price compared to its per-share earnings (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). Also sometimes known as "price multiple" or "earnings multiple."
Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
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