January 3, 2017
By Blaine Rollins, CFA
So much for the Santa Claus rally. The red sled never even left the garage. Why were the last two weeks of 2016 a dud?
1) Worries about potential roadblocks for the incoming Administration.
2) Trade war worries hitting retail importers and international manufacturers.
3) The ongoing strength in the U.S. dollar and its likely appearance in Q4 earnings conversations.
4) Year/quarter-end tactical rebalancing as assets shift from outperforming equities to underperforming bonds.
But what a year it was. It looked like Emerging Market stocks and bonds were going to take all the performance chips for the year with Domestic bonds being a safe place to hide given the lack of growth and inflation in the world. But then the U.S. election occurred and the market was flipped entirely upside down.
With 2016 now in the rear-view mirror, we can focus on where to be best positioned for 2017.
As I do not run a diversified portfolio, I only want to own assets that I think are going to outperform and generate positive absolute returns. Until the election, the last two years have left little in the way of positive trends to pick through. But this year looks much different. The surprising election swing has caused a change in investing sentiment not seen since the bursting of the Tech, Telecom and Media bubble in 2000.
Asset classes, equity sectors and individual stocks have become completely unhinged. This is a major positive for active equity investors - giving them an opportunity to put up significant outperformance if they get their investment allocations correct.
As my models and research tools dig into the data, I see a few areas of the financial markets that I want to be very overweight. There are other areas that have potential, but that I am waiting for more information and less risk. Then there are areas that I do not want to be anywhere near or that I would prefer to be short. With the rapidly changing political and fiscal policy environment, much is riding on the outcomes in Washington D.C. to determine the large macro impacts on the U.S. dollar, interest rates, commodity prices and corporate earnings.
Between Congressional action and Presidential tweeting, the markets will be on edge. The top overweight themes that I am looking at for 2017 are U.S.-based equities focused in the Financial and Energy sectors, as well as Small Caps. Before we get to the ideas, let's look at some data.
First off, the market completed its 8th straight annual gain for not only the S&P 500, but also the Dow Industrials and Nasdaq 100...
One streak that did end was the Nasdaq 100's seven-year dominance over the S&P 500. Time for some Value stock leadership?
Looking at the broader asset class ETFs, it was tough for a U.S. investor to lose money...
Only Agricultural commodities and Healthcare stocks lost money. Every other asset finished in the green. Big brownie points and merit badges to those overweight Energy & Financial stocks, Base Metals and Energy commodities and U.S. Small Cap stocks.
(Morningstar Daily Total Returns)
U.S. Sector returns showed Energy winning the race with Financials picking up the bouquet...
Last year's Bridesmaids have a good history of the following year's performance (although 2016 is not a good data point given that Health Care was the 2015 Bridesmaid.) But I am willing to bet that 2017 will be better for the Financials.
(Stockcharts Total Returns)
One more time, it is now time for Active Managers to shine...
The markets are double daring Portfolio Managers and Analysts to put their best ideas on the table. Go home closet indexers!
Back to my best ideas: Financial stocks are set up for a great 2017...
1) Rising U.S. interest rates.
2) A stronger U.S. economy means better loan growth & reduced credit losses.
3) A corporate income tax cut has a significant impact given the concentrated U.S. revenues and earnings.
4) Less rules and regulation.
5) Financials have not outperformed the market for back-to-back years in since 2000-2002.
6) The Bridesmaid for 2016.
Which sub groups should do best? Banks, Brokers, Life Insurers, and Finance Companies. So, if you don't like ETFs go hunt for a basket of your favorite names.
Small Cap equities should also outperform in 2017...
1) A very strong US dollar that will give Small Caps the earnings advantage over Large Cap Multinationals.
2) The reduction in the corporate income tax will also give extra leverage to Small Caps that don't have the 100+ person tax departments to shield their incomes.
3) The largest Small Cap index (Russell 2000) is heavy Financial stocks at an 18% weight.
4) Small Caps have flat relative performance vs. Large Caps for almost a decade.
5) The annual seasonal effect of small caps versus large caps expects outperformance right now.
Small-cap stocks tend to outperform big caps in January. This is frequently referred to as the "January Effect"; the tendency is clearly revealed by the graph below. Thirty-six-plus years of daily data for the Russell 2000 index of smaller companies are divided by the Russell 1000 index of largest companies, and then compressed into a single year to show an idealized yearly pattern. When the graph is descending, large caps are outperforming smaller companies; when the graph is rising, smaller companies are moving up faster than their larger brethren. (Jeff Hirsch Tumblr)
Fred Wilson's outlook into 2017 also sees Smaller Companies (public and private) having a big year as repatriated cash leads to an M&A boom...
- Trump will hit the ground running, cutting corporate and personal taxes, and eliminating the preferential treatment of carried interest capital gains. The stock market has already factored in these tax cuts so it won't be as big of a boon for investors as might be expected, but the seven and a half year bull market run will be extended as a result of this tax cut stimulus before being halted by rising rates and/or some boneheaded move by President Trump which seems inevitable.
We just don't know the timing of it. The loss of capital gains treatment on carried interest won't hurt professional investors too much because the lower personal tax rates will take the sting out of it. In addition, corporations will use the lower tax rates as an excuse to bring back massive amounts of capital that have been locked up overseas, producing a cash surplus that will result in an M&A boom. This will lead to adding even more fuel to the fire that is causing "old line" corporations to acquire startups.
- The IPO market, led by Snapchat (CHAT), will be white hot. Look for entrepreneurs and the VCs that back them to have IPO fever in 2017. I expect we will see more tech IPOs in 2017 than we have since 2000. (AVC)
While Energy stocks have both an OPEC and strong U.S. dollar risk, I still believe there is a decent base value in the stocks from this level...
But if you think the global economy will tank or OPEC will fracture, then stay away from Energy and go play elsewhere. I think that U.S. growth could help global growth and that investors want more value-oriented and commodity-based equity exposure. Hopefully, OPEC has also realized its past mistakes and the floor price in crude oil has been set.
It will be very difficult to invest overseas without currency hedging this year...
I see plenty of attractive international names but would prefer not to worry about the currency or a U.S. trade war. So my pockets are three feet deep on investing in non-financial international equities.
We have seen many economic surveys since the election. This consumer confidence survey sums them all up. Optimism is rising.
Combine rising consumer and business confidence with incoming fiscal stimulus and a Fed unwind, and the match may have been lit on the interest rate bottle rocket...
Will rising rates affect mortgage and housing demand? Goldman is betting on it...
Too much capital has hit the house flipping industry. Big returns are in the past. Don't let your clients, friends, family increase their exposure here as returns will dissipate. In addition, tax law changes are coming and they could hit the mortgage interest deduction, depreciation and interest expense rules significantly.
The increasing amount of speculative housing in recent months is "concerning," ATTOM noted in a recent report. "We're starting to see home-flipping hit some milestones not seen since prior to the financial crisis."
ATTOM said profit margins are getting squeezed in some markets. While house-flippers typically aim to purchase a house at a 30% discount to the market, in some areas, they're buying homes at a 15% or 10% discount, said Senior Vice President Daren Blomquist. The research firm noted that the number of smaller, inexperienced house-flippers entering the market is a sign of rising speculation. (WSJ)
Disney (NYSE:DIS) now owns the box office thanks to their acquisitions of Star Wars, Marvel, and of course, Pixar...
If you missed it while on break, Consumer Reports updated its Owner Satisfaction scores...
The battery company in California topped the list followed by Porsche, maybe there is a substitute?
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