Perhaps as humans, but certainly as investors, we all suffer from hindsight bias. After an event has occurred we have an inclination to see the event as having been predictable despite there having been little or no objective basis for predicting it. This is one of the reasons we remain skeptical of providing an "outlook" for what we believe the following year will bring.
Instead, we can say with relative certainty that we will stick to our sphere of competence: our core investment strategy. We can also say that we will remain self-aware and "active" as we take the "temperature" of the market and ask: what are the implications of what's going on around us? As such, our outlook for 2017 should be thought of as more of a humble "reflection" on where economies/markets are and where they may be headed.
For 2017 it could be summed up as follows:
2016 proved to be a good year for the "active" investor and 2017 will unfold similarly as 3 big picture investment themes suggest continued volatility and divergence.
What do we mean by "a good year for the active investor"? To understand this we must consider where we began in 2016. This is summed up well by the following statement:
"The Worst Start To A Year Ever!"- Everyone
In fact, last January was the worst start we had to the year ever in the history of the stock market.
There were several moments in January in which we were told that a poor January was an excellent indicator of a bad year ahead.
Yet as it goes, 2016 was confirmation that the way a year begins tells us ABSOLUTELY SWEET NOTHING about how it will end. In fact, if you had listened to these "expert opinions" you would have "gone to cash" as many in the punditry advised and perhaps missed out on a few interesting developments in 2016:
- The S&P 500 (NYSEARCA:SPY) returned about 9.54%
- The Dow (NYSEARCA:DIA) returned about 13.42%
- The Russell 2000 (NYSEARCA:IWM) about 19.48%
- The Dow Jones Transport Avg. (NYSEARCA:IYT) about 20.86%
- The Energy Select Sector SPDR (NYSEARCA:XLE) about 24.87%
Not a bad year to remain fully invested despite the chop we witnessed at the beginning of the year. And all of this in spite of an absence of help from the Fed, an "earnings recession", Brexit, the surprise election of a man who was deemed as "disastrous" for the stock market, more disorder in Europe, rising populism and nationalism, an emboldened Russia, a few terrors attacks and whatever other disturbances the media told us we should worry about.
What we can glean from this reality is well put by George Soros:
"If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring." -George Soros
Trying to decide which way the market will turn when someone gets elected, or how exactly it will price in a policy change is entertaining. It gives us all something to talk about. Something to feel smart about if we just so happen to get it right. But it isn't a sustainable strategy for excellent long-term investment returns.
Instead we may find ourselves jumping in and out of the market. As Peter Lynch has cautioned:
"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." - Peter Lynch
If you are in the stock market you have to know that there will be declines. In fact, in roughly the last 90 years the stock market has gone up almost 75% of the time and down 25% of the time…yet the gains in positive years produced more than double the losses in the negative years. So should it come as a surprise that virtually every strategist surveyed by Bloomberg is predicting that the S&P 500 will be higher next year?
These are the boring facts…Time appears to be on the side of the patient long-term investor.
Nevertheless, that's just how things have played out in the last century or so. Past returns are no guarantee of future returns as it is all together possible that some form of systemic risk could change the way we think about investing and portfolio strategy.
Thus we are not suggesting that remaining passive is the answer. For many investors, buying a low cost index fund remains attractive, especially in light of the fact that by buying the SPY at the beginning of 2016 you would have generated roughly 9.54%. Instead, we believe that the market of 2017, like the market of 2016, will offer the "active" investor an opportunity to outperform. The "active" investor being the individual capable of:
- Distinguishing productive investment activity from mere entertainment;
- Discerning the true implications of the few significant things that occur around them.
2016 reminded us of the unentertaining and somewhat predictable side of the stock market as despite great volatility the active long-term investor had the opportunity to do well. We believe 2017 will bring more of the same volatility as global instability and uncertainty will continue as the year unfolds. How should the active investor understand 2017?
Three major overarching themes will be explored below and their investment implications for the active investor will be considered:
- Markets And Economies Will Go Through A Transition Period
Voters on both sides of the Atlantic delivered a decisive repudiation of their political establishment and shifted the fault lines of Western politics from left vs. right to open vs. closed. Globalization, liberalism and democracy are decreasing in popularity as they have become short hands for a rigged system that benefits only a self-serving elite. Nationalistic self-interest bolstered by outright populism will continue to upset the world order in 2017 with populists amassing power in the French, Dutch and German elections. Thus, a climate of political and economic uncertainty is likely to persist for the foreseeable future. As such, one of the key questions in 2017 will not be whether big new trade deals are concluded but where the anti-globalists will succeed in further eroding the rules that facilitate international trade and investment.
Sluggish growth will remain the new normal for the global economy. In 2017, world output measured at market exchange rates will increase by less than 3% for the sixth straight year extending what was the longest stretch of weak growth in more than half a century. Weak demand and poor productivity growth will continue to keep sustainable growth elusive as weak investment and overregulation continue to take their toll.
As such, the world's overstretched central banks will remain in the spotlight as growth drivers. Expect rates to remain lower for longer. Nevertheless, the U.S. Federal Reserve's importance and impact will start to fade in 2017 as real interest rates rise, market volatility resumes and the US Dollar continues to strengthen.
On the bright side, an on balance pro-growth Trump administration looks set to establish a more business friendly environment (lower taxes, lighter regulation, significant fiscal spending) in the U.S. which may provide a much needed tailwind for corporate earnings and U.S. stock markets. In addition, President-elect Donald Trump plans to put into effect a one-time tax holiday on cash that U.S. firms bring home from abroad. Both would mean more excess cash on companies' balance sheets, which could lead to more share buybacks but ideally to capital expenditures, increased R&D and perhaps ultimately to productivity growth.
Despite the prevailing climate of political and economic uncertainty causing global stock market volatility, look for regional banks (NYSEARCA: KRE) to outperform the S&P. These banks have further upside to EPS forecasts and already have solid loan growth, improving margins and will enjoy the strengthening path of wage inflation in the U.S. workforce. In fact, the Financials sector is expected to lead all groups with an 11.6% EPS growth rate in 2017.
As for emerging markets, 2016 was a year of incredible divergence with Brazil and Kazakhstan leading the way:
2017 will be no different as fears that the Trump Administration's policy approach will bring down the entire emerging world are overblown. Domestic strength in the U.S., a strong dollar and rising inflation will be favorable for certain emerging markets. Look for strength in Brazil, Canada, Russia, South Africa, India, Indonesia and perhaps even China. Stay away from Turkey and other countries that are vulnerable to external shocks arising from higher U.S. borrowing costs and Trump's policy changes.
As for earnings and free cash flow for the S&P 500 index, they are expected to grow at double-digit rates in 2017. Yet it is interesting to consider that to get where bulls think earnings are going, the economy would have to pull off a push that is unprecedented since at least 1937. Specifically, on the three occasions the U.S. has gone 7 1/2 years without a recession, earnings have never grown 10 percent this late in the cycle.
Thus, there are reasons to be prudent. Equity valuations have widened this year as prices rose and profits atrophied. Using data on CAPE ratios provided by Yale University's Shiller, stocks are more expensive now than 96 percent of the time since 1871. Currently at 28, the multiple has held at least one standard deviation above its historic average every month since July 2013.
Investors are indeed confident and thus the active investor should be cautious entering 2017. If the U.S. economy is not as close to full employment as we believe it to be, the multiplier effect resulting from Trump's proposed fiscal policy choices could be significant. In addition, the active long-term investor should remember that demography and sluggish productivity will make it very difficult to push economic growth up to the 3-4% hoped for by the Trump administration. After all, neither fiscal nor monetary stimulus has done much to lift Japan out of its rut.
In addition, in 2017 the steady flow of monetary stimulus from the U.S. Federal Reserve will be curtailed as it is now tightening policy. This won't be easy and it is unclear that the baton will be smoothly passed from monetary policy to a Trump administration's fiscal policy. Especially at a time where the hunt for yield has driven record demand for corporate debt issuance, the proceeds of which have in turn propped up stocks via buybacks…
Finally, and more fundamentally, the populism that has gripped the developed world feeds on its own failures. The more business tries to cope with uncertainty by delaying investment or moving money abroad, the more politicians will interfere with them distorting their operations.
As economic stagnation encourages populism, so pandering to the popular will reinforces stagnation. Thus, a Trump administration is no panacea and the active long-term investor will remember that the devil will be in the details especially while growth expectations and valuations sit at all time highs…
Prepare for a possible reckoning as the pendulum swings back...
- Rising Inflation And Interest Rates Will Favour Value Based Management Styles
2017 may prove to be an inflection point for markets and perhaps for management styles as well. This year growth strategies embodied by the iShares S&P 500 Growth ETF (NYSEARCA:IVW) seem to have begun to give way to value strategies embodied by the iShares S&P 500 Value ETF (NYSEARCA: IVE).
Before 2016 investors were prepared to pay just about anything for secular growth stories and thus we saw the relentless rise of FANG (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google, now Alphabet (NASDAQ:GOOG)). What has changed? Interest rates look set to rise along with inflation.
In September 2015, Barron's published an article looking at the relationship between value and interest rates. The article focused on the findings of Jonathan Lewellen, a finance professor at the Tuck School of Business at Dartmouth College who, at the request of the magazine looked, at the returns data for both value and growth strategies compiled by Kenneth R. French and Eugene Fama.
Fama and French's work on value investing and its relationship with growth investing is widely respected and considered to be some of the most robust research on the subject.
Lewellen looked at five periods of increasing rates from January 1983 to the present, and compared the returns of high book to market stocks (value) to low book to market stocks (growth) during these periods. The professor found that:
When the Fed was raising interest rates, value stocks had an average return of 1.2% a month or 14.4% year versus growths return of 0.7% per month or 8.3% year. However, over the six-month period leading up to rate increases, growth outperformed value with a return of 1.6% a month versus 1.5%.
Look for this trend to continue in 2017 as managers go back to basics and stock performance becomes differentiated by company fundamentals.
- The Elite Will Remain Disconnected With The Rest Of The Planet
As hinted above, perhaps the biggest trend this year has been the disconnect between the commentators' analysis and forecasts and what actually happened. It will continue in 2017.
Brexit and the American Election were analyzed wrongly yet funnily enough, this trend continued even after those big events, as the popular commentary repeated that there was a great deal of uncertainty whilst if you look at data such as consumer confidence in the U.S., it hit the highest since 2001.
Why? Perhaps one of the most significant risks facing the world today is how out of touch the elite is with the rest of the planet. Brexit, the U.S. election and other populist anti-globalization movements around the globe have placed the spotlight on the gross amount of class cluelessness that exists today. Growth and productivity in the rich world are stagnating and the fruits of what growth remains are getting captured by an ever narrower section of society. If we don't take steps to bridge the class culture gap, when Trump or other populist movements prove unable to bring prosperity to those left behind the consequences could turn dangerous.
Ironically, in a year when populist voters reshaped power and politics across Europe and the U.S., the rich just kept getting richer ending 2016 with $237 billion more than they had at the start. The politics of profits matters. Corporate profits rebounded quickly and robustly after the 2009 recession which has underpinned the outstanding performance of equity markets despite a sluggish economic recovery.
Yet the other side of the coin of a high profit share for investors, is a low share of GDP for workers as companies have kept their labor costs low. This lack of real wage growth has proven to be a key reason for the political unrest that has griped the developed world.
Thus, investors or "the elite" find themselves in a bind. The kind of real wage growth that would calm political risk would have a negative effect on profits and thus share prices.
The stage is set and sadly, 2017 looks primed for more fireworks…Expect class cleavages to fan the flames of market volatility and social unrest.
Stepping back and looking at the big picture, cracks in liberalism/capitalism's foundation are starting to show. This economic/political system began as a world-view premised upon the businessperson as a hero: one who dreams of a better world and who brings that world about through hard-work, discipline, compassion and craftsmanship.
Societies flourished with open borders and the free exchange of goods, capital and ideas. Today, the anti-capitalist intelligentsia (created by capitalism) dominate our classrooms as politicians decry open borders, open markets and even open mindedness. The problem is that people are loosing faith in progress. Liberals included.
Today, many in the developed world feel that progress is what happens to other people. Progress is what past generations had the pleasure of enjoying. If liberalism/capitalism is to make a resurgence it will need to address this growing malaise. It will also need new ideas and new champions.
Will we see forward progress on this issue in 2017? Unfortunately, we think not. Especially given the fact that 2016 heralded the beginning of the "post-truth" era. Our system of governance was always premised on reasoned debate regarding mutually agreed upon facts yet the combined effects of addictive and "entertaining" social media, shameless politicians and a weakening traditional media has made truth simply a matter of one's own personal "feelings" or "perspectives". We are each the "unique", "special" and "correct" stars of our own shows as we Facebook, Instagram and SnapChat our way through life trapped in our echo chambers. Indeed, it is always darkest before dawn.
Beyond The Stock Market
Despite the concerning aspects of these 3 big picture investment themes, they will provide the active investor with excellent opportunities to outperform.
Nevertheless, beyond stock market outlooks, the active investor should take the time to ask themselves: who am I? Instead of simply: where am I going?
They may find that when it comes to outcomes the former holds more importance than the latter.
"One must find the source within one's own Self, one must possess it. Everything else was seeking - a detour, an error." -Hermann Hesse, Siddhartha
All the best for a 2017 filled with thoughtfulness and contentment,
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Disclosure: I am/we are long KRE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.