This is going to be a rapid summary of my thoughts shared with clients at the beginning of 2017. I'm not going to go into great detail because I realize that most if not all who see this do not want to spend the time reading a long dissertation. I will first offer some notes on the "Trump Rally." Second, I will list the positives and third, the negatives. Which will win out this year remains to be seen, but we would be foolish to ignore risk. How we plan for the risks should be at the top of our concerns.
Notes on the Trump Rally:
Dow 10,000 was reached March 30, 1999. Therefore, if it hits 20,000 in January 2017 it will have taken just shy of 18 years to get that far. That is an annualized price gain of just a bit over 4%. No wonder so many investors have been disappointed in their performance since 1999.
Consider that a Dow 40,000 in ten years would be only a price gain of a bit over 7.2% per year, which would be quite average from a long term historical perspective. Given current market valuation metrics, that might be optimistic.
If we believe in the basic adage of "buy low, sell high," then what we bought after the election makes long term sense. Most of our purchases were income equities that had corrected 10-15% from their recent highs. However, they did not appreciate as much in the Trump rally, and if we are just comparing against indexes, we don't look so smart.
The "Trump Rally" is somewhat less than what it seems on the surface. If you did not own the top 3-5 stocks of the Dow Jones Industrial Index, you made much less and only a third actually did much better than the average from the election through December. The broader larger stock market gained only a bit more than half what the DOW did and even those gains were mostly weighted toward a minority of stocks. Small company stocks performed the best. (Self-compiled statistics from various sources)
Index returns are not representative of most investor portfolios. For good reason most investors are diversified and are invested according to personal objectives, and direct comparison to any one index is not appropriate. If you are diversified among sectors, including international, and balanced with bonds and cash, it would be unrealistic to have achieved double-digit returns in 2016. A "balanced" portfolio having 1/3 intermediate bonds, short term bonds and cash along with 2/3 invested broadly in large, small and international stocks might have returned, after expenses, 3-7% in 2016 depending on weighting. (Self-compiled statistics from various sources)
Positive Factors that Could Mitigate Risks: It's not all bad, and here are some positives that could mitigate the negative factors if they come to pass.
Tax Reform - Lower Corporate Taxes to 10%. I'd say cut it to zero to make us not only competitive but make us the top tax haven for international companies who would bring their businesses here. (Note: corporations don't pay taxes; they are built into the price of their goods and services and passed on to us.) Greatly Simplify the Personal Income Tax System. The current income tax system is an abomination of complexity creating a huge burden on the middle class. And if both federal and state governments ended the immoral federal estate taxes and state inheritance taxes that hurt small business owners and middle class families, that would also be a huge boost.
Government Reform and Regulatory Environment Reform - Reducing governments' wasteful spending and controlling spending increases to be less than GDP growth would go a long way to managing our growing debt problem. Even a Spending Freeze for a year or two should be considered. Reducing burdensome regulations is essential to small business health. In conjunction with tax reform, if the Trump administration can slow government spending while lightening the overly repressive regulatory environment for small business, the economy could get a huge boost. I'm not holding my breath, but there is some hope.
Better Overall Policies Encouraging Small Business Growth and Overall Business Innovation.
Health Care Reform - The system is deeply flawed. Costs might be reduced with more competition on the services and product side. Funding needs to be creatively addressed.
Diplomacy Reducing Global Tensions - Diplomatic negotiation and actions need to be taken to reduce economic and military conflicts.
Effective Anti-Terror Progress - See above. Terror cannot be tolerated, much less encouraged. More effective cooperation with other countries in this area is critical, and severe penalties for countries that promote or support it should be consistently carried out.
Orderly and Lawful Immigration - Our country is built on immigrants. We need immigrants. But they must be here in an orderly and legal manner. If we can address this issue constructively in 2017 it will be a positive.
Less Business and Personal Debt - If these can improve along with lower government deficits, it would lower overall economic risk.
"Real Unemployment" (U-6)has shown modest signs of improvement.
The millennial generation has recently eclipsed the baby boomers in total numbers. If they can get good jobs and work hard like previous generations, they will help support the future costs of Social Security and Medicare.
Infrastructure spending. Necessary, and if can be done in concert with cuts in waste, it would be a positive stimulus.
If the outlook on a number of these remains positive as Trump takes office, early 2017 could be positive for the stock markets.
The Negative Risk Factors:
The Trump Rally is suspect from a fundamental perspective.
PE Ratios are quite high. The trailing Price Earnings (NYSE:PE) Ratio of the S&P 500 has been in the 24 (December) to 26 (current) range versus an historical average of 16-17. Levels above 20 are considered high during bull markets, so this is very high. (Sources: Wall Street Journal, Multpl.com, Macrotrends.com)
To justify such a ratio companies would have to increase revenues and earnings at a higher rate than most analysts consider probable going forward. Seven major financial institution strategists (in a 12/31 Yahoo Finance 12/31 article) averaged an S&P 500 target value of just under 2338 at year-end 2017, just 56 points (or 2.4%) higher than the recent January high. The uphill climb is likely to get harder.
Terrorism may be ramping up and tensions in the Middle East and elsewhere are significant. Major terror events can have terrible effects on markets and economies.
Global economic competition is fierce and foreign relations could be increasingly strained.
Immigration and refugee problems might get worse before they get better.
Europe could be headed towards disarray and many countries are undergoing strife and financial stress. (I remember a folk song (The Merry Minuet) from 1959 by the Kingston Trio that started out with "They're rioting in Africa, they're starving in Spain…" The song had a humorous lilt, but it accurately described a state of human affairs that is ongoing. I have thought about rewriting the lyrics. All I would need to do is change the names of countries and a few other minor revisions and it would describe today's world perhaps even more accurately than it did then.)
Individuals and families face the need for increasing income, while the economy is having trouble growing fast enough to create the jobs and pay levels necessary, much less support retirees' expectations.
Massive Debt including Unfunded Liabilities is a tremendous problem that will strain the economy. Add over $100 trillion to the $19 trillion most often quoted and the total IOU's of the Federal Government is estimated to equal more than $1 million per taxpayer. These estimates are a year or more old and don't include the debts and unfunded liabilities of state and local governments.
Health care costs as a percentage of GDP (currently 17.5%) are likely to increase. They rose 5.8% in 2015 and the 2016 rise could be more. The costs of both health care and education have increased faster than any other categories in the last few decades and the burden is becoming unbearable for the middle class.
Computerized Market Manipulation and High Frequency Trading -- I won't go into detail here, but large amounts of money are being traded in ways that have not existed before. I submit that much is happening that is not fair to small and traditional investors, and that the allowing of such trading adds risk to the overall market. Many of the types of factors that helped create the 2008 crisis have not been adequately addressed and both new and some old risks may have increased.
The math of index investing presents a new kind of risk to investors. I call it the "indexing math force." Huge amounts of money going into index funds forces buying of all stocks in the index, whether justified or not. The reverse would happen in a crash and that mathematical force has not been present before at this magnitude. A panic could cause forced sale of all stocks with few safe havens.
This bull market is getting long in the tooth and the higher it goes the harder it could fall.
As Will Rogers once said, "I am less concerned with the return on my money than I am with the return of my money."
Our financial and investment management should emphasize on "what can go wrong" scenarios and we need to manage and plan accordingly. Careful planning and a sound conservative strategy will be essential going forward.
I recommend that you make the annual review of your financial plan and investment strategy a priority in the next couple months.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: No specific positions are mentioned in this article. Our clients are invested in a diversified mix of securities.