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4th Quarter 2016


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Large-U.S. company shares posted a 3.8% fourth-quarter total return following a 3.9% return in the third quarter, a 2.5% return in the second quarter, and a 1.4% return in the first quarter of 2016.

The strong fourth-quarter return was unexpected and followed the surprise election of Donald J. Trump as the 45th U.S. president.


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Unexpected events last quarter capped a year of surprises.

In fact, 2016 may be recalled in history as a watershed year of spectacularly confounding outcomes.


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Fittingly, 2016 started with a surprise — and not a good one, the worst start ever to a year in Wall Street history.

In the first six weeks of the year, a crash in crude oil prices raised fears of a global slowdown, triggering an avalanche of selling and a 11% decline in the Standard & Poor 500 index, a measure of the value of America’s largest publicly held companies. Abruptly, the blue-chip index rebounded in the quarter’s closing six weeks, eking out a 1.4% return for the quarter.


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In the second quarter of 2016, stocks returned 2.5% — average gains, but they were fraught with fear.

On Friday, June 24, Great Britain’s vote to exit the European Union caused a two-day, 5.3 percent plunge in stocks.

After a two-day Brexit bashing, investors realized they had overreacted.

Surprise! Brexit was not a consequential economic event to U.S. stock investors. It was political. Should the U.S. lose all trade with all of Europe — including Great Britain — it accounted for 2% of GDP and would not have a material impact on U.S. economic growth.

Three trading days after the surprise Brexit vote, stocks rebounded, bouncing back strongly to return 2.5% in a rocky second quarter.


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In the third quarter, stock returns surged 3.9%, and positive economic data continued to contradict forecasts by economists.


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The surge since June 2016 in the Citigroup U.S. economic surprise index confirms that a stream of better than expected reports on U.S. economic growth has repeatedly surprised economists.


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Capping the year, the strong final quarter was attributed largely to the “Trump rally,” and it was aided by an exceptional 3.5% rate of economic growth in the third quarter, a strong earnings recovery in the S&P 500, and oil production cuts announced by OPEC.


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Markets are driven by economic fundamentals and the data underlying the economy fell into a virtuous cycle in the fourth quarter, with one good surprise feeding the next.

A new low in the unemployment rate was achieved, as job openings hit a record high.  Strong personal income rose, fueling spending growth and strong retail sales. The index of leading economic indicators (LEI) rose, the forward-looking monthly purchasing managers indexes improved, and the Federal Reserve reiterated its intent to maintain a stimulative monetary policy, lowering the chance that a policy mistake by the Fed would cause a recession, as has happened in all recessions in the post-war era.


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In the quarter ended December 30, 2016, a 10-point return gap separated the best from the worst.

Small- and mid-cap value stocks beat large-cap growth stocks, the laggards of this three-month period. Small- and mid-caps historically have outperformed in the past when investors are bidding stock prices up, as happened following Donald J. Trump’s election as the 45th U.S. president.


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The fourth quarter of 2016 marked a reversal from the third quarter, with U.S. indexes outperforming major foreign stock indexes representing bourses in China, emerging markets, Asia Pacific, and Europe.

Foreign markets’ U.S. dollar-calculated returns were handicapped by the dollar’s surge in strength in the quarter.


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Financial stocks soared in the quarter ended December 30, 2016, after a surge in bond yields led investors to bet a steeper yield curve would improve profits at lenders. Also driving financials higher, investors began assuming that some of the costlier aspects of the Dodd-Frank legislation regulating financial services might be eliminated under a Trump administration.

The energy sector gained on a rise in oil prices, following OPEC’s November announcement of a production-cut agreement.

At the bottom of the sector performance rankings in 4Q 2016 were health-care stocks, which sank on Mr. Trump’s plan to rein in excessive insurance price increases.

Of course, analyzing one quarter’s performance is of limited value. As a strategic investor, you want to understand quarterly performance but know how to put the recent short-term data in perspective.


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These two charts are placed side by side to show you the quarter’s performance versus a long-term portfolio.

On the left is the performance of the 10 S&P 500 industry indexes for a single quarter and on the right is the corresponding sectors’ five-year performance.

Financials were No. 1 in the quarter and also are top-ranked for the five-year period. However, the No. 2 sector of the quarter was energy, and that sector’s paltry return earned energy stocks last place in the sector performance race over the five-year period.


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Think of the past five years in the context of the recovery that was ignited after the near-collapse of the global financial system in October 2008, during the global credit crisis, and historic global recession that ensued for the first three quarters of 2009.

Financials, as you might expect, sustained the worst losses in the Great Recession and, quite naturally, have the biggest bounce back recently to become the No. 1-performing sector over the past five years. As Nobel laureate, Bob Dylan would say, “The first one now will later be last.”

The next three best-performing sectors — consumer discretionary, health care and technology — consist predominately of growth stocks, companies with strengthening earnings since the worst economic calamity of the post-war era, the Great Recession, this generation’s Great Depression.

Conversely, the lagging sectors — energy, utilities, telecom services and materials — the value stocks, which have less sizzle and, as you might expect, share prices have not run as hot as investments in fast-growing shares.

The energy and material sectors were slammed by the collapse in crude oil, as were commodity prices generally in this five-year period. The price of a barrel of oil, while up 100% from its early 2016 bottom of $26 per barrel, still is priced at less than half its peak of $114 per barrel in 2014. The energy sector of the stock market is highly correlated with crude oil prices.

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Looking at the performance in the fourth quarter of 2016, crude oil rallied on the strength of OPEC’s November production-cut agreement, pushing up the GSCI commodities index, which has a heavy crude-oil weighting, and the MLP index with it.

The S&P 500 index rallied 3.8% in the fourth quarter in what the press tagged the Trump rally.

Leveraged loans and high-yield bonds rallied with investors’ continuing their “risk-on” posture.

Fixed income, across the spectrum, posted negative returns, as bond yields surged post-election.

And, gold slumped as the U.S. dollar surged post-election.


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In calendar-year 2016, the S&P 500 stock index gained a robust 12%, as U.S. companies recovered from last year’s collapse in earnings in the energy and mining sectors.

The average share in the S&P 500 plunged 12% in February on fears that a global slowdown led by China would begin as crude oil prices sank below $30 per barrel.

Those fears abated by the end of the first quarter of 2016 as global economic data firmed up.

Healthy monthly jobs reports, a declining unemployment rate, and a rising index of leading economic indicators buoyed stocks until — surprise! —  Britain voted to exit the European Union in the last week of the second quarter of 2016, which rocked the S&P 500 with a loss that Friday, June 24, and the following Monday, totaling 5.3%.

On Tuesday, sentiment abruptly changed and the blue-chip stock index fully recovered by the second quarter’s end, within a week’s time.

Stocks rallied in the third quarter of 2016 on a surprisingly strong July jobs report and the S&P 500 trended more-or-less flat through September’s end.

Stocks rallied again in the fourth quarter on the Trump election win, OPEC’s announced production cut, strong 3.5% third-quarter GDP growth, and a continued flow of better-than-expected economic news.


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Examining stocks by their size and investment-style characteristics in the 12 months ended December 30, 2016, small- and mid-cap indices led U.S. stocks. They had been the laggards in 2015.

Investors, broadly speaking, bid up prices for risk as 2016 progressed and economic data strengthened both in the U.S. and globally.

Conversely, large-cap growth issues, which had huge runs in 2015, led by Facebook, Amazon, Netflix and Google, took a breather in 2016.

This was yet another illustration of how good performance among sectors, styles, and market cap routinely rotates.


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The purple bars show returns in 2016 for U.S. stocks with different styles and market capitalization, and the blue bars show the performance of that style in 2015.

Rebalancing once a year at the end of 2015 would have meant buying the biggest losers of 2015, which in 2015 were small-cap value and mid-cap value stocks.

In 2016, the purple bars indicate rebalancing would have worked well because those two styles were the best performers in 2016.

It’s easy to see how rebalancing at year-end 2015 would have added to diversified portfolio returns in 2016.


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For the 12 months ended December 30, 2016, the energy sector was the standout as it recovered from the beating it took with 2015’s oil price collapse.

Telecom, the No. 2 top-performing sector for 2016, showed a 23.5% gain as investors sought out dividend yield in lieu of record-low bond yields.

Virtually all of financials’ 23% surge in 2016 occurred in the fourth quarter, with the post-election rise in bond yields encouraging investors to believe increased banking profits will result from a steeper yield curve.

Industrials and materials, cyclical sectors that are sensitive to perceptions of improving momentum in the economy, both had nice gains on signs of improving U.S. and global economic data.

The health-care sector took a hit in 2016 on heightened public sensitivity to excessive price increases.


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This chart illustrates the impact of rebalancing a hypothetical portfolio across the Standard & Poor 10 industry sectors.

The sectors are ranked by their 2015 performance, which is in blue. The purple bars show 2016 return.

In 2015, the worst sector was energy. Rebalancing would have meant buying the biggest losers of 2015 to make up for the diminished influence in a diversified portfolio.

In 2016., energy was the top-performing sector.

Rebalancing at year-end 2015 would have added to diversified portfolio returns in 2016.

Diversification is no guarantee of investment success but it seems likely to improve the odds.

If you want to be sure you are rebalancing your portfolio properly, please contact us because this can be a really important investment technique over the long run.


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For the 12 months ended December, 2016, in a turnaround from the third quarter, U.S. stocks outperformed rest-of-world on the strength of the “Trump rally” and the U.S. dollar’s fourth quarter’s surge of about 7%.

A strengthening dollar masks the foreign stock index gains.  A strengthening dollar makes it tougher for foreign markets’ indexes, translated into dollars, to keep up with returns on U.S. stock indexes.

Even though these markets showed gains in 2016 in their local currency, their share prices are reduced in their dollar value.


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Over the 12 months ended December 30, 2016, crude oil doubled in price from its January bottom of $26 per barrel. Master Limited Partnerships (MLPs) and high-yield bond indexes surged. The high-yield index is significantly weighted in oil exploration company debt issues.

Third among asset classes in the 2016 performance rankings was the S&P 500 index, which returned 12%, exceeding most forecasters’ expectations. The fourth-quarter post-election “Trump rally” accounted for 3.8 percentage points of the 12% gain. which means that the rest of the year was strong, too. That was because economic and corporate earnings data improved as the year progressed.

Near the bottom of last year’s rankings were bond indexes, both taxable and tax-exempt, which posted only fractional returns as bond yields surged post-election.


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Looking at the broad array of asset classes represented here, perhaps the biggest surprise was the 16.9% return on high-yield bonds in 2016.

For high-yield bonds to be the No. 2 performer among 13 different asset classes defies logic!

High-yield bonds are a fixed-income asset class, and fixed-income investments were among the worst performers for the year.

Yet junk bonds returned nearly 100% more than their average annual return of 8.5% over the past five years.

This underscores the wisdom of diversification and rebalancing. No one can reliably predict the next best asset class. So you really cannot lament not owning more stocks.

Other important takeaways from this one-year chart is that Master Limited Partnerships were the No. 1 asset class of 2016 after getting hammered in 2015.

MLPs are a new asset class that appeared in the last few years. Income investors suffered large setbacks a year ago in MLPs, but the business has recovered and they were at the top of the heap in 2016.

This, again, was quite a surprise.


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After trading sideways for approximately a year, from mid-2015 to mid-2016 — hitting two turbulent air pockets along the way and nosediving in two frightening double-digit descents — the S&P 500 broke out in the second half of 2016.

Over the five years ended December 31, 2016, the S&P 500 with dividends reinvested returned a total of 98%. That’s a 78% price gain, with a 20 percentage point return differential coming from dividends being reinvested.

The likelihood of a bear market — a correction of at least 20% — increases as the bull market grows older.

But fundamental economic conditions that have accompanied bear markets in the past were not present as of early 2017. Restrictive Fed policy, the likelihood of slowing economic growth, stock market overvaluation, and irrational exuberance — historically important precursors of a serious market downturn — were not evident.


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For the five years ended December 30, 2016, the third and fourth quarters’ small-cap surge put small-caps back in first place. The S&P 500 large-caps had been leading for many quarters in a row.

Small-caps’ return to leadership reflected investors’ improved confidence in the economic outlook and a growing appetite for riskier assets.


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For the five years ended December 30, 2016, what particularly stands out is how the U.S. indexes – small-, mid- and large-cap – outperformed rest-of-world.

Also, among the U.S. indexes, note that small- and mid-caps lead the large-cap S&P 500 index. This is, in fact, the long-term pattern in which investors have gotten slightly better returns in small- and mid-caps compared to large-caps in return for taking slightly more risk, as measured by volatility of returns.


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For the five years ended December 30, 2016, the index representing large-cap U.S. stocks was the No. 1 performer among this array of 13 different asset classes. Keep in mind a prudent investor would, by definition, own the array of asset classes and would not perform as well as the S&P 500. However, nor would a broadly diversified investor have performed as poorly as the worst-performing asset class. That is the nature of investing for the long run by using the path of moderation and broad diversification.

REITs, both U.S. and global, were also top performers in this five-year period.

The S&P 500 index’s total return of 98% over the past five years is almost triple the return of 35% on the S&P Global index excluding-U.S. stocks. This was testament to the resilience of the U.S. economy, relative to foreign economies, in recovering from the last recession, which by historical standards was severe.

In last place, of course, was crude oil, having been broken by the surge in U.S. supply that came from the shale-fracking revolution. Commodities and gold, too, have been money-losers over the five years shown because of the strong dollar, slowing growth in demand for most commodities, and dwindling inflation.

Looking at five years of returns, the Standard & Poor 500 was No. 1 among the broad sampling of 13 asset classes, hinting at what a heady period this has been for U.S. stocks.

Bonds showed a 9.3% cumulative return over the past five years — a 10th of what stocks returned in this same period — and the next five years are almost certain to be even more cruel to bond investors.

Interest rates hit lows over the past five years that have not been seen in generations in a long cycle of declining interest rates.

However, the Federal Reserve hiked rates a quarter point in December 2015 and again in December 2016; while rates are widely expected to head higher gradually in 2017 and 2018, a rising rate cycle is now underway and likely will last for years.


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The Standard & Poor’s 500 index and gross domestic product — the metrics of U.S. financial and economic strength — both surprised everyone on the upside for the year.

Despite the worst start to a year ever, stocks defied expectations, gaining 12% in 2016 — compared with the average annual return on stocks since 1926 of about 9.5%.

After the November 8 election of Donald Trump as the 45th U.S. president, which was a huge surprise, stocks repeatedly broke records before profit-taking in the last week of the year.


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What’s more, the economy in 2016 grew by 3.5 percent.

That was better than almost anyone expected at the start of the year.


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This chart of recessions and recoveries since 1957 versus the price of stocks shows the current expansion, at 91 months old, is a little more than two years shy of becoming the longest recovery in modern U.S. history.

If nothing bad happens, this expansion stands a fair chance of becoming the longest on record.


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The depth of destruction wrought in the Great Recession has made this expansion different from others — slower, but with inflation staying dormant.

The 2.4% growth rate expected in 2017 maintains the economy’s growth trajectory in a stable, sustainable low-inflation environment.

This 60-year chart of U.S. economic cycles shows that recessions trigger bear markets; however, not every bear market has occurred in times of recession.

Stock-price corrections of 10%, or even bear-market drops of 20% or more, have occurred during economic expansions, and that could happen again.

At this stage in an extended bull market, broadly diversifying becomes difficult for some investors.

When they see stock prices soaring, they lament not owning more stocks.

So let’s talk about that.


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By definition, diversified portfolios can’t keep up with the returns on the S&P 500 in a bull market.

A diversified portfolio is guaranteed to underperform the best-performing asset class in a portfolio.

It’s also guaranteed not to perform as badly as the worst asset class.


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Diversifying is a systematic way of trying to moderate the ups and downs of investing for the long run.


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If you're on a path with steep ups and downs, you are more likely never to get where you're trying to go.


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A frightful descent is more likely to make you abandon course.

If you own an all-stock portfolio, you’ll bail out of the market when things get scary.


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The moderate path is not as exciting but is easier to complete.

 


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2nd Quarter 2017
1st Quarter 2017
3rd Quarter 2016
2nd Quarter 2016
1st Quarter 2016

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.
@2017 Advisor Products Inc. All Rights Reserved.

 




©2017 Legend Financial Advisors, Inc.®. All rights reserved.