For U.S. investors, after enduring many months of tumultuous market behavior during the year, 2016 ended on a positive note. At one point in February, the S&P 500 had dropped more than 12%. In the last quarter of the year, with the uncertainty surrounding the election, the market swooned again into election day, repeatedly testing the resolve of investors and their ability to stick to their plan. Those who did, however, were rewarded: the S&P finished with a total return of 12%, a recovery of approximately 24% from the February lows. Here are the numbers for the year:
EAFE – 1.9%
Barclay’s Agg Bond + 2.6%
In addition to a strong domestic stock market performance, commodities had a banner year largely due to a notable recovery in oil prices. After a strong seven-year run, real estate investments cooled, and bonds largely marked time. While it is always pleasant to discuss investment results with clients after years like 2016, invariably we start to get the same questions, such as: “Why do we own bonds at all?”, “Why bother with real estate or international investments?”, “Shouldn’t we just be in the U.S. market?”. Granted, the US market just had an excellent year, and over time is one of the top performing asset categories, with all indications are that equities have a bright future ahead. However, while we celebrate the gains we’ve achieved, it is important to note that we are now in the third-longest (albeit one of the slowest) economic recoveries since 1900.
I think Dr. David Kelly, Chief Global Strategist with JP Morgan, summed it up perfectly when he referred to the U.S. economy as a “Healthy Tortoise”. The slow recovery remains in good shape, but we cannot expect too much from it. I liken it to Lew “Iron Lew” Hollander, with 24 Hawaiian Ironman Competition finishes and the Guinness World record for oldest finisher ever at 82, when he says, “I haven’t sped up at all! I can still do the distance, I just can’t do the time or the speed.” We have a new year, a new administration, but an old recovery…we should be careful not to let our expectations run too high.
Over the past several years, we have preferred U.S. stocks to international holdings and the results have been in our favor. Today, we remain at our minimum international equity allocation but we are seeing some trends which indicate that opportunities may be improving overseas. In looking at the most recent Purchasing Manager’s Index (a widely-followed indicator of economic health) numbers globally, the U.S. posted strong numbers in December, but many other economies, including Australia, Canada, the Euro Zone and even the U.K. despite Brexit posted even stronger numbers. Our assessment is that for the first time in 5 years there is as much growth outside of the U.S. as there is inside, and many of those economies are very early in their recoveries, making them more sustainable and having much more room to grow. We will continue to monitor our allocation to the international sector with an eye toward increasing our exposure should the right opportunities develop.
Does this mean it’s time to get out of U.S. equities? Have they come too far too fast? Are valuations too high after the recent run up? We don’t think so, and here are some of the reasons why:
As the graph and table show, domestic equity valuations are only slightly higher as compared to historical norms. Given the recent strong growth in corporate profitability and our expectation for that growth to expand somewhat in the coming year, we feel these slight premiums are justified. However, as we were reminded in 2015 and in February of 2016, equity markets are volatile, and you must make sure you match the design of your portfolio to your needs and your goals. This ensures you have the cash available when you need it to accomplish the things that are important to you. For those of you who have worked with us over the years, you know that we at Cascade are firm believers in what we call “Strategy Allocation”, or constructing your portfolio to allocate among your short term needs for stability and liquidity, to your need to provide capital growth to sustain your years in retirement, and to your strategic portfolio, where you may trade liquidity for stable cash flows or higher expected returns. After that, the focus is on asset allocation, employing an endowment-based model to maintain exposure to multiple asset classes to provide adequate growth to achieve your goals, but with prudent diversification to provide a measure of stability to the portfolio over time. This story of asset allocation is best told here:
This colorful chart represent performance by each primary asset class since the year 2002. The columns represent each individual year, and the boxes represent the performance of that class each year. A couple of things jump out at me right away when I look at this chart:
To us, this tells the whole story of why it is important to Plan Wisely, Invest Confidently and stick to the plan. Understanding the journey to your goals is of paramount importance, just like “Iron Lew” knows there will be difficulties training for his race. Along his journey to the start line of the Ironman, he will encounter numerous mechanical issues with his bicycle, he will have long cold runs in the wind and rain, he will get blisters and sore muscles, and without question, tidal currents will pull him away from where he wants to go while swimming. He will slowly run up steep hills and descend at breakneck speeds on his bike. Hopefully, he will see some amazing aquatic life as he swims through the ocean and beautiful views along his runs and rides. He may get a little lost along the way, but these are all expected when taking on such a lofty goal. Your investment plan is the same way. If you know your goals, we can work with you to make course corrections, adjust the parts that aren’t working, prepare you for the bad weather and monitor your progress toward your goals.