The Bottom Line
The market closed out the year with results that surprised even the most ardent bull – up +21.8%. Even more impressive was the complete lack of volatility on the way up. The market did not have any meaningful pullbacks – we only had a couple of -2% pullbacks. It’s been pretty much straight up since Trump got elected last year.
Looking back, the ingredients that powered last year’s rally are pretty much what we have experienced for several years: growth with low inflation. The economy has been on good footing and this has translated into improving earnings. Fiscal policy has also delivered as the tax plan is now reality. Surprisingly, interest rates have not gone up as inflation has been contained.
The New Year has started with a bang and we are now likely in the 7th-8th inning of this bull market. We have yet to experience the euphoric part of the rally where positive sentiment is rampant and investors throw caution to the wind ala the dot-com bubble of 2000 and the housing bubble of 2007. There are some signs that we are perhaps entering this stage, but if so, it is very early. These stages often last a year or two and are punctuated with higher volatility.
Looking forward, it’s hard to find evidence that the favorable fundamentals we are experiencing will change in the near term. Given the lack of volatility, it wouldn’t be a surprise that the market finds something to be worried about and a near term pullback ensues. We have often noted that, on average, -5% declines happen three times a year and -10% declines occur once a year. So if that happens, it doesn’t mean the bull is coming to an end.
Until the fundamental reasons for an enduring bear market occur, a bear market doesn’t appear to be in the cards. The biggest threat to the bull market doesn’t seem to be the economy; in our view if there is something that upsets the market it’s either higher interest rates or a geopolitical event that surprises us. The bond market seems to be taking growth in stride as inflation isn’t apparent yet, but this will have to be carefully monitored as this could easily change if the economy picks up more steam.
The Economy, Earnings, and Monetary Policy
We continue to see nothing but positive signs for the economy. Unemployment continues its downward trajectory, most signs of growth are improving, all of which is translating into an improvement in earnings. If there is any reason to be concerned, it’s that the economy may be approaching levels that trigger higher rates. But that is not currently the case.
Inflation has stayed lower than almost anyone has imagined, even in light of the pickup in economic improvement. The Fed is on record that they are surprised as well! There are important structural reasons that inflation has been contained: the baby boomers are starting to retire, the economy has been on a slow growth trajectory, efficiency from technology continues to improve and there has been a high global savings rate largely due to aging demographics.
The Fed is controlled by doves, though that may change under Trump, and they will likely be slow to push rates too quickly, and slow to unwind their balance sheet which has grown to historic proportions to battle the Great Recession. We do believe the days of easy money are behind us and we need to be on the watch for a more restrictive Fed if the economy heats up too much, and in particular, if inflation starts to tick up.
Valuation
We continue to be in the camp that while valuations are clearly extended by many, if not most measures, we feel this is the least important factor to be concerned about. Higher valuations are normal in a bull market. Moreover, relative to interest rates, the market doesn’t seem to be too rich. This underscores the importance of interest rates! If they move higher in a material way our opinion may change. But until then, we see rich valuations as a concern that will hamper longer term returns down the road but in the intermediate to long term they are not a reason to derail the current bull market.
Sentiment and Technicals
If there is one rule we weave into our analysis it is this: The trend is your friend. We categorize ourselves as trend followers in most everything we do. From that perspective, the market is on a strong footing. Big up years like we have had do not often result in bad bear markets in the near term. In that sense, the technicals are fine in our view.
However, we also are of the belief that longer term signs of excessive sentiment – either bullish or bearish – are often important sign posts of potential changes in secular trends. The lauded investor, Sir John Templeton, famously noted that “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” This is one of the factors that have kept us bullish since early 2013: This has been the most hated bull market in history. Investors have been loath to embrace the bull market, but this is starting to change. We are seeing early and very slight signs that investors are now finally becoming positive, but not quite euphoric. The “optimism turning to euphoria” mode can continue, so it’s not likely that a secular trend change is at hand now. As more of these signs evolve and sentiment gets too bubbly, we will start to raise our guard. For now we are just watching carefully.
Equity and Fixed Income Strategy
Our individual stocks closed out a very strong year, beating the S&P 500 by a large margin. This continues our fairly strong performance in our stock picking process over the last few years. We will continue to pursue finding companies that have a good balance of growth at a reasonable valuation, while retaining some measure of quality.
Our ETF Strategy also outperformed its benchmark of US Mid/Small and International stocks. We believe that the ETF Strategy may have better relative performance going forward as US Mid/Small and International have underperformed for some time and relative valuations here are attractive.
It is very anomalous for US Small/Mid and International to underperform for as long as they have in a bull market. Usually riskier assets such as these outperform US Large Cap in a bull market. We have essentially played defense over the last few years and avoided these areas by purchasing mostly US Large Cap areas we find attractive. However, this changed last year and we have moved a large part of the ETF Strategy into US Mid/Small and International in 2017 and its likely we will continue to add to these areas.
We remain very conservative in our bond strategy. With economic growth improving, the case for keeping duration and interest rate sensitivity low is strong, as the potential for higher rates is growing. We cannot discount another scenario here: one that keeps interest rates low for a longer time that most believe if inflation does not pickup. It is possible that the structural case for low inflation outweighs the cyclical case from a strong economy. But the risk for higher rates is too great in our opinion.