“With all thy getting, get understanding” (Proverbs 4:7)
My first job real job in the investment business was as a municipal credit analyst back in early 1990 for Clayton Brown & Associates, a small, regional broker-dealer here in Chicago, and Mr. Brown used to teach Bible study in the firm’s conference room. A number of people went, (including myself occasionally), and I enjoyed the study, although i learned (at least for me) that to study the Bible too intensely or rigorously, was to lose some its wisdom.
The above quote is all about “getting” wisdom, and my belief is that you don’t really learn wisdom in the investment business until you’ve experienced a bear market (or two) and in the 2000’s, we saw two bear markets of enormous scale, that resulted in the monthly, rolling, 10-year return of the S&P 500 reaching a negative return in January, February, 2009, that had not been seen since the 1930’s or the Great Depression.
From a bigger picture, broader global scale perspective, I do think the S&P 500 began a secular bull market in March, 2009, and S&P 500 returns will be “normally distributed” once again, i.e. good years and bad years, but nothing like the scale seen from the late 1990’s where the S&P 500 rose 143% cumulatively from 1995 through 1999, and then the decade from 2000 to 2009, the S&P 500’s total return for that 10-year period was just 12% cumulatively.
With 12% “expected” earnings growth from the S&P 500 in 2017, the US stock market has one of the strongest fundamental metrics in its favor as we kick off 2017, before any additional positives from major tax reform, cash repatriation, lower tax rates for US corporations, better small business sentiment, less regulation and any number of pro-business and pro-economic growth incentives that have been put into the pipeline since November 8th.
The S&P 500 is expecting its strongest year of earnings growth in 2017, since 2011, with 12% earnings growth expected. What’s more, those who regularly follow earnings data as this blog does, knows that this 12% growth rate has not seen the typical downward revisions that occur as the clock ticks closer to the quarter/year, which is a positive signal that the earnings growth rate will be realized. (Note these articles here and here.)
Reread those two links – given what we now know on December 31 ’16, there is some prescient analysis contained in both (and rarely do I blow my own horn).
Top-down 2017 expected allocation (thinking about the standard 60% / 40% asset allocation for retail clients):
- Overweight US equities
- Underweight US bonds
Clients' relative weighting between stocks and bonds has been what is shown above since 2009, and really hasn’t changed in six years.
Equity allocation:
The top two sector overweight’s in 2017, are expected to be the same (for clients) as the last six years, Technology and Financials, since the two sectors comprise roughly 35% of the market cap of the S&P 500 as it stands currently.
The top three sector overweights relative to their S&P 500 benchmark:
- Technology
- Financials
- Energy
Energy is likely a temporary trade through the first 6 – 9 months of 2017. The supply-demand dynamics of crude oil have forever changed from both the supply (fracking) side and demand (electric and hybrid auto’s) side. Gasoline distillation drove about 50% of the demand for crude oil over the past 30 years, and I simply cant see how that doesn’t decline with more and better electric cars and hybrids. President-elect Trump has talked about favoring traditional fossil fuels, but I just don’t think that cat is going back in the bag. Tesla (NASDAQ:TSLA) is going to survive and ultimately thrive. (Long a small position in TSLA.)
The “dividend trade” and the safety trades have been avoided for clients for years simply because I felt these were crowded trades, and that 2017 will likely see the same avoidance. Utilities, Staples and REITs, real estate will continue to be
Client’s largest Health Care position is Pfizer (NYSE:PFE), and a much smaller weight in Merck (NYSE:MRK), although the Health Care weighting today is far short of its 15% S&P 500 benchmark weight. Could that reverse in ’17? Sure, but Health Care has been a crowded trade the last few years given muted market returns, so I’d like to see it under-perform for a few more quarters.
Emerging markets had a tough 10 years following the incredible rally from 2003 to 2007. Some Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and iShares MSCI Emerging Markets Fund (NYSE:EEM) was bought in Q1 ’16 for clients as well as iShares MSCI Brazil Capped (NYSE:EWZ), but these are small weights in client accounts, still under 5% total. Emerging market ETFs had never been bought for clients before this year, but as of Q1 ’16, the 10-year return on the EEM and VWO had gone negative. Couldn’t pass that up.
The core equity “premise” is that President-elect’s and Congress’s policies as currently being discussed, including Mr. Trump’s cabinet appointments, could result in one of the most pro-economic-growth, pro-business and pro-wealth creation economies of the last 50 years. That means S&P 500 earnings growth and that should lead to a strong stock market in 2017.
Fixed income allocation:
Client’s bond allocation looked pretty bad up until the Brexit lows, and now it looks pretty “smart”.
The majority of client fixed income money is in cash, with roughly a 10 – 15% Treasury short position via the ProShares Short 20+ Yr Treasury (NYSE:TBF) in client accounts, and client fixed income money has been invested like this for many years. Some clients do own Strategic Income funds like Bill Eigen of JP Morgan, and the BlackRock Strategic Income Fund, and it is expected that these funds will be added to, but only as interest rates hit predetermined levels, such as the 10-year Treasury yield reaching 3.5% – 4% and then again at 5%. (Here are some previous blog posts on the fixed-income strategy, here and here. Again, looked pretty bad then, not so much now.)
High yield had a good year this year, up roughly 14% – 15%. Some iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) was bought for clients last Spring ’16 as commodity prices started to recover and then sold over the summer ’16. Here is a Seeking Alpha article written in the past few weeks on how the market caps of the HYG differs from the S&P 500. Although high yield bonds might look attractive here with the pro-growth policies in Washington being discussed, my own opinion – as the article states – is that high yield could simply end up being “less negative” across the fixed-income universe if the rise in rates is dramatic enough.
My own opinion is that the Treasury market and duration-sensitive markets are due for a blood-letting that the NASDAQ saw from 2000 – 2003, if only from retail investors' expectations.
Here is what is worrisome today:
- Bullish sentiment around the stock market has already risen rapidly, even though – over the last two years – sentiment remains below 50%.
- The 10-year Treasury yield just since November 8th (the election) has risen 80 basis points, and mortgage rates have followed
- President-elect Trump will have to “disavow” a lot of his campaign promises: he cannot weaken Mexico economically and expect less illegal immigration.
- President-elect Trump’s trade commentary and trade rhetoric were absolutely “Smoot-Hawley” Part II. Protectionist and protectionism are “no bueno” for expected stock returns, bond returns or the US economy.
- Here is my biggest fear: all this fiscal stimulus is being proposed with a US economy sitting with a 4.6% unemployment rate. The only “carburetors” that could help temper a rapidly-overheating economy are the US Treasury market, the US dollar, and the Fed. (Saying that, readers might now understand the logic behind the fixed-income allocation.) Given the commentary, the US economy is poised to go from 0 to 60 in a hurry, or from 8 years of sluggish, monetary-policy-induced growth, to rapid growth in a short period of time.
No question this was enjoyable to read. Strategist forecasts for 2017 look pretty subdued.
Remember, client positions and forecasts can change at any time. Look at Q1 ’16. The S&P 500 in 2016, had its worst start to a year ever, and yet the benchmark ended the year +11% – 12%.
Check back for an S&P 500 earnings update and a look at expected Q4 ’16 S&P 500 earnings.