Q4 Market ReviewSubmitted by Karstens Investments on February 10th, 2017
Michael D. Karstens, CFP®, AIFA®
After a rugged start, 2016 ended up being a very solid year for investors. The year actually began with its worst ever five-day start with the Dow Jones Industrial Average (DJIA) losing 6.2%. Fears of a slowing Chinese economy, plunging oil prices and worries of a U.S. recession drove the market lower into February. The DJIA bottomed at 15,660 on February 11th, a fall of 10% from the end of 2015, and a two-year low. Not coincidentally, oil prices also bottomed out on February 11th at $26.21, the lowest level since 2003 and a fall of over 83% from its high of $154.38 in 2008. As oil prices recovered and recession fears eased, DJIA rallied to 18,000 over the next two months, slightly above where it began the year. The next shockwave hit on June 23rd, when the U.K. voted to leave the European Union and markets around the world dropped sharply. The sell-off proved to be short lived for U.S. markets. In less than three weeks, the DJIA had recouped all the Brexit losses and recorded its rst record high since May of 2015.
Markets traded in a fairly narrow range and trended slightly lower into the election. Despite widespread fear that a Trump win would tank the markets, the markets actually rallied strongly after the election and most of the year’s gains were earned after November 8th. The Dow closed the year up 8.66% after a 7% post-election rally. The S&P 500 nished the year at 2,238.83 up 11.96%, while the NASDAQ Composite rose 8.87%. This year’s stock market rally extends a bull market that has tripled the DJIA from the March 2009 lows set during the nancial crisis.
The larger markets in Europe also posted gains but they were not nearly as robust as those in the U.S. The underperformance vs. the U.S. now goes back several years. For the year the U.K. market was the best performer (despite Brexit), up 13% while Germany (DAX) gained 6.7% and France (CAC-40) gained 4.5%. Spain and Italy both lost ground during the year. Emerging markets had a volatile year and were a mixed bag varying country by country. As a whole, the MSCI Emerging Markets finished up 11.60%. Despite the gain, this is the fourth year in a row the MSCI Emerging Markets trailed the S&P 500.
With the exception of agriculture, most commodities were positive in 2016 after severe losses in 2015. As mentioned earlier, oil prices bottomed at $26.21 in February then quickly doubled, closing the year at $53.72 per barrel, up 45% in 2016. This rebound was significant to the market as it not only eased the fear of a recession, but also calmed fears of massive bond defaults in the energy area. Zinc, nickel and copper were big winners based on economic optimism. Gold was sharply higher early in the year, but gave back much of the gain later in the year and ended up 9% to $1,159 an ounce. Silver did better, up 17%. Despite the rally in commodity prices, they still are at historically low levels (see Chart 1).
When you look at the annual returns for bonds, it looks like a pretty benign year, but there were actually some large swings in the bond market. The 10-year Treasury bond opened 2016 with a yield of 2.27%. With easy money, negative interest rates in Europe, recession fears and the shock of Brexit, the 10-year Treasury yield fell to 1.37% on July 8th, the lowest level on record. As fears subsided, the yield rose sharply and finished the year at 2.45%. This rise of the 10-year Treasury could be significant for a few reasons: 1) Mortgage rates are tied to the 10-year rate and rising mortgage rates could affect real estate prices. 2) Some believe we have bottomed in terms of interest rates and could be in a longer term uptrend in terms of rates. 3) Valuations of real estate and stocks have been driven higher by ultra-low rates.
A year ago, we wrote of the stealth bear market of 2015. Although the major U.S. indices - DJIA, S&P 500, NASDAQ - were all slightly up for the year, most other asset classes – U.S. small caps, international markets, commodities - were actually at to down. High quality stocks, value stocks and actively managed stocks had underperformed. The primary gains in 2015 were driven by a limited group of companies led by the “FANG” stocks (Facebook, Amazon, Net ix and Google/Alphabet). 2015wasn’t a great year for long-term, diversified, value investors like us. 2016 was a year of redemption, so to speak. Value outperformed growth, active fund managers began to outperform indexes, small company stocks rallied sharply and international stocks did very well.
As you can see on the back page, some of our closely watched funds had a stellar year. Gold mining stocks were star perform- ers up 56% (although they were up over 90% at one point dur- ing the year), a couple of the small cap Royce funds rebounded sharply up 26% and 32% respectively, and Lazard Emerging Markets fund was up 21% for the year. Twelve-month returns as a whole were very strong.
Looking forward is, as usual, a challenge. Clearly the market has embraced many of President Trump’s proposed policies. Business owners almost universally believe that over regulation has tied business development and look forward to an un-winding of some previous policies. In talking with engineering firms, all agree that there is a tremendous need for infrastructure. Potentially repatriating overseas funds to the U.S. would result in a huge amount of capital being brought back to the U.S. Perhaps more significantly, potential tax reform could dramatically improve the economy. All of these areas could be major drivers of economic growth. Unfortunately, things most likely won’t be this easy. Lowering tax rates, infrastructure spending and building walls all cost money. With government debt at very high levels, adding to this debt or printing more money could lead to some severe consequences. Inflation is certainly one of the possibilities.
Despite the positive year, we do have some worries about the stock markets. Stocks are trading at very high levels compared to historic values. At 7+ years, the current bull market is one of the longest ever. If interest rates have indeed bottomed and are set to advance over the longer term, stocks and real estate could be negatively affected. Rising interest rates also are a challenge for bonds. A 1% rise in rates can cause a significant loss in bonds. Geopolitical risks certainly have not been diminished and could rear their ugly head. And certainly there remains a great divide between Trump supporters and non-supporters and how this plays out is certainly a wild card.