4th Quarter 2016 Market Commentary

Executive Summary

  • Year in Review – “Worst Start”, Brexit, Trump surprise victory
  • Small cap and Value stocks outperform
  • Interest rates decline mid-year, then rise to finish year higher
  • Will the US pass income tax and corporate tax reform in 2017?
  • Late innings for the current US economic expansion
  • The folly of forecasts 

In 2016, the US stock market reached new highs. You may recall that the market began the year with the “worst start” of any year on record. The “worst start” began early, with a 5% decline in the Dow Jones Industrial Average in the first four trading days in January. It continued in mid February, with US stocks down more than 11% for the year. By year-end the S&P 500 Index was up 11.96%. That’s a remarkable difference in market performance within the same calendar year. It makes the case for long-term thinking and following a disciplined approach to investing.

Last year was also a year marked by surprises. In June, voters in the United Kingdom voted to leave the economic agreement with the European Union. Prior to the voting results, almost every poll, and certainly the financial markets, expected a vote to remain in the EU. The reaction from financial markets to this surprise was initially strong. The Dow Jones Industrial Average lost 900 points in two days, and the British Pound declined below $1.30, a level not seen for over 30 years. However, within a week, global stock markets recovered their initial losses and even climbed higher. It was a remarkably fast reversal in market sentiment.

Markets reacted strongly to the surprise victory of Donald Trump in the US Presidential Election in November as well. This time, markets corrected even faster … literally overnight. On November 8, the day before the election, almost every poll predicted a win for Hillary Clinton. The New York Times gave Clinton an 85% chance of winning, and famed pollster Nate Silver of FiveThirtyEight predicted a 71.4% chance for a Clinton victory. To say that Trump’s win was unexpected is an understatement. What is more interesting, however, is the initial reaction and subsequent reversal in financial markets. As the election results became clear, Dow futures fell as much as 800 points. S&P 500 Index futures declined 5%, prompting a halt in trading. In Japan, the stock market was open overnight and closed down -5.4%. European markets initially traded down but finished the trading day higher than the open. US stocks initially opened lower on November 9, but recovered by mid-morning and closed in positive territory for the day. Stocks continued to rally through the end of the year.

The Brexit and US Presidential election market reactions were initially severe with quick reversals. These two instances illustrate the human nature of financial markets, which can be ruled by both fear and greed. Investors are best suited by avoiding the temptation to act in reaction to headlines, surprises, and short-term events. Over the long-term, markets do a good job of pricing securities. 2016 provided some excellent examples of the pitfalls of short-term investment decisions.

Small and Value Premiums Return

The year marked a return to normalcy in regards to premiums for small cap and value stocks. After a multi-year run for large cap stocks, small stocks outperformed significantly in 2016. The small cap index, the Russell 2000 was up 21.31%, while the large cap Russell 1000 Index was up 12.05%. International small cap stocks also outperformed their larger counterparts. The MSCI World ex-US Small Cap Index was up 4.32% versus 1.00% for the MSCI EAFE Index.

Value stocks outperformed growth stocks in the US and internationally. The term value refers to stocks of companies that are trading at or below their book value of shareholder’s equity. This contrasts with growth stocks, which trade for a higher price than book value, generally in anticipation of high growth rates in earnings in the coming years. Over long time periods, value stocks have historically outperformed, with growth stocks experiencing bouts of outperformance in certain time-periods.

For US large cap stocks, the Russell 1000 Value was up 17.34%, while the Russell 1000 Growth was up 7.08% in 2016. The differential was even greater for US small cap stocks. The Russell 1000 Value was up 31.74%, while the Russell 1000 Growth Index returned 11.32%. That’s a 20.42% difference! Internationally, the MSCI EAFE Value returned 5.02% versus -3.04% for the MSCI EAFE Growth Index.

Interest Rates and Bonds

Bond prices retreated during the 4th quarter as interest rates rose. The US 10-Year Treasury yield, which began the year at 2.27%, declined to 1.49% by mid-year. It subsequently recovered and climbed to 2.45% by year end. Internationally, several countries had negative, nominal 10-year yields on their bonds at mid-year. The German 10-year bund yield was -0.13% and the Japanese 10-year yield -0.23% on June 30. Rates globally rose to end the year in “positive” territory.

In December, the Federal Reserve bank increased its policy rate by a quarter point to 0.50% – 0.75%. The Fed’s announcement cited “solid” job gains and an economy “expanding at a moderate pace since mid-year.”[1] The Board of Governors’ projections indicate they expect to raise rates 2-3 times in 2017. Perhaps we are finally entering a period of interest rate normalization, which is welcome relief for investors relying on fixed income returns. Of course, consensus has called for rising interest rates for the past 5 years. Anything is possible.

Municipal bonds saw $9 billion in outflows for the month of November. Rising rates, combined with investors taking tax losses, likely attributed to these outflows. Valuations in the municipal market have been high for several years, and credit spreads very tight.[2] Perhaps this pullback will allow room for opportunities to invest in municipals going forward.

Despite a 4th quarter pullback, international bonds and emerging market bonds posted positive returns for the year. The Citigroup World Government Bond Index (hedged to the US dollar) finished 2016 up 5.13%. The JPMorgan Emerging Markets Bond Index was up 10.19% for the year.

Tax Reform?

The combination of an incoming Republican President, House, and Senate in the US has investors expecting both personal income tax and corporate income tax reform in 2017. The run up in US stocks, particularly small cap stocks, is likely in anticipation of lower corporate tax rates.[3] As Michael Kitces points out in a recent blog, we may be “due” for individual income tax reform simply based on the calendar. The income tax was first introduced with the 16th Amendment in 1913, and subsequently amended by the Internal Revenue Codes of 1939, 1954, and most recently, 1986.[4] Reform tends to occur once every 30 years, and we are currently 32 years from the last reform bill.

A closer look at the US federal budget may provide clues of how likely reforms, or at least reforms with tax cuts, are in 2017. The Congressional Budget Office’s (CBO) baseline forecast for 2016 illustrates that income tax accounts for 40% of federal revenues, while corporate taxes account for 8%. Borrowing, to finance the deficit, accounts for an additional 15% of the federal budget. The CBO projects the debt, deficit, and the debt/GDP ratio, to rise over the next 10 years. Despite the lack of deficit and debt discussion in this fall’s election, there are many members of Congress concerned with these budget projections. The devil is in the details on how tax reform issues will be resolved, in addition to the President-Elect’s pledge to increase spending for defense and infrastructure. Stay tuned.

JPMorgan Asset Management: Guide to the Markets 1Q 2017, slide 25.

US Economic Expansion

On December 22, the Bureau of Economic Analysis released a third estimate for Third Quarter 2016 GDP growth of 3.5%, a strong number. The US economy is now 28 quarters, or 7 years into the current economic expansion. This is the third longest expansion since World War II. The latest unemployment rate of 4.7% in December, is well below the 50-year average of 6.2%. The Federal Reserve noted rising household spending and solid job gains in its decision to raise the Fed Funds rate in December. Not everything is perfect; however, as the labor force participation rate has declined from 66% in 2005 to less than 63% today. Productivity numbers, a measure of the amount of output per hour worked, also remain sluggish. The US economy is on solid footing and is stronger than most other economies around the world, a fact that often gets lost in the hustle and bustle of the 24-hour news cycle. Investors should not lose sight of the length and maturity of the current expansion. It begs the question, how much further can we realistically climb from here?

Forecaster Follies

Did you know that stock market forecasts are less accurate than weather forecasts? Every calendar year, stock market forecasters publish their new expectations. The flaw in this system is that calendar years are arbitrary for the stock market. Each day, investors are bombarded with thousands of new pieces of information about the economy, interest rates, inflation, individual companies, currency exchange rates, commodity prices, and international conflicts.

However, stock market forecasts are not a useless exercise. There is value in the interpretation of information. Rather than focus on the level of the forecast, investors are wise to dig deeper into the content and information supporting the forecast. The message here is to go deep. Question every 30-second spot on television and radio. Check the primary sources cited in magazines and newspapers. Intelligence is no match for the power of curiosity.

In the end, investors are best served by taking a longer-term view on the markets. As we learned from 2016, the “worst start” for any year on record in US stock markets became an 11.96% year for the S&P 500 Index. Over the course of an investor’s lifetime, there will be bull and bear markets, economic expansions and recessions, Republican and Democrat administrations, tax cuts and hikes, high and low inflation, war and peace. Rather than running in circles trying to predict the future, spend time focusing on how to build a portfolio that will withstand a wide range of possibilities; hopefully providing adequate return for the amount of risk in the process.



[1] Press Release; December 14, 2016, Board of Governors of the Federal Reserve System: https://www.federalreserve.gov/newsevents/press/monetary/20161214a.htm

[2] “A Post Election Discussion with the Muni Team Managers”, Thornburg Investment Management, December 2016.

[3] “Impact of Potential Tax Reform”, Schwartz, Jeremy and Russell, John; Wisdom Tree Investments; January 13, 2017, https://www.wisdomtree.com/blog/2017-01-13/Impact-of-Potential-Tax-Reform

[4] “Understanding the 2017 Income Tax Reform Proposals: President Trump vs House Republicans”, Michael Kitces, November 30, 2016; https://www.kitces.com/blog/understanding-the-2017-income-tax-reform-proposals-president-trump-vs-the-house-republicans/


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