State of the Markets
The final quarter of 2016 saw dramatic shifts, both positive and negative, across many asset classes. These moves were primarily driven by the outcome of the election and the anticipated changes that will result from the new administration. Positive moves in U.S. stocks outweighed negative moves in bonds and emerging markets, which resulted in modest gains for the quarter and significant gains for the year across most portfolios.
The total returns for major asset classes are below.
2016 – Year in Review
While browsing social media, I saw that many people have declared 2016 to be a terrible year. The reasons vary but from an investment perspective the opposite is true. 2016 was a year that tested, and then rewarded patient investors with strong returns.
The year started out with a steep drawdown in equity markets. There was much speculation that this January decline was somehow predictive of a negative year overall but the markets were back into positive territory by early spring. Throughout the rest of the year, the negative news cycle seemed to dampen the confidence that is often needed for strong market returns, but once the election passed, the U.S. stock market surged and ended the year with significant gains.
2016 was also a year that illustrated the value of diversification. Almost every asset class had a turn being in the lead this year and many had a turn being in last place as well. At the depth of a significant January/February pull back, bonds were the only asset class with positive returns, providing significant ballast to diversified portfolios. Once markets recovered, emerging market equities, real estate, and MLPs led the pack for a good part of the year before yielding the lead to U.S. small cap stocks, which finished the year with gains upwards of 20%. The significant outperformance of small cap stocks (represented by the iShares Russell2000 ETF) is illustrated in the cart below.
A Few Thoughts
Below are several items worthy of comment regarding the state of the markets and returns over the past year. Below you’ll find our commentary plus a few takeaways on each topic.
Politics and Investing
Through most of 2016, politics – the Brexit vote in the summer followed by the contentious U.S. election in the fall – had an outsized impact on market returns and investor confidence. Interestingly, both the outcome of these political events and their ultimate impact on investments turned out to be the opposite of expectations, which once again reinforces the challenge of relying on the news to direct investment decisions.
Takeaways (quoting Howard Marks, Chairman, Oaktree Capital, who is famous for his wisdom and insight):
- First, no one really knows what events are going to transpire.
- And second, no one knows what the market’s reaction to those events will be.
There is Value in Sticking with your Strategy
You may have heard us speak about how we position our portfolios to have systematic exposure to smaller and cheaper parts of the stock market, which we refer to as small and value factors. You may have also heard us say that while we expect these exposures to provide increased returns over the long-term, there is no guarantee that they will be positive in any given month, quarter, or year.
For several years now, these tilts have contributed little to overall performance, which has led some to question whether the historical premiums associated with small and value will ever return. The rally in the fourth quarter was driven significantly by the small and value factors, tipping the scale for these factors from negative to positive across most time horizons.
- In the stock market, big moves sometimes come in short bursts and you have to be positioned to capture the upside no matter what drives it.
- The successful Implementation of a long-term strategy takes long-term patience.
Interest Rates and Bond Returns
The bond market had a positive return for 2016 but the choppy journey was driven by significant moves in interest rates. The 10-Year U.S. Treasury bond started the year with a yield of 2.27% and in a classic “flight to quality” reaction to the equity market decline, bond prices increased and yields fell. The yield of 10-Year Treasury reached a record low of 1.37%, before climbing back to 2.45% by the end of the year. The Barclays Aggregate U.S. Bond Index, which represents the broad U.S. bond market, had a total return of 2.65% in 2016. This journey and the relationship between interest rates and bonds returns (represented by iShares ETF) are illustrated in the chart below.
In the context of the full year, a 2.65% return for the bond market is very reasonable and in line with our expectations given where yields were at the beginning of 2016. However, when yields were at their lowest point, the return of the bond market was in the 6% range, and as yields climbed back in the fourth quarter, some of those gains were lost.
Adding exposure to low duration bond sectors like “High-Yield” and “Leveraged Loans” would have resulted in slightly better performance for the year, but doing so can significantly increase an investor’s exposure to low quality bonds, which can often result in more volatility and a higher correlation to the stock market.
In hindsight, this would have been an ideal move when interest rates were at record lows, but owning bonds that act like stocks can introduce unintended risks in a portfolio. We would much rather look for (and capture) significant upside from stock exposure than take on more risk in the portion of our portfolio designed to provide safety and liquidity.
- If we own bonds for safety, we should own safe bonds.
- Expecting and capturing reasonable returns is smart investing. Trying to pick up nickels in front of a steam roller is not.
2016 was a year with solid investment returns that defied most investors’ expectations. Being a long-term investor with a long-term strategy means being positioned to capture returns whenever they are offered to you.
 Bond prices and yields are inversely related. When yields decrease, bond prices increase and vice versa.