December 31, 2016
The end of the year provides finality, if only in turning the calendar to a new year. For investors, the end of 2016 saw uncertainty replaced by absolute certainty in two important areas – the election and interest rates. With the election of Donald Trump and a Republican Congress, the market expects quick legislative action on a fiscal stimulus package, tax cuts and reduced regulations, all of which could provide a boost to economic growth and corporate profits. As a result, the stock market reacted positively and finished the year strong. In addition, after months of guessing by investors on the timing and magnitude of interest rate moves, at its year-end meeting the Federal Reserve (Fed) confirmed its confidence in the state of the economy and raised the federal funds rate by 0.25% and indicated its intention to bump rates higher in 2017, potentially more than once. Unlike stocks, bond prices reacted negatively post-election in anticipation that a stronger economy would put additional upward pressure on interest rates.
Between Election Day and year end, the S&P 500 hit eight all time highs, reaching 2,271.72 on December 13 and closed the year at 2,238.83, a total return of 11.96% for the year. For the fourth quarter, the S&P 500 Total Return (TR) was 3.82%. The Dow Jones Industrial Average TR was 8.66% for the quarter and 16.50% for the year. Our other key benchmark, the Bloomberg Barclays U.S. Government/Credit Bond Index return was a negative 3.39% for the fourth quarter and a positive 3.05% for the full year.
Leading all sectors, financials gained more than 20% in the fourth quarter as the potential beneficiaries of corporate tax cuts and a rollback of onerous federal government regulations. In addition, rising interest rates should help profits with wider lending margins.
We enter 2017 with contradictory signals in the equity markets. As the post-election “Trump Bump” pushed stock valuations up, price-to-earnings multiples climbed above their long-term averages in a rising interest rate environment – an unusual combination. On the positive side, several economic indicators improved in the fourth quarter not only in the U.S. but, surprisingly, in Europe and Japan as well. The U.S. unemployment rate dropped to 4.6%, consumer confidence continued to rise and the Purchasing Managers’ Index, which measures the outlook for manufacturing, reached a two year high. It appears that as growth is starting to accelerate globally, the expected stimulus package from the new administration may boost the economy further.
While stronger economic growth and accelerating earnings growth create a tail wind for the market, rising interest rates typically create a head wind. Investors may be disappointed if the new administration struggles to implement its economic policies as it faces the reality of trying to get things done in Washington. The market could be quite unforgiving if growth in the economy and corporate earnings aren’t as strong as expected.
These competing positive and cautionary scenarios play out against a backdrop of a re-assertive Federal Reserve. If the economy heats up, the Fed may become even more aggressive in boosting interest rates. While it’s important to stay abreast of macro factors, our primary focus remains on what companies are in our investment portfolios and where we see opportunities. As we start the New Year with significant changes on the horizon, we remain confident in our long-term investment approach, which involves continuing to seek out opportunities overlooked by the market and focus on good companies with durable competitive advantages.
S&P 500 TR (Total Return) Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock market. It tracks both the capital gains of a group of stocks over time and assumes that any cash distributions, such as dividends, are reinvested back into the index. It is not possible to invest directly in an index.
Dow Jones Industrial Average TR Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. It is not possible to invest directly in an index.
Bloomberg Barclays U.S. Government/Credit Bond Index is a broad-based flagship benchmark that measures the non-securitized component of the U.S. Aggregate Index. It includes investment-grade, U.S. dollar-denominated, fixed-rate Treasuries, government-related and corporate securities. It is not possible to invest directly in an index.
Price to earnings is a ratio of a company’s share price to its per-share earnings.
Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.