Happy New Year! And here’s hoping that three weeks into the new year at least one of your resolutions is still intact. Personally, our stretch goal of avoiding terrible puns for an entire year lasted...approximately thirty seconds. (Something about ushering in the New Year with the sound of trumpets. Trump-Pence….trumpets….ugh. Even we were ashamed.) But since we already went there, we didn’t think twice about “Planuary” for this month’s newsletter. January is the time of year one gets to read all sorts of fantastic click-bait; sorry, fake news; sorry, magic 8-ball prognostications; sorry, forecasts of what the year ahead will look like.
Have you ever gone back and looked at those forecasts a year or two down the road? This is kind of what it has looked like recently. And by “recently”, we mean every year for the last 4 years.
For those keeping track at home, US growth has not gotten back to 3%, rates have not gone up, headline inflation hasn’t much moved, China hasn’t collapsed, and neither has the Eurozone. Yet, anyway. Now, there’s a reason these same forecasts have been trotted out year after year - there is a good bit of truth to the assumptions underlying those forecasts. It’s just that the timing goes a little wonky sometimes.
In our view, predicting what will happen over the course of a year is....perhaps a fun exercise in Nostradamic role play (and is a great excuse to put on our wizard coats and hats), but largely doesn’t accomplish much of anything for us or our clients. We feel it’s more important to be aware of potentialities in the coming year and have a plan for how to deal with them as they develop. Or don’t develop, as the case may be. A plan for taking advantage of investment opportunities that might arise. For avoiding crises that are likely to develop.
We wish we could show you our space-time echolocation machine used for discerning such potentialities, it is wicked cool. Unfortunately, the patent is still pending and we can’t just be giving away our intellectual property like that.
We wrote after the election that US stocks were up based on expectations of growth and a business-friendly environment. Within the last week, it seems like some of those expectations have been walked back a bit - notably, tax reform doesn’t seem like the done deal it did a month ago - and stocks are responding by walking back some of their gains as well. We have long felt that the stock market in the US has been overextended based on what the economic fundamentals would suggest - in effect, a large-scale version of what we’ve seen over the last month. Stock prices have gone up based on expectations of future growth; front-loading returns, if you will. If the growth/reforms/expectations materialize as expected, that’s already been accounted for. If they don’t materialize, well, then the market drops.
How to plan: Returns are probably skewed to the downside, but we’re not there at the moment. There is potential for stocks to do well again this year, especially if pro-business policies are implemented, so to start the year we are fully invested within our US allocation, but aware of the potential for a correction to what we view as an overextended market.
Initially, there would seem to be more value in international stocks. They haven’t gone up nearly as much as the US market has over the last five years, which means they are not nearly as overextended. But. The Eurozone has some serious, possibly existential issues that could be brought to the surface this year. Remember Brexit? Yeah, so negotiations for that whole process are about to start. But that’s not the issue. The issue is that it’s not just England. The populist parties in almost every Eurozone country have been gaining in popularity, and there are some big elections coming up this year. Germany, France, and Italy will all be holding elections. Italy’s reform-minded Prime Minister lost a national referendum last year, so he’s out (Renzigned! Remember that one from the last newsletter?). France is electing a new President, as Francois Hollande has already said he won’t run again, and the current front-runner is Marine Le Pen, who is vocally anti-Eurozone. And Angela Merkel is already dealing with her own anti-immigrant populist sentiment in Germany so is not likely to want to stir any more populist ire by being particularly accommodating to anti-Eurozone factions.
How to plan: Expect even more volatility in international stocks. Buy and hold likely won’t do much for you this year, but if you can take advantage of headline risk throughout the year there are potentially some real opportunities.
Two things go into fixed income yields, really - rates and inflation expectations. The Fed has hiked rates once in each of the last two years. Each one was just 0.25% so didn’t really do much of anything in and of itself (other than let banks start making money again), but two points does make a line and it looks like the Fed is set to raise probably a couple more times this year. Inflation numbers have also been creeping up recently. Since registering 0% year-over-year inflation in January 2015, inflation has for the first time gotten back to 2%. The Fed has strongly hinted that they would be comfortable with inflation levels above 2% for a while in the interest of fostering the economic recovery. Add to this the expectation that a Trump agenda will be paid for largely by issuing lots moar debt (which theoretically should increase inflation by putting more money into the system), and the stage is set for bond prices to fall as yields rise.
But! Plot twist! If yields go up too much, it will be a negative thing for the stock market (for a couple different reasons, but just imagine that companies won’t be able to repay their loans if that helps you visualize it), and when the stock market goes down people like to buy US Treasuries for safety. Which means that the price of Treasuries goes up and yields will therefore go...down! Temporarily, at least.
How to plan: So put it all together, and the likely course of action is that yields will rise on bonds over the course of this year, causing prices to drop, but not catastrophically so. We’re not talking about going back to the 70s when savings accounts yielded 16%. This gradual increase in yields will likely be punctuated by periods of rising prices (and falling rates) as a hedge to uncertainty in the stock market (see: expectations of volatility in US and International echolocation pings). The good news is that you might be able to buy US Treasuries with a 4% yield at some point this year, and hot damn, that’s almost enough to get that retirement portfolio to last more than a decade.
If you wanted a single number for performance expectations for the year, sorry. Not getting one here. Search online, there are a bunch out there. Or throw a dart. Or, copy and paste this formula into excel:
That should get you close.
If you’re familiar with our investment philosophy, you will understand that a single end-of-year number is pretty meaningless. Say markets are up 2% at the end of the year. But what if the way they got there was down 20% for the first 6 months, then up 40% in 4 months, then down 9% over two months? You end the year up 2%, but wouldn’t it have been nice to miss some of those drops rather than just riding everything out? Yeah, we think so too. And that’s what we try to do. If you’re curious, ask us how! We’re always happy to have that conversation.
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