Year in Review
2016 could go down as the year of the underdog. In January 2016 market had one of the worst starts to the year on record with a decline of 5.5% for Dow* and 8% for Nasdaq*. Worries about the global economy pushed oil under $30 a barrel to hit 12-year lows. Many European stock markets entered into bear market territory, and data from China seemed to suggest a slowdown. Typically, weak starts to the year have led to losses the rest of the year, but just as quickly as the markets fell, they recovered and stabilized until the summer.
A surprise Brexit poll in June made the once unthinkable – the UK leaving the European Union – a real possibility. George Soros called the event “Black Friday” for Britain. The British Pound fell to a 31-year low and Britain’s 5 largest banks fell an average of 21% morning after referendum. The French CAC and German DAX responded by falling 10% at opening, but like Rocky Balboa, global markets seemed to shrug off the volatility even in the famously weak summer season. The FTSE recovered by July and it new highs – rising more than 20% from Feb low.
The presidential election brought new drama as the market rolled into the fall season. Many investors were holding a lot of cash as they were afraid of the potential volatility or fallout from any surprises. Hilary was the clear favorite in the polls but the days leading up to the election were suspenseful as the FBI both re-opened and closed an investigation in short order.
Source: S&P Dow Jones Indices
Donald Trump surprised everyone and beat Hilary Clinton to clinch the presidency. Famous portfolio managers had predicted severe losses if he was to be elected, and they were right for exactly one night. The market fell over 5% overnight following the news while Gold soared, but by the next morning, everything reversed and the market began to soar much to the surprise of all market commentators. Most of the markets gains in 2016 were made after Trump was elected, and many trends that existed prior to the election that were present the whole year were completely reversed.
The View Ahead
The beginning of the year always brings plenty of colorful prognostications from market commentators. Predictably, the forecasts can be wildly diverging from extremely bullish to bearish. However, at the end of the day, no matter how smart or how good the track record of the manager, no one can predict the future with a high degree of accuracy. Financial markets are driven in the short and intermediate term by surprises that can be good or bad. This can be the results of an election, interest rates, geopolitical tensions, currency intervention or even the weather. In the long-term, the markets are driven by economic growth and valuations. Economists have always make physicists look good due to their inability to forecast growth despite using similar mathematics. Valuations are more useful and objective but fail to provide timing information that is useful for a 12-month window. Furthermore, they need to be adjusted to account for interest rates or inflation to be objective. A P/E (price to earnings ratio) of 25 sounds high, and it implies that you are getting a 4% earnings yield. When framed in this light a 4% earnings yield can have much different implications when interest rates are 1% vs 10%.
Many market commentators suggest caution these days because they believe that the market is overvalued. Due to the lack of useful timing ability of market valuations, the best we can do is to take a look to see if we are near a major market top using a period where the market was also overvalued. One of the most extreme examples is 1999 when the market was severely overheated and speculation was rampant. Putting aside the obvious divergence between then and now- sentiment continues to be cautious but was wildly bullish in 1999- we can compare the two using a simplistic valuation model that incorporates GDP growth, inflation and interest rates.
If we convert the classic P/E to an earnings yield (1/ P/E Ratio) we can capture what we expect to earn across a wide range of companies in the market as a return. We will ignore productivity growth and corporate payout ratios in this simple example. To make things more accurate we can take an inflation adjusted P/E which is the Shiller P/E ratio. Then we can assume that inflation-adjusted GDP growth annualized over the last quarter represents the expected revenue growth rate- which in this example we will translate to earnings growth (since we assume no productivity gains). If we add the earnings yield plus the GDP growth we get a measure of the expected total return to holding a basket of companies. Then we can subtract out the Fed Funds Rate or interest rate to get the expected total return above holding risk-free investments or a proxy for the equity risk premium. We can see that currently in 2017, the net expected total return is roughly 6% for the market which is much higher than the 1.66% net expected return in 1999. Even if real GDP growth is aggressive at 3.2%, the expected total return is still much higher at half of that level. My conclusion using this very rudimentary analysis is that the market has the potential to go a lot higher than people think. Furthermore, the fact that Trump may be able to successfully table corporate earnings tax cuts could lead to 15-20% more earnings growth which is yet another wild card that could boost returns.
On average the market has risen in 65% of years (source: S&P Dow Jones) and if we admit to knowing nothing certain about the future, then we should expect that the probability the market will rise in 2017 is 65%. Of course, a new bear market could lead to significant losses at this stage of the cycle as well. Our cursory analysis suggests that the market is not wildly overvalued, and still has plenty of potential for upside even 8 years into a bull market. The best way to capture some of these gains but still prepare for extreme downside is to follow a risk-managed approach that diversifies.
*(sources: Wikipedia, Marketwatch, CNBC)
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