As we’ve pointed out countless times, it is impossible to predict the near-term future with any degree of accuracy. Therefore, our strategy is to focus on probabilities and risk. This is done to protect retirement funds from substantial losses while providing a return that is equal to, if not greater than our benchmarks over a 2-3-year period.
This also means that investors portfolios may occasionally lag their benchmarks. While frustrating for some in the short-term, patience is required. Investors overall lose a lot more money chasing recent performance due to envy and the feeling of being left out, than they gain by remaining patient and respecting market risk.
As we’ve mentioned previously, one of the best ways to outperform the market is to become more cautious when markets become overheated (1998-2000, 2007, 2015-2016) and more aggressive once markets become severely undervalued (2002-2003, 2009).
This is one of those times. So far, the strategy paid off handsomely and we expect that trend to continue over the next two years.
U.S. Stock Market
Due to the “Trump Rally”, the U.S. Stock market once again sits at the high end of valuations. Outside of the 1999-2000 market, stocks are priced higher at the median point of multiple valuation metrics, than they ever have been in history.
That’s really all that needs to be said about the current risk/return profile of the U.S. Stock market. Unless you have data to support that we are about to enter the greatest economic expansion in our history, I advise great caution in aggressively buying U.S. stocks going forward.
As mentioned in our last issue, there have only been two times in history that the 10-year Treasury Note yielded less than the dividend on the Standard & Poor’s 500 index of stocks. Both times led to losses for bond investors within about a 12-month timeframe.
Therefore, we shifted to and continue to favor bonds with lower durations. That move paid off as short term bond indexes outperformed intermediate bonds by almost 4X and long term bonds by 8X in the last quarter of 2016. Short term bonds decreased 1.1% in 4th quarter compared to a loss of 4.2% for intermediate bond fund indexes and a loss of 8.3% for long-term bond fund indexes.
During times prior to rate increases and appreciation in inflation, bonds with lower duration are considered less risky than those with higher duration. The possibility of the Treasury funding the current deficit through the purchase of T-bills that mature in less than a year, would help our position.
Valuations in Europe continue to be attractive as they sit near 2011-2012 levels. For this reason, I believe there is greater price appreciation potential and less downside risk in European assets compared to the U.S. over the long-term. That’s not to say there won’t be any short-term pain in the interim.
Brexit and the potential debt problems surrounding select European Banks continue to be a concern. It’ll be important to watch for any materialization of a credit slowdown in the European banking system which could pose a systemic risk to the financial system. However we don’t see any Lehman moment (which makes for a great sensationalized headline) resulting from it.
The concerns I continue to have about China (which have been written about in previous issues) trump the attractiveness of Emerging Markets Indexes in which China constitutes the greatest portion of such funds.
Additionally, we have witnessed that even a tiny rate increase and tapering of quantitative easing has led to a higher dollar. Any increase in the time frames of rate hikes could lead to a surging dollar. This would hurt commodity prices and put further pressure on those countries with heavy debt levels. We are already seeing the dollar appreciate on speculation the FED may raise rates once prior to the end of the year.