4th Quarter Client Note

By Steven Smith | Financial News

Jan 09

Now that was exciting. With the surprise election of Donald Trump as President of the United States, the S & P 500 (total return) Index gained 3.82% during the fourth quarter – and more than 5% since election day. The index was up 11.96% for the year. This, after losing 10.5% in January and early February.

Factor Premiums Reborn

Following six years in which large cap growth stocks (think: Facebook, Amazon, Netflix and Google – the FANG stocks) have led the market up since the Great Recession, 2016 finally demonstrated a re-emergence of the historical small cap and value (factor) premiums. For 2016, the Russell 2000 Value (small cap value) Index gained 31.74%; the Russell 2000 (small cap) Index gained 21.31% and the Russell 1000 (large cap value) Index rose 17.34% — all trouncing their growth counterparts and the market as a whole. Over long holding periods these premiums have been evident and available for long term, patient investors to capture; but their emergence is sporadic, random, volatile and of large short-term magnitude – making them impossible to time.

Fixed Income

The bond market was equally exciting. The yield on the 10 year Treasury Note rose from 2.27%  to 2.45% during 2016; but not before hitting a record low of 1.37% in July. Election based economic optimism caused interest rates to increase across the entire yield curve during November and December. And the Fed’s long awaited .25% rate increase in the short – term federal funds rate occurred in mid-December. Accordingly, the benchmark Barclay’s Aggregate Bond Index (which is dominated by US Treasury securities) lost 2.98% in the quarter, but managed a 2.65% gain for the year.

While yields remain at historically low levels and could still result in fixed-income losses – if and when rates continue to rise – it is critical to remind yourself of the role bonds play in your portfolio: To reduce the more significant risk of stocks. Negative returns occur in bonds about half as frequently as in stocks. And the magnitude of losses in stocks is much greater. The worst 12- month return in stocks (June, 1932) was 67.6%. The worst 12-month return in bonds (September 1974) was 13.9%. And bonds tend to be great diversifiers during periods of precipitous equity losses.

A comprehensive picture of both the quarter and the year is contained in the Quarterly and Annual Market Review from our friends at Dimensional Funds Advisors. Their reports also contains an interesting and important story about the Power of Markets.

Trumponomics

Quite obviously, the big question is what will be the impact of a Trump presidency on the economy and the markets. There appears to be a widespread consensus that a Trump presidency will be “good for business.” Tax rates – including corporate tax rates – will likely be lowered. Promises have been made to reduce federal regulations, particularly on the banking and fossil fuel industries. There will be a push to create more manufacturing in this country and reduce the amount of imported goods. Whether we actually have a broad infrastructure spending plan with the resulting fiscal stimulus is anybody’s guess; given the reluctance of a Republican Congress to increase the budget deficit. Will the Affordable Care Act actually be repealed and/or replaced? What effect will that have on the economy, which is one-sixth comprised of the health care industry? Interest rates may continue to rise. Or they may not.

Reflect on Your Strategy

For investors, the most important thing is to remain humble. The professional pollsters and pundits almost uniformly got the election results wrong. Forecasting how the market will react to any of this uncertainty and attempting to incorporate those forecasts – or even worse, your instincts –  into an investment plan is a fool’s errand.

To the extent any of this would be optimistic for the market in 2017, many of the gains may already be priced in by the strong fourth quarter. The past 90 years of market history shows that there is no correlation between rising interest rates and stock returns. Valuation levels remain relatively high. And there remains a strong – albeit not certain – consensus that returns will be modest over the next decade. So try to model and implement a broadly diversified “good for all seasons” plan that will probably work in all but the most extreme environments. And control what you can – such as your saving and spending.

With the continued strong equity returns and the turn of the calendar this is a good time to review your asset allocation. First, whether the strategy – and your ability to stick with it – remains consistent with your long term goals and risk tolerance. And second, to see if the performance of the various asset classes has resulted in your allocations being out of whack and ready to be rebalanced.

Tax Planning

It’s a virtual certainty that 2017 will bring significant changes to the tax code; resulting in fewer brackets (reduced from 7 to 3) and with the objective of lowering taxes for all taxpayers.  Preferential rates for capital gains and dividends are likely to remain, but perhaps via a different mechanism than with the existing system of differential rates. The Alternative Minimum Tax appears to be on life support.

But the certainty ends there. Considerable differences exist between the incoming Trump administration and the Republican caucus (and even within the caucus) regarding the extent to which the standard deduction should be raised and whether certain itemized deductions should be eliminated or capped – including long time scared cows; such as the home mortgage interest deduction and the charitable deduction.

There is also a strong possibility that the estate tax (and possibly the gift tax) will be eliminated. Leaving the difficult question of how to handle the cost basis step-up at death which has existed for decades. And discussions have once again emerged to eliminate the lifetime stretch for non-spousal inherited IRAs.

And finally, there may be considerable differences between the administration and Congress on the possible budget impacts of any tax reform.

So given all the uncertainty surrounding what eventual tax reform will look like once it emerges from the legislative sausage machine – and what will be its effective date – the best advice may be to just sit back and watch the show.

A Happy and a Healthy New Year to All!

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