July, 2016
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

There is a scene in the popular Broadway musical “Hamilton” where Alexander Hamilton and his friends are offended to the point of wanting to instigate a duel with General Charles Lee after Lee’s disparagement of General George Washington’s handling of the Revolutionary War following the Battle of Monmouth. Lee states:

“Washington cannot be left alone to his devices. Indecisive, from crisis to crisis.The best thing he can do for the revolution is turn ‘n go back to plantin’ tobacco in Mount Vernon.” But Washington, wanting to present a united image to the world, tries to tone down the actions of his defenders.Washington: “Don’t do a thing. History will prove him wrong.” Hamilton: “But sir!” Washington: “We have a war to fight, let’s move along.”

The concept that history will prove the correctness of a strategy is an important one regarding your investment portfolio.

Recently, the world received the unexpected news that British citizens had voted to leave the European Union, an act now known as “Brexit.” This heaped multiple levels of uncertainty upon the markets causing a significant sell-off, which left investors contemplating what their appropriate response should be. The chart on the next page illustrates that history is strongly on the side of those who do not over react during market corrections. The gray bars show the S&P 500 return for each calendar year since 1980. Notice how in most years, in fact 27 of the last 36, the stock market has a positive return. The dots indicate the largest peak-to-trough correction (the amount the market went down) during that year. A certain amount of correction every year is perfectly normal, even double digit corrections occur quite frequently.

Most people have a significantly longer investing horizon than one year. This chart again uses history as our guide to show how frequently the stock market gives you a positive return when you maintain your investment over longer periods.

One more thought on this subject; one that shifts from the historical perspective to a more pragmatic one. When markets drop significantly, this often triggers a response that says, “I want to get out of the market for a while, but I’ll get back in once things settle down.” The problem is that things settling down usually means the news is better, the economy doesn’t look so scary, and the market has rebounded accordingly. This results in the terrible strategy known as “sell low, buy high.” Again, history tells us that staying the course is a much more profitable strategy.

Following the Brexit vote, the markets were faced with the precise thing that markets detest the most: uncertainty. As a result investors sold “risky assets” like stocks and purchased safe haven items like gold and U.S. Treasury bonds. This pushed the price of gold up to a 2-year high and drove the yield on the 10-year Treasury bonds to a record low. But the S&P 500 was able to rebound and recover most of what it gave up within a week. As the world analyzes the political and economic repercussions of this event, which could take a couple of years, expect there to be various periods of increased market volatility.

One result is the lowering of the probability that the Federal Reserve will increase rates this year. Rumblings have also begun that there may even be a rate cut in the near future. The hunt for yield is getting more challenging. More than 70% of the bonds in developed-market government bond indexes today have yields of 1% or lower. This environment should cause us to temper our overall expectations as to the returns our investment portfolios will be able to provide in the short term.

The U.S. economy continues to grow, albeit slowly (first quarter GDP numbers showed a growth of 1.1%); with very few signs of recession.

  • Housing
    • Real estate values, which were deeply hit by the last recession, have nearly recovered to the record highs experienced in 2005
    • With mortgage rates remaining low, housing continues to be very affordable, though lending standards have tightened
    • Housing starts have increased and have room to continue rising as they are still below the historical average rate
  • Automobile Sales
    • Light vehicle sales remain strong, though in contrast to housing starts, these numbers have been coming in above historical average numbers for several years which suggests that there is not much opportunity to increase from here
  • Employment
    • The unemployment rate has fallen to 4.7%
      • Since the 1970s there have only been 5 months when the rate was below 4% - that puts us very close to full employment
    • Wage growth has been picking up and we would expect this to continue as a by-product of lower unemployment
    • As the U.S. came out of the worst of the Global Financial Crisis around 2010, there were more than six unemployed for every new job opening, that number is now down to 1½
  • Consumers
    • Consumer spending and confidence remain strong

The price of oil jumped 20% during the quarter, propelling energy to be the best performing market sector. The higher yielding segments of telecom and utilities were next; while technology was the worst performer. Here is a recap of how the major indexes performed in the 2nd quarter of 2016:

Index 2nd Qtr
2016 Return
1 Year Return 3 Year
Annualized
Return
5 Year
Annualized
Return
S&P 500 2.5% 4% 11.7% 12.1%
Dow Jones Industrial Average 2.1% 4.5% 9% 10.4%
Nasdaq Composite -2% -1.7% 13.9% 13.2%
Russell 2000 – Smaller Companies 3.8% -6.7% 7.1% 8.4%
MSCI EAFE – International -1.5% -10.2% 2.1% 1.7%
Barclays US Aggregate Bond 2.2% 6% 4.1% 3.8%

We will close this quarter’s letter with excerpts from a recent Washington Post column containing investment wisdom by Barry Ritholtz of Ritholtz Wealth Management: It is my never-ending charge to remind you (once again) that the time to read the card on the seat back in front of you is before the plane takes off. At 30,000 feet, with the engines catching fire, you will most likely have missed the opportunity to think calmly and clearly about your best options. I keep a short list handy to remind myself of all the things investors must remember when these sorts of macro events cause turmoil:

  • Markets surge and sell off. This is the ordinary course of events.
  • The future is inherently unknown and unknowable. Those who claim otherwise are trying to sell you something.
  • What sounds sexy and looks good in a brochure is not what usually makes you money over the long run.
  • The gurus and talking heads have failed you. Once again, their forecasts were wrong. They were selling you a product, not providing any insight.
  • Emotional reactions are bad for your portfolios.
  • “Nobody knows anything.” The William Goldman quote, written about Hollywood, applies to just about everything in life. Get used to it.
  • You need a plan. EOM.
  • Your brain has evolved to adapt to keep you alive in changing conditions, not to make risk/reward decisions.
  • The world is filled with random outcomes. Even more so when people are involved.
  • Boring, steady portfolios can withstand about anything you throw at them.
  • “Uncertainty” is a misnomer. The future is always unknown and always uncertain. When you hear people using the word “uncertainty,” it is because they are scared enough to briefly acknowledge their own ignorance.
  • Adrenaline, it turns out, is not the basis of sound portfolio management.
  • That plan mentioned above? You must have discipline to stay with it.
  • Bull and bear markets have their own timelines. They do not care about your retirement, your saving for your kid’s college, or the new house you want to buy.
  • Investing is hard.
  • Sometimes, Brexit happens.

Have a great summer.

Sincerely,
The Castle Investment Team

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.