January, 2017
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

When was the last time you went to a surprise party where the guest of honor was actually surprised? The typical drill includes a few trust-depleting lies, a thinly veiled excuse to get the honoree away from and then back to the party’s location, the inevitable wrinkles in the planning time line, all followed by a grand reveal that by that time is not surprising in the least, but often accompanied by a display of pretend shock for the benefit of the beloved planner. Because this is the norm, the rare time a true surprise is pulled off becomes noteworthy.

2016 brought the investment markets, and the world at large, 2 significant, genuine surprises; both involving decisions made at the ballot box. The first occurred in June when voters in the United Kingdom chose to leave the European Union; an act known as “Brexit.” Following this surprising result, stock markets fell sharply for 2 days, then quickly recovered and produced new highs. The second surprise was Donald Trump winning the U.S. Presidential election. This time the market’s initial negative reaction was even shorter, just a few hours over election night; followed by a month of market exuberance as the prospect of lower tax rates and reduced regulation pushed stocks to even further highs. The following chart shows the returns of various indexes:

Index 4th Qtr
2016 Return
1 Year Return 3 Year
Annualized
Return
5 Year
Annualized
Return
S&P 500 3.8% 12% 8.9% 14.7%
Nasdaq Composite 1.7% 8.9% 10.1% 17.1%
Russell 2000 – Smaller Companies 8.8% 21.3% 6.7% 14.5%
MSCI EAFE – International -0.7% 1% -1.6% 6.5%
Barclays US Aggregate Bond -3% 2.7% 3% 2.2%

The following section contains info that may only interest “numbers geeks” like me, if that’s not you, skip to the next.

  • Nearly all market sectors participated in this year’s rally, the only exception being Health Care.
  • Energy was the best performing sector, up by 27.4%, a welcome reversal after two years of negative performance.
  • The price of oil ended 2016 at $53.72 a barrel, up 45% from its 2015 closing price of $37.04; and more than doubling the $26.21 low for the year on February 11.
  • The yield on the 10-year Treasury note ended 2016 at 2.44%, after hitting a low of 1.36% on July 8. This is the second consecutive year yields have risen – 3 in a row hasn’t happened in 36 years.
  • The S&P 500 has been positive for the last 8 years in a row (9 would be the all-time record) and 13 of the last 14 calendar years. 
  • The market had 252 trading days last year, 52% of them were up days.
  • If you missed the 3 best percentage gain days last year, the 12% gain falls to a 4.4% gain.
  • If you avoided the 3 worst percentage days last year, the gain rises to 22.1%.

The big event that was not at all surprising was the Federal Reserve’s decision to increase interest rates by 0.25% after waiting a full year since their initial raise last December. The Fed also raised their forecast for the number of 2017 rate hikes, from two to three; keeping in mind that their forecasts have expected higher rates for years. This trend of rising rates leads to higher bond yields and the strengthening of the U.S. Dollar; many economists are expecting to see Dollar/Euro parity in the near future. While inflation has begun to show signs of rising, it continues to remain around the 2% level.

The labor market strengthened over the course of 2016 with the U.S. adding average of 180,000 payroll jobs per month, lowering the unemployment rate from 5% to 4.7%. This should continue to decline if wages continue to climb, but we essentially are at full employment. The chart below tracks the number of weekly unemployment claims which recently hit a 43 year low. This is especially significant considering that our country’s population is more than 50% larger than it was 43 years ago.

Fred Chart

In evaluating the current state of the economy, keep in mind the context that we remain in an economic expansion that is now the 3rd longest since 1900 (see chart below). I heard one economist analyze it this way: “Like that old professor emeritus who kept his college office; he was entitled to respect because of his age, but not much was expected from him in terms of liveliness.”

Expansions cropped

The United States economy is a healthy tortoise. We continue to see steady, but underwhelming, GDP growth of 1.7% (as of Q3) while we wait to see the impact of the policies of a new administration. The 2017 projections I’ve seen range from a high of 3.5% to a low of -1.5%, but the most frequent coming in around 2.3%.

Great uncertainty abounds regarding what policies will get approved, how soon they will get implemented, and what their economic impact will be. Here are 8 policy areas that we think markets will be watching, particularly during President Trump’s first 100 days:

  • Corporate Taxes
         - Rate reduction
         - Repatriation
         - Elimination of Corporate AMT
         - Businesses likely to wait for impact to increase their spending
  • Personal Taxes
         - Rate reduction
         - Repeal the Individual AMT
         - Potential to push national debt higher
  • Immigration
        - Stricter controls balanced with its impact on our aging workforce
        - Build a wall
        - Mass deportation could have negative economic impact
  • Defense
         - Increased spending
  • Regulation
         - Cabinet picks seem to favor deregulation
         - Energy rules that have slowed production may get changed
  • Trade
         - Tariffs
                  - Become an immediate penalty on people who buy stuff
         - Withdrawal from TPP
         - Crack down on violations of existing agreements
         - Renegotiate NAFTA    
         - Chinese currency
  • Affordable Care Act
         - Remove and replace
         - Many questions about the details
  • Infrastructure
         - Increase spending on electrical grid, transportation, clean water, security…

Realistically, the overall impact will likely be less than most are currently expecting; additionally, the legislative process has shown itself to be slower than most anticipate. While pro-growth, expansionist policies should benefit the U.S. economy and extend our current growth cycle, they do introduce a risk of overheating the economy by spending money we don’t have on stimulus we don’t need.

While the global growth outlook continues to improve, we find ourselves in an uncertain world that is increasingly more nationalistic and protectionist with the man on the street wanting and voting for change. Elections in the Netherlands, Germany, and France will give further evidence if this trend is continuing. In the U.S. we expect to see increased fiscal stimulus (implemented by Congress) and decreased monetary stimulus (higher rates set by the Federal Reserve).

Overall signals do not point to an imminent U.S. recession. The companies in the S&P 500 collectively earned $28.69 in the 3rd quarter of 2016, which was the 3rd highest quarter ever and projections for the next few quarters are even higher; though a rising dollar will create some drag. This came after a period of 5 consecutive quarters of negative year-over-year growth (see chart below).

Corporate Profits cropped

A question that investment committees (ours included) are currently wrestling with is whether the post-election stock market rally is overdone. Valuations are slightly high, but might be justified by some of the policy changes we talked about earlier. Given the difficulty in predicting politics and policies, our investment views remain grounded in fundamentals, valuations, and diversification. Though the markets seem to increasingly focus on the short-term, remember that investing requires patience and optimal results are achieved by taking a long-term perspective.

I’ll close this quarter’s letter by addressing a topic brought up in the last edition. No, “coloring book” did not make it into the Toy Hall of Fame. It got beat out by “Swing”, Little People, and Dungeons & Dragons. Sigh. Maybe someday. Have a great winter.

Sincerely,
The Castle Investment Team

 Darren signature Page 3          Gary signature Page 1          Michael signature Page 1

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.