Executive Summary
During the fourth quarter, the financial markets provided another example of the difficulty of predicting returns. At the start of the fourth quarter, U.S. stocks were already at record high levels. As we approached the Presidential election, global stock markets declined as Republican nominee Donald Trump improved his chances of winning. On election night, as it became obvious he was going to win, stock markets around the globe sank over 6% (a rather large amount). The next day, the U.S. stock markets turned on a dime and recovered the 6%, along with Europe. The following day, Asian stock markets recovered their large losses. The election result created a rapid repricing of assets. In the following weeks, U.S stocks gained dramatically, especially small cap stocks, while bond yields moved up sharply from historically low levels (reached in July 2017). As interest rates increase, it acts as a brake on the economy. However, there are numerous periods of positive stock returns during increasing interest rate cycles and as long as the rate increases are not rapid enough to cause contraction, stock returns can increase. Economic indicators continue to improve with solid job and wage growth in the U.S., which bodes well for the continuation of our late stage economic expansion. The primary issues facing expected stock returns are high valuations and rising interest rates (as employment numbers continue to improve, and if there is an infrastructure spending package that comes out of Washington, we could see inflation jump, forcing the Federal reserve to act).
For those who want to dive deeper into our market and economic commentary:
World Asset Class 4th Quarter and Full Year 2016 Index Returns
Fourth quarter index returns were strong for U.S equities and slightly negative for international stocks, while more negative for emerging market and global real estate stocks. For the broad U.S. stock market, the fourth quarter return of 4.21% was well above the average quarterly return of 1.8% (since January 2001). The value and size dimensions of return, which we speak about often as additional factors of return, were very strong during the quarter.
A larger sample of asset class returns shows the strength of small cap stocks and the value bias. The Russell 2000 Value index was up 14.07% in the fourth quarter, well ahead of the broad Russell 2000 Index. Value was also strong in the top 1000 companies by market cap, the Russell 1000 Value index was up 6.68% while the broad Russell 1000 was only up 3.83%. Even is emerging market stocks, value (down 1.1%) was up considerably more than the broad index (down 4.16%). U.S. stocks were much stronger than international, emerging market and global real estate during the fourth quarter.
Full year, 2016 results were very positive for most asset classes:
U.S. stocks were the best performing broad asset class and Emerging Market stocks performed better than International Developed Stocks and Global Real Estate during 2016. For the full year, the value effect was positive in the U.S., international developed, and emerging markets; and small cap stocks performed significantly better than large cap stocks in developed markets. The Russell 2000 Value Index was up 31.74%, well ahead of the broad Russell 2000 small cap index (up 21.31%). The Russell 1000 Value Index was up 17.34%, well ahead of the broad Russell 1000 large cap index (up 12.05%).
Bond markets around the world were negative due to a strong shift up in the yield curve, after the election and from the all-time low yields reached in early July. Here is the large shift up in rates for the fourth quarter and notice the longer end had a larger shift up:
When the yield curve shifts up across all time periods, bonds lose value and the longer duration bonds are going to perform worse. The Citi World Government Bond Index (1-5 years) is slightly ahead of long term government bonds for the year. Notice high yield bonds are up over 17% for 2016, which is another sign of investor preference for riskier securities.
One cannot time markets and typically the short term is just noise. At the start of every year and once again, major financial news outlets were discussing the January effect and how the trend in January sets the tone for the year. There is no empirical evidence to support this theory and we had a great counter example in 2016 when January, 2016 was the worst U.S. stock market start in history and we ended the year with strong stock returns. So far, January has started well for stocks, both in the U.S and internationally. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A DEEPER LOOK
The fourth quarter stock market rally in the U.S. was an extraordinary example of why we stay in the stock markets with our small cap and value bias, because you just don’t know when the outperformance will occur. Well documented historical research shows that U.S. small company stocks have higher average returns than large company stocks; but long periods of relative underperformance and outperformance exist. Small cap stocks had a strong third quarter of outperforming large cap stocks and were at record highs prior to the election; and proceeded to outperform the large cap stock index by 8.6% (a huge margin). Here is the chart of the S&P 500 large cap index in blue and the Russell 2000 small cap index in green from November 2nd through December 31st: (Source: Yahoo Finance)
This is a result of the expectation of business-friendly policies that Congress may implement will likely impact smaller companies more than larger companies. At the same time, the strengthening dollar has a negative impact on large companies’ overseas revenue. However, the rally since the election, which has been mostly contained in the U.S., has been so rapid that it is likely ahead of itself. Investors will need to see follow through from the administration and positive capital spending news from corporations during earnings season, which begins in the second half of January. Financial market research also shows that U.S. stock market performance compared to international stocks is cyclical and currently, the U.S. has outperformed international stocks for 110 months (over 9 years), which is one of the longest cycles of relative outperformance on record. We are watching a number of positive indicators, including a strong U.S. dollar, lower valuations in Europe and emerging markets, economic expansion in Europe and higher inflation expectations, which could reverse this trend. The stronger economic data around the globe has helped the case of lifting inflation expectations so that deflationary pressures are not nearly as strong. In summary, inflation is once again the stronger force in the discussion of a stagflation / deflation scenario.
CONCLUSION
Economic data in the U.S. and around the globe was positive enough to further reduce expectations of a developed market recession in the next 12 months. However, when stocks climb faster than corporate profits, valuation multiples expand and they were already elevated in most risky asset classes. At the end of 2016, The P/E 10 ratio (price divided by 10 years of earnings) was 27.9, which is a new interim high since the great recession of 2008/9; and a few percentage points from hitting two standard deviations above the historical mean. At the end of the fourth quarter, the S&P 500 P/E ratio was 20.5 for 2016 year-end EPS, compared to the historical average of 17 and if we look at the S&P 500 price to sales ratio, it is over 2 for the first time since 2000 (currently 2.01). Global growth is still low, global debt levels are still very high. We are closely watching growing auto loan and student loan debt in the U.S., non-performing loans in Europe and China and other variable rate debt, which is now more expensive due to higher interest rates. It is wise to be prudent and we will continue to be prudent in our investment committee meetings in the coming weeks. The U.S. stock market has high expectations built in for the new “business friendly” president and our current late stage economic cycle. We will be watching for any catalyst that could cause a significant re-pricing of risky asset classes.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Dimensional Equity Balance Strategy Index Description
Rebalanced monthly. The Dimensional Equity Balanced Strategy Index is comprised of commercial and Dimensional indices, 70% US equity indices, and 30% non-US indices. US: S&P 500, large cap value, small cap, small cap value, Dow Jones REIT; non-US: international value, international small cap and small cap value, emerging markets, and emerging markets value and small cap. Additional index information is available upon request.
Real Estate Strategy weighting allocated evenly between US Small Cap and US Small Cap Value prior to January 1978 data inception.
International Value weighting allocated to Fama/French International Value Index prior to January 1994 data inception, and evenly between International Small Cap and MSCI EAFE Index (net dividends) prior to January 1975 data inception. International Small Cap Value weighting allocated to International Small Cap prior to July 1981 data inception.
Emerging Markets weighting allocated to MSCI Emerging Markets Index (gross dividends) prior to January 1994 data inception, and evenly between International Small Cap and International Value prior to January 1988 data inception.
Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One-Year prior to January 1985 data inception.
For illustrative purposes only. The balanced strategies are not recommendations for an actual allocation.
Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Rebalanced monthly. All performance results of the balanced strategies are based on performance of indices with model/back-tested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies. The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money.
Past performance is no guarantee of future results.
Description of Dimensional Indices:
Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.
Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market-capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.
Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.
Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year.
Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.
