Investment Committee & IA Department News – February 2017

Fear the Consensus?

As we transition into 2017, it’s fair to say that 2016 was a test in fortitude as it relates to investing, a year littered with skepticism and uncertainty. After experiencing a sell-off at the beginning of the year of over 11% in the S&P 500, as well as volatility around the Brexit vote in June to name just a few obstacles, is it any wonder why the average investor underperforms over time when trying to navigate on their own?

To cite the famous Dalbar Study that goes back 20 years from 1996-2015, the year 2016 is an example of why it’s not surprising the average investor had annualized returns of 2.11% vs. 8.19% for stocks and 5.34% for bonds. (BlackRock; Bloomberg; Informa Investment Solutions; Dalbar.) Adhering to process and emotional detachment is really important for long-term investment success. This above-mentioned reality underscores the importance of broad based diversification (even in segments that may be against the consensus), a disciplined process, and “being in the market”, as the opportunity cost of being “out” can add up. Additionally, one should be skeptical of the trend or of the consensus, as the catalyst for change can happen quickly. Small cap stocks, for example, were up over 21% in 2016 and if you made decisions based on recent trends, you’d be very disenchanted by recent history as small cap stocks trailed the S&P by roughly 9% in 2014 and by roughly 6% in 2015. Moreover, international stocks have lagged US Large cap almost every year since this bull market began in 2009, but over the last month they’ve handily outperformed by almost 170 basis points, so is it time for a secular change in leadership? International equities are certainly cheaper, but have been for quite some time. Again, the process and discipline, as opposed to feeling and emotion, is extremely important in investment success.

The recent stock market action and general optimism suggests that many are optimistic that a Trump presidency and Republican sweep of Congress will likely bring more equity market gains ahead, so let’s examine that optimism:

  • NFIB Small Business Optimism Survey rose the most since 1980 and hit highs last seen in 2004 (The Seven’s Report).
  • American Association of Individual Investors Bulls/Bears ratio is very bullish at 46.2% compared to its average of 38.4% (The Seven’s Report).
  • The Conference Board’s Consumer Confidence Index rose to 113.7 in December, the highest level since August of 2001(Zack’s).
  • University of Michigan’s Index of Consumer Sentiment climbed to 98.2, the highest level since January 2004 (Zack’s).

This increase in confidence and optimism is encouraging, and may lead to an increase in consumption and capital expenditures ultimately driving growth, but should we be so sure? When and how will the market focus on rising inflation, rising rates and tighter Fed policy? As the economy embarks on its 91st month in a row of growth, the post-election stock market performance suggests and expects that tax reform, deregulation, and infrastructure spending will drive growth over the years to come, thus delaying a recessionary downturn that will be necessary to experience again at some point in time.

Savita Subramanian (head of US Equity Strategy at Bank of America-Merrill Lynch) as recently at 10/9/16, predicted that the US will hit a recession sometime in the 2nd half of 2017 (CNBC – AMG Funds). That is certainly a forecast that is contrary to prevailing opinion. However, much of the conversation around “The Great Rotation” out of bonds and into equities seems to be a little misguided. I’m not suggesting that the secular bull market in bonds over the last 3 decades isn’t over given what appears to be a great deal of structural reform under President Trump, however, I am suggesting there are risks to this thesis and that it’s simply the wrong conversation. The old expression “fear the consensus” just might have some merit when it appears to be a foregone conclusion by many that tax-reform, de-regulation and infrastructure spending all get accomplished in the way the market is anticipating. We do know the difference between easy monetary policy, that we’ve experienced throughout this bull market cycle, and fiscal policy in that it takes longer for the fiscal policy impacts to take hold and work through the economy. While we’re encouraged by the optimism, for most investors, we believe there is still significant need for fixed income investing and negatively correlated or less correlated assets as it relates to accomplishing your financial objectives that are hopefully laid out in your financial plan.

I think what most end up realizing in focusing on a swinging for doubles mentality (to use the old baseball analogy) as it relates to investing, is that focusing on achieving lower volatility can lead to higher returns over time, through avoiding the big downdrafts that few foresee or are able to navigate through as emotion often takes hold. The real truth is that the bond market offers tremendous diversification opportunities within it and I think most make the mistake of thinking about investing and asset management from a position by position perspective and not from an overall portfolio construction perspective. Whether it’s high beta or negative correlation, it all has its place and rationale in a properly constructed portfolio. The biggest questions pertain to discipline and process for navigating through and across different market cycles as most of us need our wealth to last and grow for decades and decades to come.