2016 brought many wild surprises. The biggest and most obvious is summed up perfectly in two words: President Trump. Donald J. Trump, despite no political or military experience, overcame long odds and became the 45th President of the United States in what many called the biggest upset in American political history.
Almost as surprising was that an avowed Socialist who had honeymooned in the Soviet Union – by choice – nearly achieved a major party nomination for president. Indeed, without the fix having been put in by the Democratic establishment, he may well have won it. Across the pond, the United Kingdom shocked political experts and voted to leave the European Union.
In more prosaic matters, the Chicago Cubs won the World Series after 108 years of futility. After 111 years and 29 consecutive losses, Ireland beat World Cup champion New Zealand in rugby. LeBron James led the Cavaliers to the team’s first NBA championship and brought Cleveland its first championship of any sort in 52 years by upsetting the defending champion Golden State Warriors, who had the best regular season record in league history and who led the Finals series 3-1. In Great Britain, Leicester City came from out of nowhere to win the English Premier League championship despite preseason odds against them of an astounding 5000-to-1. And in perhaps the biggest surprise of all, the film Bridget Jones’s Baby made over $200 million.
From a markets perspective, 2016 started off dismally. In fact, it was the worst start to a year ever. Things looked so bad that many alleged experts were proclaiming doom and gloom, led by RBS urging clients to “sell everything” except high-quality bonds and warning of a “ fairly cataclysmic year ahead“ that “all looks similar to 2008.” Later, legendary bond manager Jeff Gundlach offered the same advice. “The artist Christopher Wool has a word painting, ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good,” Gundlach said. “The stock markets should be down massively but investors seem to have been hypnotized that nothing can go wrong.” Legendary investors Stan Druckenmiller, Bill Gross, George Soros, Jeremy Grantham and Carl Icahn (among many others1) were also prominent members of the “sell everything” club.
But they were all dead wrong. The markets in 2016 were much more mundane than most expected. By the time the calendar had turned from 2016 to 2017, from the time of the initial “sell everything” call, the S&P 500 was up more than 20 percent, emerging markets stocks were up more than 25 percent and oil was up nearly 60 percent. But before we look head to the future, we should review 2016 to make sure we understand the position we’re in.
2016 in Review
Despite some quite astonishing events across the globe, despite a wild start to the year and despite market experts and icons preaching doom and gloom, 2016 was not at all a surprising or even very remarkable year in the markets for U.S. Investors. About the only things that offered anything like a surprise is what didn’t happen – markets didn’t tank after Brexit and didn’t collapse after Mr. Trump’s election, as many expected. Indeed, markets rallied after the election (from November 10 through the end of the year, the S&P 500 gained 3.5 percent).
Even though it remains an index of just 30 hand-selected large cap stocks, most newscasts that report what “the market” did refer to the Dow Jones Industrial Average, the granddaddy of them all. The Dow dropped early in the year, did little through the summer, and then rode 2016’s final wave of success to the brink of the 20,000 mark (a mark that it finally hit this week), a level it has never before touched. Most reports focused on the “post-election rally” (up roughly 8 percent election through year’s end to provide an annual total return of around 16 percent), but the year’s price action was largely predicated upon rising interest rates, which will be favorable to banks, driving Goldman Sachs in particular up about 25 percent, and which began before the election.
The S&P 500 closed 2016 up 12 percent in total return for the year (actually 11.96 percent, to be precise, just above its long-term average of 11.83 percent), which is about as average a year as we’re likely to see. The S&P beat all other asset classes including gold (+8 percent), investment grade corporate bonds (+6 percent), long-term U.S. Treasuries (+1 percent) and the VIX (-23 percent). Domestic stocks also beat non-U.S. equities (+8 percent in local currency/+5 percent in USD). Emerging markets led for most of the year but the late rally pushed U.S. equities back on top for the second year in a row. In fact, U.S. stocks are now the best-performing asset class over the last 10 years (+96 percent). By year’s end, the combined market value of the technology “Fab Five” (Apple, Alphabet/Google, Microsoft, Amazon and Facebook) was roughly $2.4 trillion, or more than 11 percent of the S&P 500’s total value (that’s up significantly, but tech superpowers were 16 percent of the S&P at the peak of the bubble in March of 2000).
In the fixed income world, the post-election rally in domestic bonds (that is, the bond rally since the election of Ronald Reagan in 1980) may finally be over. Bond yields rode economic anxiety all the way to a record low of 1.36 percent on the benchmark U.S. Treasury 10-year note over the summer. After that, though, with both presidential candidates talking about much more government spending and the Fed insisting that it really would be raising rates, traders thought “inflation” and started selling. Yields settled down late in the year, however, and the 10-year yield closed the year only modestly higher from where it began, at 2.45 percent. The yield premium above Treasuries in high yield bonds dropped from a February high of nearly 900bp to roughly 400bp at year’s end, providing a terrific return for junk in 2016.
The dollar struggled for much of the year, but the election in November helped to propel the buck higher, fueled by expectations that fiscal spending on infrastructure and other programs will increase as Mr. Trump promised, that the Fed may pick up the pace of its rate increases and that taxes will go down, also as promised by the new administration. That said, the dollar’s strength could hit multi-national companies with a U.S. manufacturing base by making their exports less competitive overseas.
Gold began 2016 fast as shaky growth and very weak markets brought on lots of disaster talk. But as time passed and traders decided that Brexit and the Trump election weren’t such big deals after all, the precious metal that looks pretty but does nothing looked much less attractive and was only +8 percent on the year (but still well above its long-term average).
Value beat growth in 2016. From 2009-2015, the Russell 3000 Value Index underperformed the Russell 3000 Growth Index by more than 65 percent. During that same period the Russell 2000 Value Index (small-caps) underperformed the Russell 2000 Growth Index by almost 75 percent. That turned around in 2016, as the Russell 1000 Value index led the Russell 1000 Growth index, outperforming by the widest spread since 2006.
The U.S. economy continued to grow in 2016, just not as much or as quickly as everyone would like. That’s not very exciting…in either direction. GDP growth in 2016, like 2015, was just about 2 percent, which is also the aggregate GDP level since 2010 and less than the long-term average. We have seen one of the longest recoveries on record since the financial crisis but it has been and still is a modest one. The Fed hasn’t forecast much of a change in that going forward even though President Trump promises to change that.
The unemployment rate ended the year at a very low 4.7 percent (down from 5.0 percent in the 1st quarter and 10.0 percent in October of 2009) and jobs were added for a record 75th consecutive month in December. Since early 2010, 15.8 million jobs have been added to the domestic economy. However, most of that job growth has been in lower-paying retail and food service industries and many people have been out of work for so long that they’ll never be able to return to the higher-paying jobs they used to have. Many have stopped looking for work. A lot of workers are part-time and would prefer full-time work. That makes the unemployment rate seem artificially low.2
The latest employment report showed that private sector workers earned, on average, twenty-six dollars an hour, compared to $25.26 a year earlier, outpacing inflation. Since December of 2007, the peak of the last business cycle, real hourly wage growth has averaged 0.8 percent a year, the fastest growth of any business cycle (measured peak-to-peak) since the 1970s. However, in 1972 (according to the Bureau of Labor Statistics), the average hourly wage of non-managers and production workers was $9.26, measured in inflation-adjusted dollars. In October of 2016, the average hourly wage was just $9.20, measured in inflation-adjusted dollars. Thus, over forty-four years, the hourly wages of ordinary workers have actually fallen a bit (after inflation). Over the past few decades, we have also seen labor’s share of the income generated by businesses fall and the proportion going to profits rise. That’s good for stockholders but no so good for workers. The past few years have seen a bit of a reversal in this area, but labor’s share of overall income is still well below where it was a generation ago.
Inflation has begun to appear – a 1.5 percent rate in 2016 after 0.7 percent in 2015 – but still well below the Fed’s target rate of 2.0 percent and far below the long-term average of 3.1 percent. Oil was the biggest mover in 2016. The FOMC raised the Fed funds rate to 0.5 percent in December 2015 and raised interest rates again in December 2016 to 0.75 percent. The benchmark U.S. Treasury 10-year note opened 2016 yielding 2.25 percent and closed at 2.45 percent (but in between touched both 1.36 and 2.6 percent).
Between 1995 and 2005, output per worker rose at an annual rate of about 2.5 percent, which was an improvement on the previous period. However, between 2005 and 2015, the growth rate fell to less than one percent. Nobody really knows what has caused this productivity slowdown, but whatever it is, it’s hard to sustain wage growth in such an environment.
U.S. manufacturing remains the strongest in the world, producing more than 18 percent of the world’s goods, and is forecast by the Fed to increase faster than the general economy going forward. But the robust health of the manufacturing sector hasn’t translated into jobs. U.S. manufacturing jobs fell from 17 million in 2000 to 11 million in 2010, with only a small bounce-back since then (+800,000 jobs). The driver here has been technological advancement, which has increased productivity and profits, but not jobs. Industrial production had an up-and-down year but is still dramatically up since the financial crisis although relatively flat more recently.
Looking Ahead to 2017
The global economy and markets enter 2017 on better footing than a year ago. The outlook has improved for developed economies as growth momentum has picked up in recent months and risk assets across the board have continued the rally sparked by higher interest rates and President Trump’s unexpected victory. The question going forward is whether (or to what extent) the election result will fundamentally re-order the economic, financial and security arrangements of the post-WWII era. If it does, there could be big changes in the economic performance of nations, industries and corporations across the globe, much of it positive.
A faster growing U.S. is positive for the global economy too, but the impact will likely be limited in 2017. In the eurozone, political uncertainty, banking systems that are restrained from expanding credit by onerous regulation, a monetary policy that is geared towards supporting the periphery, and an unsustainable public debt burden in key countries will all weigh on economic performance. The outlook has improved for emerging markets, but a stronger dollar and rising interest rates provide performance risks.
Looked at in the best possible light, the defining feature of President Trump’s economic approach is likely to be a shift in the policy mix away from such a heavy reliance on easy monetary policy towards a more balanced reliance on deregulation of economic activity, supported by an expansionary fiscal policy as a means to jump-start the U.S. economy. The goal would be to move the economy out of low-growth secular stagnation and boost productivity and GDP. Not coincidentally, that would mean higher equity valuations and a stronger dollar. On the other hand, much more infrastructure spending would increase an already exceedingly high government debt burden while protectionism would raise prices for everyone and hurt American businesses that trade globally.
None of this analysis factors in Mr. Trump’s penchant for the unexpected – for good and for ill. Mr. Trump aims for “deliberate chaos.” He places great importance on his being “unpredictable.” It’s not “throwing shade“ to note the obvious fact that Donald J. Trump will be a high volatility president and that nobody has any idea how it will go or how it will turn out.
Why an “Outlook” at All?
We typically see all sorts of outlooks, forecasts and predictions every January. But before we start to look at what might be ahead for the markets in 2017, let’s consider what is and isn’t possible or likely and what we can reasonably expect from this sort of Outlook.
Nassim Taleb tells a sardonic story about forecasting that is true in spirit if not specifically true. As the story goes, a trader listened to his firm’s chief economist provide a forecast about the markets and then lost a bundle acting on it. His boss fired him. The trader angrily asked why he was fired rather than the economist, as the economist’s poor forecast led to the poor trade. The boss replied, “You idiot, we aren’t firing you for losing money; we’re firing you for listening to the economist.”
As the expression goes, an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today. The joke is funny because market forecasts and predictions have such a long and ignominious history.
Dresdner Kleinwort issued some important research in 2005 on the history of financial forecasts (the primary author was James Montier, now at GMO) and found that when a composite of analyst forecasts on things like bond yields and stock prices were overlaid with what actually happened, the forecasts had an almost perfect lag. A few months after bond yields rose, analysts forecast that they would keep rising. A few months after yields fell, analysts switched their forecasts and predicted yields would continue to fall. Accordingly, the paper’s conclusion was a very simple one to make. “Analysts are terribly good at telling us what has just happened, but of little use in telling us what is going to happen in the future,” the report stated. Markets, like analysts and investors, tend to assume that tomorrow will look a lot like yesterday, moving as a herd toward what is often the wrong conclusion.
The problem is as obvious as it is difficult. As the great Danish philosopher and theologian Søren Kierkegaard put it, “Life can only be understood backwards; but it must be lived forwards.” A look at 2016’s evidence demonstrates the point (yet again).
From a betting standpoint, the odds of a Trump win opened at around 25 to 1 in August 2015 when he first announced his campaign and moved to 5 to 1 by Election Day, still a major longshot, as there were only two major candidates. Paul Krishnamurty, who runs Political Gambler, claimed that “[Trump’s win] was 1,000 time less likely than Brexit. I was arguing that Trump had no chance.”
From a prediction standpoint, by Election Day, most analysts saw Trump as a highly unlikely winner, generally with less than a 30 percent chance of success. The Upshot at The New York Times gave him a 15 percent chance of winning while the Times’ political coverage actually referred to Clinton’s “administration-in-waiting.” Other alleged experts had the numbers much lower: 2 percent or even one in a hundred. So called “thought leaders” offered wordy, self-serving rhetoric about supposed necessities and inevitabilities, yet almost nobody saw Trump coming.
As always, 2016 brought many wildly wrong market predictions too. Wall Street strategists typically missed what would happen in 2016 by a lot, as usual. Robert Kiyosaki, author of the “Rich Dad” series of popular personal-finance books, predicted that 2016 would bring about the worst market crash in history. Harry Dent predicted a crash too. So did Paul Farrell. Goldman Sachs predicted a second half 2016 S&P 500 return of 0.01 percent. Others concurred. Instead, the market provided more than 7.5 percent in the second half of 2016 and 12 percent for the year.
More broadly, history has provided a long list of similar forecasting failures. The favorites have not swept the NFL playoffs since 2008 and didn’t again this season. Analyst Clifford Stoll argued that “no online database will replace your daily newspaper.” Bob Metcalfe, an electrical engineer widely credited with the invention of Ethernet technology, predicted that the internet would “in 1996 catastrophically collapse.” Federal Communications Commission commissioner T.A.M. Craven stated in 1961 that “There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television or radio service inside the United States.”
Marconi predicted that the “wireless era” would make war ridiculous and impossible. Decca records rejected the Beatles because they didn’t like the group’s sound and thought guitar music was on the way out. At the World Economic Forum in 2004, Bill Gates predicted that, “Two years from now, [email] spam will be solved.” My inbox begs to differ.
Most of the alleged experts making market and other predictions are highly educated, vastly experienced, and examine the vagaries of their fields pretty much all day, every day, Yet they are wrong a lot — pretty much all the time in fact. Why are we so bad at forecasting?
The great Russian novelist Leo Tolstoy gets to the heart of the matter when he asks, in the opening paragraphs of Book Nine of War and Peace: “When an apple has ripened and falls, why does it fall? Because of its attraction to the earth, because its stalk withers, because it is dried by the sun, because it grows heavier, because the wind shakes it, or because the boy standing below wants to eat it?” With almost no additional effort, today’s scientists could expand this list extensively.
As Daniel Kahneman and Amos Tversky have so powerfully pointed out, we evolved to make quick and intuitive decisions for the here and now ahead of careful and considered decisions for the longer term. We intuitively emphasize (per anthropologist John Tooby) “the element in the nexus that we [can] manipulate to bring about a favored outcome.” Thus, “the reality of causal nexus is cognitively ignored in favor of the cartoon of single causes.” In short, whenever we try to figure out complex future outcomes we enter dangerous territory with disaster lurking everywhere.
Even when we recognize the fallacy of thinking in terms of single, linear causes (Fed policy, market valuations, etc.), the markets are still too complex and too adaptive to be readily predicted. There are simply too many variables to predict market behavior with any degree of detail, consistency or competence. Unless you’re Seth Klarman or somebody like him (none of whom is accepting capital from the likes of us), your crystal ball almost certainly does not work any better than anyone else’s.3
All that said, the idea that we can live our investing lives forecast-free is as erroneous as the market predictions that are so easy to mock. As Cullen Roche emphasizes, “any decision about the future involves an implicit forecast about future outcomes.” As Philip Tetlock wrote in his wonderful book, Superforecasting: The Art and Science of Prediction: “We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a product, or retiring, we decide based on how we expect the future to unfold.”
It’s a grand conundrum for the world of finance — we desperately need to make forecasts in order to succeed but we are remarkably poor at doing so.
The key then, as Roche has argued, is that we should shun low probability forecasts. Thus Superforecasting points to (and laughs at) the general inaccuracy of financial pundits at CNBC, whose forecasts are low probability ones of the highest order. As Jon Stewart famously remarked, “If I’d only followed CNBC’s advice, I’d have a million dollars today — provided I’d started with a hundred million dollars.”
The central lessons of Superforecasting can be distilled into a handful of directives. Base predictions on data and logic, and try to eliminate personal bias. Working in teams helps. Keep track of records so that you know how accurate (or inaccurate) you (and others) are. Think in terms of probabilities and recognize that everything is uncertain. Unpack a question into its component parts, distinguishing between what is known and unknown, and scrutinizing your assumptions. Recognize that the further out the prediction is designed to go and the more specific it is, the less accurate it can be.
In other words, we need rigorous empiricism, probabilistic critical thinking, a recognition that absolute answers are extremely rare, regular reassessment, accountability and an avoidance of too much precision. Or, more fundamentally, we need more humility and more diversity among those contributing to decisions. We need to be concerned more with process and improving our processes than in outcomes, important though they are. “What you think is much less important than how you think,” says Tetlock. Superforecasters regard their views “as hypotheses to be tested, not treasures to be guarded.” As Tetlock told Jason Zweig of The Wall Street Journal, most people “are too quick to make up their minds and too slow to change them.”
Most importantly, perhaps, Tetlock encourages us to hunt and to keep hunting for evidence and reasons that might contradict our views and to change our minds as often and as readily as the evidence suggests. One “superforecaster” went so far as to write a software program that sorted his sources of news and opinion by ideology, topic and geographic origin, then told him what to read next in order to get the most diverse points of view.
The best forecasters are all curious, humble, self-critical, give weight to multiple perspectives and feel free to change their minds often. In other words, they are not (using Isaiah Berlin’s iconic description, harkening back to Archilochus), “hedgehogs,” who explain the world in terms of one big unified theory, but rather “foxes,” who, Tetlock explains, “are skeptical of grand schemes” and “diffident about their own forecasting prowess.”
But as Tim Richards has argued, we are both by design and by culture inclined to be anything but humble in our approach to investing. We invest with a certainty that we’ve picked winners and sell in the certainty that we can reinvest our capital to make more money elsewhere. We are usually wrong, often spectacularly wrong. These tendencies come from hardwired biases and also from emotional responses to our circumstances. But they also arise out of cultural requirements to show ourselves to be confident and decisive. Even though we should, we rarely reward those who show caution and humility in the face of uncertainty.
One forecast we should invoke, at least until the evidence demonstrates otherwise, is that the markets will generally trend upward. According to University of Oregon economist Tim Duy, “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”
Because of the many problems we have with forecasting generally, our portfolios should also be diversified. A diverse portfolio — one that reaches across market sectors — greatly increases the odds that at least some of a portfolio’s investments will be in the market’s stronger sectors at any given time — regardless of what’s hot and what’s not and irrespective of the economic climate.
At the same time, a diverse portfolio will never be fully invested in the year’s losers. For example, according to Morningstar Direct, about 25 percent of U.S. listed stocks lost at least 75 percent of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75 percent of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!). On the other hand, a well-diversified portfolio will always include some poor performers, and that’s hard for us to abide.
Next, make sure your time horizon is long enough. If you don’t have at least a five-year time frame before using the money, stocks are almost surely a bad idea. That’s because the chances of negative returns over shorter time periods are too high. But over the longer term, our investment prospects are reasonably bright.
Finally, recognize that there are limits to how precise even good forecasting techniques can be. No forecast should be seen as more than the roughest of outlines. Your mileage can and will vary. Keep your attention focused squarely on specific needs, goals and what you can actually expect to control about your portfolio and its results.
Forecasting is a necessary element of financial planning and investment management. Yet we tend to be really bad at it. Thus handle your forecasts and your forecasting process with extreme care.
If you think you can predict the future in the markets, think again. Your crystal ball does not work any better than anyone else’s. Pretty much the only forecast that is almost certain to be correct is that market forecasts are almost certain to be wrong. We’d all be wise to recall Warren Buffett’s admonishment to ignore all forecasts because they tell you nothing about where the market is going.
So why an Outlook at all (even though this is not a forecast and even less a prediction)?
There are three primary reasons. The first is that doing so is interesting and fun. It forces serious consideration of what’s going on. That is a valuable exercise. Secondly, longer-term forecasts (and especially those based upon appropriate valuation measures) do have a history of rough accuracy. We can have almost no idea of what will happen in the near-term while still having a pretty good idea of what investment prospects and returns should look like over the next 5-10 years. For example, Duke professor Edward Tower studied the predictive power of the asset-class forecasts from the investment-management firm GMO and concluded that they were quite valuable. Finally, a good Outlook can remind us where we are and highlight the trends and possibilities we are most likely to face going forward. There are so many variables and “unknown unknowns” (to use Donald Rumsfeld’s famous phrase) that we will necessarily be wrong a lot. Nobody can offer Truth with a capital “T.” But it is possible to be helpful. It’s a modest but important goal.
What to Watch For
Nobody can predict the future. There are any number of factors and events that could have very significant impacts upon what happens in 2017 and beyond. Here are some of the big ones – a dozen Ps – that I’ll be watching with the utmost interest.
President. On November 8, 2016, Donald J. Trump was elected President of the United States. He took office as 45th president on January 20, 2017. Millions are ecstatic about this news. Millions are terrified. And many millions are somewhere in between. The President has made it clear that he is first and foremost a dealmaker, that “everything is negotiable” and thus this flexibility overrides any ideology or principal. He places great stock in being “unpredictable.” In fact, he insists that “we need unpredictability.” Mr. Trump aims for “deliberate chaos.”
Therefore, we have no good reason to think that anyone can know with any degree of certainty how the Trump Administration will proceed. And yet, ironically, the electorate’s wish for simple and certain “common sense” solutions was a key element of Mr. Trump’s success. We all want the world to be a much simpler, certain and knowable place than it actually is. Is President Trump going to set off some animal spirits or scare the markets with a tweet? Maybe a little bit of both? Neither? No one really knows what’s going to happen with our incoming president. All I know is anyone who thinks they know with any degree of certainty is nuts. It’s impossible to predict with any degree of relative certainty.
Promises. By one count, President Trump made 663 campaign promises. He promised4 his supporters that “every dream you ever dreamed for your country” would come true if he became president. We have big problems in this country, of course; Mr. Trump claims that “I alone can fix it.” In short, “I will give you everything.” Supporters of the incoming president are remarkably loyal. “I could stand in the middle of 5th Avenue and shoot somebody and I wouldn’t lose voters,” Mr. Trump has said. Every president breaks promises, of course, and that’s not always a bad thing. Events sometimes require something different. But Vice President-Elect Mike Pence insists that the Trump Administration is “going to be in the promise-keeping business.” I will be watching events unfold to see if and how Mr. Trump keeps his many promises and what it will mean if (when?) he doesn’t and even when he does.
Putin. 2016 was a very good year for Vladimir Putin and Russia. Donald Trump was voted in. Great Britain voted out. The international community stood idly by as the Russian and Syrian air forces cluster-bombed Aleppo and as international investigators discovered that Russia had provided the weapon that shot down Malaysia Airlines Flight 17. Putin’s efforts to undermine the U.S. election in Mr. Trump’s favor have gone largely unpunished. This year could be even better. Mr. Trump is now the president and seems unwilling or unable to think ill of Putin. Elections are due in France, Germany and perhaps Italy, with pro-Russia candidates on the rise in all three. Trans-Atlantic unity on sanctions is under pressure, the campaign to break Aleppo and restore authoritarian socialist Syrian President Bashar al-Assad to power appears to be succeeding and OPEC has even agreed to cut production, boosting the price of the oil on which Russia’s economy depends. This Russian bear bears watching.
Populism. Over the past decade, 20-25 percent of households in the developed world, including the United States, have seen personal income levels stay flat or decrease. Many low to mid-skilled, blue-collar workers in less competitive industries have lost their jobs, owing to technological advance and globalization. These economic factors, together with increased unrest about increasing globalization and foreign immigration, have birthed a populist movement throughout the industrialized world, and it hasn’t always been pretty or mannered.
Harvard’s Yascha Mounk asserts that 2016 was the most bitter year for liberal democracy since the depths of World War II. In nearly every major election across the globe, populists carried the day and did so by attacking liberal ideals. Great Britain voted to Brexit, the Philippines elected Rodrigo Duterte, and the United States became Donald Trump’s new gig. Also, don’t forget about Italy, Slovakia, the regional elections in Germany, and more.
By year’s end, the string of populist victories (usually seen as upsets to boot) had become so constant that it was widely seen as a major victory when Norbert Hofer, whose ironically named Freedom Party has deep links to the neo-Nazi movement, “merely” got 46 percent of the vote in Austria’s presidential elections. In 2017, Angela Merkel, perhaps liberalism’s last best hope, faces election. Geert Wilders, who has called for a ban of the Quran, is vying to lead the Netherlands. And Marine Le Pen, whose presidency would ally France with Russia and threaten the European Union, may be chosen to lead France. Populism demands careful analysis in 2017.
Polarization. In former President Obama’s final State of the Union address last January, he stated that, “It’s one of the few regrets of my presidency — that the rancor and suspicion between the parties has gotten worse instead of better.” America seems more divided than it ever has, and data confirms it. Most supporters of both Donald Trump and Hillary Clinton don’t know anybody who voted for the other candidate. Fully 86 percent of Americans describe their country as more politically divided today than in the past; 40 percent expect this polarization to persist over the next five years while 31 percent think it will be even more divided. According to Pew Research Center, more than 4 in 10 Democrats and Republicans say the other party’s policies are so misguided that they pose a threat to the nation. Moreover, our elected leaders in Congress have continued to drift further and further apart on the issues and in their ability to strike compromises.
One common argument is that polarization has been intensified by the Internet, which is awash in “fake news,” offers ideological echo chambers and enables anonymous bullying and hate. But the mainstream media is at fault too, because conflict is much more interesting than harmony. “They’re conflict entrepreneurs. They kind of thrive on the pathologizing of our politics,” said Yale’s Dan Kahan. Unless and until voters decide that they want compromise and want the two major parties to work together, it’s not likely to happen, with obstruction and stalemate the most frequent outcome. Republicans control the government today and will be judged on how things turn out, for good or for ill. But we remain terribly polarized overall, and that remains a major concern going forward.
Perception. As Emma Roller wrote in The New York Times, “The strongest bias in American politics is not a liberal bias or a conservative bias; it is a confirmation bias, or the urge to believe only things that confirm what you already believe to be true.” In related news, consumers of information are now routinely demanding coverage that conforms to their preferred worldview, and they have the ready ability to go elsewhere if they do see themselves as not having been served.
A logical extension of such demands is the “fake news” phenomena. Ridiculously false stories like “Obama Signs Executive Order Banning The Pledge of Allegiance in Schools Nationwide,” “Pope Francis Shocks World, Endorses Donald Trump for President, Releases Statement,” “Trump Offering Free One-Way Tickets to Africa & Mexico for Those Who Wanna Leave America” and “FBI Agent Suspected in Hillary Email Leak Found Dead in Apparent Murder Suicide” were widely circulated.
As Martin Baron, The Washington Post‘s Executive Editor, said in reflecting on the “fake news” problem, “How can we have a strong civil society when we can’t agree on basic facts, when people accept lies as truth?” I don’t know. But it’s a great question.
Permanent Institutions. According to research from Gallup, Americans’ average confidence in 14 permanent institutions (such as Congress, the media, the church, unions, business, the courts, school systems, the military and police) is at only 32 percent. A 2015 Pew study found that only 19 percent of Americans trust the federal government always or most of the time. It is perhaps no coincidence then that the country elected Donald Trump to be president, choosing a Washington outsider with no experience in politics who ran on a platform of basically doing everything differently. Some have gone so far as to suggest that Western democracy is in decline. Nine in 10 Americans lack confidence in our country’s political system, and despite being wildly polarized generally, there are few partisan differences in the public’s lack of faith in the political parties, the nominating process, and the branches of government. Something has to give on this score.
Press. Only 6 percent of Americans say they have a lot of confidence in the media, putting the news industry roughly on par with Congress and well below the public’s view of other major institutions. We want accuracy and transparency but are increasingly likely to assume “our side” is right and the “other side” is wrong. We are increasingly likely to seek specific news sources that confirm our preexisting views and are less and less likely to want to check out an alternative view. In fact, while we trust the news source (s) we use, we distrust others; media outlets give their customers what they want and cover who they want. As the late journalist Gwen Ifill has said: “We have stories to tell, but many in our audience have stopped listening because they can tell that we’re not talking about them.” The industry is in a financial mess too. Finding, reporting and interpreting the facts is perilous business (see here and here, for example), but the lack of trust in media goes a long ways toward describing many of the polarizing political problems we face.
Pay and Productivity. By the 1970s, the connection between productivity and the wages of the median worker had started to break down. Workers have continued to get more productive over the past 40 years since then. But median compensation hasn’t kept up even though the highest-earning workers have seen their incomes rise along with productivity growth. This disconnect remains and is a key component of the political and economic unrest channeled by President Trump on the right and Senator Sanders on the left during their respective presidential campaigns.
Participation. The labor force participation rate measures the fraction of the civilian, non-institutionalized population, age 16 or over, that is either working or looking for work. At the peak of the tech boom, this figure reached 67 percent, which represented an all-time high. But has been all downhill since. Labor force participation is now at its lowest level since the 1970s. To be sure, this figure can be deceptive because it includes retirees, a class that is growing as the Baby Boomers age, students, and stay-at-home parents. But it remains a troubling statistic.
Petroleum. Ever since the Jimmy Carter era, much concern has been expressed about the U.S. becoming or being “dependent” on foreign oil. These concerns were often overstated in that close American allies like Canada, Mexico (a close ally at least until very recently), and the United Kingdom are major oil producers and because major oil exporters are as dependent on American money as we are on their oil. That said, technological advances and especially fracking have dramatically reduced America’s dependence on foreign oil over the past decade. America’s net imports of crude oil and petroleum products declined from 12.5 million barrels per day in 2005 to 4.7 million in 2015. All that added supply has cut the cost too. But that reality has had consequences for markets and for the environment. What that means going forward remains a huge issue.
Population. Late in 2016, the U.S. Census Bureau released data showing that the U.S. population had grown at just 0.7 percent over the year ended July 1, 2016, the lowest rate of growth since the Great Depression. Declines in the birthrate and the slowing pace of immigration are the reasons why. And while the interrelationship between population growth and economic expansion is controversial among economists, there is little doubt that a population slowdown makes future growth more difficult. While this slowdown, to date, has been slower in the U.S. than in other developed countries, further immigration restrictions (and/or deportations) will increase the difficulty. This lack of workers will be an important statistic to watch going forward.
Top Ten Recommendations
As is usually the case, the evidence concerning the markets looking ahead is decidedly mixed. “Part of the problem from our perspective, when you look at the world’s assets, is nothing’s cheap. It’s not a great starting point if you’re an investment manager,” says GMO’s James Montier. The U.S. market is expensive by any measure, but it has been for years. Yet we have just seen the biggest post-election market rally since at least 1952. Carl Icahn left the Trump’s victory party to buy U.S. stocks. Shortly thereafter Stanley Druckenmiller, who earlier in the year told a conference for fellow hedge fund managers to “get out of the stock market”, announced he had sold all of his gold on election night and liked sectors of the stock market tied to economic growth.
The U.S. is the most expensive market across every valuation metric, but that makes sense given the huge outperformance over the past five years. Taking the CAPE yield — the inverse of the CAPE ratio — would give us expected returns of 3.8 percent, 6.0 percent, 4.9 percent and 7.1 percent, going from left to right on the chart immediately above.
Unlike stock market performance, bond returns are more or less governed by math. If you would like to approximate your long-term returns, the best place to look is the current yield. The following chart shows the starting yield for the benchmark 10-year U.S. Treasury note going back to 1928 plotted against the subsequent 10-year annual returns.
The correlation between starting yield and subsequent returns is 0.95, showing a strong positive statistical relationship. It would seem obvious that returns would come close to starting yields since the 10-year time frame matches the maturity of the bond, but this relationship seems to hold over various maturities and other time frames.
So there are some very good reasons to be cautious and other very good reasons to be optimistic.
Perhaps worse, there are always a much wider range of possible outcomes than we tend to think. For example, it’s easy to find a long list of people decrying Donald Trump as “a mindless, vengeful carnivore who holds grudges the way mother koalas carry their babies,” that we are underestimating the danger he presents and that he poses an existential threat to American democracy. It’s just as easy to find a long list of people who are convinced that President Trump will self–regulate his baser instincts and usher in a new golden age of prosperity and dominance by making America great again.
Moreover, as Nobel laureate Richard Feynman is said to have quipped (but probably didn’t), “Imagine how much harder physics would be if electrons had feelings!” Or as Newton put it: “I can calculate the motions of the heavenly bodies, but not the madness of people.” The markets are pretty much driven by millions of people and their feelings. That’s why, as I have taken great pains to point out, we’re just really bad at forecasting the future.
But even though we can’t expect to be very good at it, investing requires making the best choices we have with the information we’re given. With those careful caveats, my “top ten” 2017 recommendations for your consideration are as follows.
- Save more. We aren’t saving nearly enough even though saving is the most fundamental and most important component of successful investing. If we save enough, our other investment decisions – where and how to invest, asset allocation, retirement withdrawal strategies, etc. — are almost irrelevant. Aggressive saving allows one to take advantage of compound interest, the so-called “eighth wonder of the world.” The best thing any of us can do for ourselves and for our families’ futures is to save more and to keep saving more. Similarly, we should all have a carefully constructed plan for dealing with emergencies or other contingencies, unexpected or predictable. Every financial planning client, like every financial planner, should have such a plan in writing and in place.
- Keep your expectations in check. According to a recent survey, nearly all investors expect to do at least as well as the market, even though the vast majority of us do not. Moreover, many of them expect an annual return of at least 20 percent over the next decade – and they even scored higher on a test of financial literacy than those who had a more reasonable estimate. Since 1926, the S&P 500 has returned an average of about 10 percent annually, according to Howard Silverblatt, a senior analyst at S&P Dow Jones Indices, and the closest it came to 20 percent in any decade was in the 1950s, when it averaged roughly 19 percent annually. Since nearly everyone has investments other than stocks (and they should), and since those other investments offer lower historical returns, we shouldn’t expect anything like 10 percent annual returns over the longer-term. Plan accordingly.
- Beware the political trade. We know to a rock-solid certainty that avoiding mistakes provides more benefit than sound positive decision-making (although both are important). We also know that basing your investment decisions on your politics is a recipe for disaster (as detractors of President Obama who avoided the market from 2009 going forward found out – they expected disaster but the S&P 500 gained 3 percent annualized during his eight years in office). That’s especially true because a president has far less control of market performance than is generally assumed. Those who loved or (especially) hated Mr. Trump will need to be very careful that their politics don’t dictate their investment decisions. When things go the way we’d like politically, we tend to think that all will be win, win, win and when things don’t go the way we’d like, we tend to think it’s the end of the world as we know it. But neither of those extremes – or even very close – are ever likely.
- Infrastructure. The easiest trade in the new year is this one because President Trump has promised more infrastructure spending and because it is desperately needed. The American Society of Civil Engineers has estimated that the U.S. needs to spend $3.6 trillion by 2020 just to put the infrastructure we have in good working condition. According to the think tank Smart Growth America, current road maintenance spending is only about a third of what it needs to be in order to maintain the system’s quality. Moreover, the longer we postpone repairs to roads and other infrastructure, the more expensive it gets. Thus the need is urgent, even before factoring the potential benefits to blue-collar men, who are disproportionately out of the workforce. It remains to be seen how much infrastructure spending President Trump will actually attempt, but this trade still seems smart and all but inevitable.
- Financials. I like financials. The idea behind this trade is pretty simple (see the chart below). If we get higher interest rates (and we should), financials will almost surely outperform. As a corollary to this idea, I like floating-rate bank loans.
- Foreign Markets. Investing primarily in U.S. stocks dramatically reduces the benefits of diversification. Not only that, but U.S. markets have been outperforming international markets for more than a decade. This outperformance is one of the reasons that stocks in the U.S. have a higher valuation than international or emerging-markets companies. Across five of the broadest metrics — CAPE ratio, price to earnings, price to cash flow, price to sales, and dividend yield — U.S. stocks currently have an average premium of more than 60 percent over European, Asian, and emerging-market stocks. Higher valuations and lower dividend yields means that U.S. stocks should have lower expected future returns than foreign stocks. As Larry Hamtil has pointed out clearly, over the last several years, American investors who have owned foreign equities have seen a significant underperformance of their foreign holdings relative to their domestic holdings. As shown below, the MSCI World ex-USA index returned an annualized -0.22 percent since 2008 while the American index, the Wilshire 5000, returned greater than 7 percent annualized. As a result of this lackluster performance, many have dumped their foreign positions; everyone was tempted. And while every sector of the market sees periods (and often long periods) of significant underperformance, this particular period of difficulty has been driven largely by the strength of the U.S. dollar. Because there exists a negative correlation between foreign equities and the dollar, foreign equities make great portfolio diversifiers. Since 2011, the S&P 500 is up over 100 percent while emerging market stocks are down more than 10 percent. These markets tend to be very cyclical in terms of their relative performance, but both markets finished with similar gains in 2016. Could we finally see emerging markets outperform after years of poor performance? Mean reversion suggests as much even if it cannot be used accurately for timing purposes. The emerging markets are where the bear market has occurred and thus where value can be found. I’d overweight here. As noted, there are some reasons to like foreign equities generally and especially emerging markets because EM stocks are cheaper. However, foreign stocks in developed countries are still cheaper than domestics by a good margin and seem to have less uncertainty built into their prices. Home country bias is a long-standing investment problem that is frequently unaddressed. I’d address it.
- Diversify. Diversification didn’t pay-off much this year, as noted above. But it always pays off over the longer haul. It’s the one sure “free lunch” in investing. I recommend it yet again, as always.
- Insurance (and especially guaranteed income). Health care will cost a lot, especially for retirees and especially long-term care (70 percent of people turning age 65 today can expect to use some form of long-term care during their lives). Most Americans need guaranteed income and are happier when they have it. Appropriate life insurance is crucial, especially for families. Don’t neglect insurance needs in 2017, no matter how much you may love the market.
- Avoid “Personal Volatility.” While a correction or even a market crash remain real possibilities, and may even be overdue, the “personal volatility” of trying to time the market is almost always a bad idea. As the great investor Peter Lynch put it, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Overall, markets are positive roughly 3-out-of-4 years. If President Trump gets much of what he wants in terms of spending and deregulation, the market’s path of least resistance is clearly higher, making a big cash position a major risk. Moreover, investors and advisors should temper their tendency to fire money managers for recent underperformance. Multiple studies have shown that the wealth lost by investors from the practice of firing and hiring managers on the basis of recent performance – at both the personal and institutional levels – far exceeds the average net-of-cost underperformance of active management. This sort of “personal volatility” is highly dangerous.
- Don’t bet against America. There is a good argument to be made that the combination of individual and corporate tax cuts, better trade deals, less burdensome and restrictive regulation, and infrastructure spending will provide real growth for the U.S. in 2017 and beyond. Small business optimism is way up and people are more upbeat about their personal finances today than at any time in the past decade while 66 percent of Americans expect to be financially better off a year from now. But even those who hate the market – and especially those who perennially hate the market – should recall that betting against American ingenuity, industry and progress has been a sucker’s bet for well over two centuries. Going back to 1928, domestic stocks and bonds have only had negative calendar year returns in the same year three times — 1931, 1941 and 1969 (using the S&P 500 and 10-year U.S. Treasury notes as proxies). Interest rates will almost surely rise this year, putting fixed income returns at (modest) risk. So don’t sleep on U.S. stocks.
Investing successfully is really hard. To put it into a bit of perspective (based upon some research by David Yanofsky for Quartz and beginning January 1, 2013), if you had picked the best stock to buy every day and put all of your money in it at the beginning of the day before selling it at the end of the day, you could have turned $1,000 into $264 billion before the year was out. Did you (or anybody else) do that or anything like that? I sure didn’t.
AK Steel Holding is a Fortune 500 company. It earned 355.80 percent in 2016. The S&P 500’s “puny” 12 percent return last year doesn’t look quite so great in comparison, does it?! If you didn’t do at least that well, you left a lot of money on the table.
It is thus imperative that our planning be as independent from forecasting as possible. That’s always an important truth, but it especially important given the range of possible outcomes before us. It is the broadest range I have seen in my lifetime. Especially if we take our political blinders off, it is remarkably easy to imagine great things happening and terrible things happening. Smart investors will be prepared for both — and everything in between.
“Prudent” is not a popular word. It’s not sexy in the least. But good investing is prudent and mindful of all opportunities and all risks. I encourage all of you to be prudent investors in 2017 and beyond.
1 Many of the biggest and smartest investors in the world were highly negative on the stock market in 2016. We heard negative equity calls from Stan Druckenmiller (net worth, $4.4 billion) (“Get out of the stock market”), Carl Icahn (net worth, $17.4 billion)(“I don’t think you can have [near] zero interest rates for much longer without having these bubbles explode on you”), Jeff Gundlach (net worth, $1.4 billion)(“[S]ell everything. Nothing here looks good”), Howard Marks (net worth, $1.9 billion), Paul Singer (net worth, $2.2 billion)(“I think it’s a very dangerous time in the financial markets”) and Bill Gross (net worth, $2.4 billion)(“I don’t like bonds; I don’t like most stocks; I don’t like private equity”). Famous hedge fund manager George Soros (net worth, $24.9 billion) doubled down on his bet against the S&P 500, buying put options on just over 1.9 million shares the SPDR S&P 500 ETF (SPY) so that he owned puts on just over 4 million shares. It was his fund’s biggest holding according to his 13-F filing. Similarly, global macro hedge fund manager Paul Tudor Jones (net worth, $4.7 billion), doubled-down on his bet against the stock market, according to his fund’s 13-F filing. During the second quarter, Tudor bought put options on over 5.95 million shares of SPY so that the fund owned puts on 8.34 million shares of the ETF, making it that fund’s largest position too. Or even consider the sad, sad case of John Hussman, who has hated the market since 2009 (he most recently called for a 55 percent loss and is invested accordingly) and suffered enormous underperformance and loss of assets (down to about 6.5 percent of what they once were) as a consequence. Of course, they can all afford to be wrong and don’t need their money to grow to experience a comfortable retirement. Moreover, that group is big but the sentiment is hardly unanimous. For example, it wasn’t shared by Ray Dalio (net worth, $15.9 billion) or Warren Buffett (net worth, $66.6 billion).
2 The Bureau of Labor Statistics does try to deal with this issue via other methods. The broadest unemployment measure (U-6) stands at 9.2 percent, and includes part-time workers who’d like a full-time job, as well as people who say they want work but have given up looking for it. However, working-age American men are much less likely to be in the labor force now than they were in the past and nobody seems to be able to figure out why. Among the guesses are the disappearance of blue-collar factory jobs, mass incarceration, chronic pain, the growing use of Social Security Disability Insurance, and even video games. U-6 doesn’t accurately reflect this group of men who, for whatever reason, don’t even claim to want a job. President Trump has suggested we use the labor force participation rate, which reflects the 95 million Americans who aren’t working. It thus captures those who have given up, but it also includes retirees, students, stay-at-home parents and anyone else who doesn’t want to work. The best measure might be the employment-to-population ratio for adults between the ages of 25 and 54, or “prime-age EPOP.” It isn’t perfect (it includes part-timers and those who don’t choose to work) but because it starts at 25 it excludes most students and because it cuts off at age 54, retirees don’t really factor into it. It also includes those who have given up looking for work. Currently, the prime-age ESOP rate is 78.2 percent, below its pre-recession high of 80.2 percent and far beneath its tech-boom peak of 81.9 percent.
3 Even with the obvious “greats,” it is never clear how much of their success is luck and how much is skill. For example, note that legendary manager Bob Rodriguez famously called the tech-wreck and the real estate meltdown, but was also certain that debt-fueled crisis would crush the market in 2011. He has kept expecting to be right, if early, and his funds badly underperformed until his recent retirement.
4 More (if not very) specifically, Mr. Trump promised to create at least 25 million jobs and “be the greatest jobs president that God ever created,” make the auto industry in Michigan “bigger and better and stronger than ever before,” pass the Middle Class Tax Relief and Simplification Act, which will reduce the number of tax brackets from seven to four and lower income taxes for all, lower the corporate tax rate to 15 percent and, in general, provide “the biggest tax cuts since Ronald Reagan.” Mr. Trump further promised to “double our growth and have the strongest economy anywhere in the world,” eliminate the $19 trillion national debt within eight years, cut the budget by 20 percent by simply negotiating better prices or renegotiating existing deals. Mr. Trump will spur the spending of $1 trillion in public and private dollars on infrastructure projects over 10 years, creating “thousands of new jobs in construction, steel manufacturing, and other sectors” to carry out this work with only “American workers” hired for these jobs. Mr. Trump promises to rebuild and fix our inner cities, especially Detroit. He will create “jobs and opportunities for African Americans and Hispanic Americans” and reduce the number of people receiving welfare.
With Congress, Mr. Trump promises to “completely repeal” the Affordable Care Act and replace it with something “terrific” that is “so much better, so much better, so much better” such that Americans will have “great health care at a fraction of the cost.” Seniors will be pleased that the new administration will preserve Medicare and Medicaid and fully protect Social Security. Mr. Trump will also build an “impenetrable physical wall” along the Mexican border that is taller than the Great Wall of China and “artistically beautiful.” The wall will be paid for by Mexico, “100 percent.” The President also plans to boot at least 5 million undocumented immigrants out of the country. As a consequence of this and other new immigration policies, “crime will go down, border crossings will plummet, gangs will disappear, and welfare use will decrease.” Indeed, illegal immigration will become a “memory of the past.” He will quickly end inner-city violence: “I’ll be able to make sure that when you walk down the street in your inner city, or wherever you are, you’re not gonna be shot. Your child isn’t gonna be shot.” The “crime and violence that today afflicts our nation will soon come to an end. Beginning on January 20, 2017, safety will be restored.” On that day, Mr. Trump says, “Americans will finally wake up in a country where the laws of the United States are enforced.” Thus he will stop the surge of violent crime and homicides in Chicago within “one week” and “dismantle every last criminal gang and cartel threatening our cities. . . . They are not going to be here very long, folks. They’re gonna be out of here.” He will also immediately stop the killing of police officers. “It’s going to stop, okay? It’s going to stop. We’re going to be law and order. It’s going to stop.”
Mr. Trump promises to strengthen the military so that it’s “so big and so strong and so great” that “nobody’s going to mess with us.” He will do that by equipping our troops with the “best equipment known to mankind,” by modernizing the nuclear weapons arsenal, growing the Army from its current size of 470,000 active-duty soldiers to 540,000, growing the Navy fleet to 350 surface ships and submarines (the Navy currently has 272 deployable battle-force ships), grow the Air Force to 1,200 fighter aircraft, growing the Marine Corps to 36 battalions, increasing the active-duty force from its current target of 182,000 to 200,000, and develop a “state of the art” missile defense system. We will “bomb the s— out of ISIS” and “knock them out” quickly.