Review of 2016
2016 was an unusual year in many respects, and the financial markets were no exception. There were three separate spikes in stock market volatility (caused by concerns about energy prices, Brexit, and the presidential campaign), and yet the S&P 500 rose by 12% for the year. International developed market stocks went up by only 1%, while emerging market stocks increased by 11%. Despite increases in interest rates late in the year, bonds earned a 3% return during the year.*
Below is a table showing key economic and market indicators (as of December 31)**:
As has been the case with most of the news throughout the year, the focus in the press on recent stock market performance has been related to the election. However, from our perspective, the main reason for the relatively high stock market valuation is that the economy is as strong as it’s been this decade. Unemployment is low, inflation is at a level that many economists consider ideal, and while interest rates have recently increased slightly, they haven’t been at this consistently low level since the 1950s. Two factors stand out in particular. Economic growth showed signs of strength, with GDP growing by 3.5% in the third quarter. Moreover, corporate profitability showed outstanding growth in 2016, and most analysts are expecting that growth to continue throughout 2017.
Stock Market Outlook
Because of the current state of the economy and reasonable stock market valuations, we remain optimistic on the long-term prospects of equity investing. However, we do see volatility (both upside and downside) increasing over the next six months. A new presidential administration always creates uncertainty, and the policies that will be set forth in 2017 are more unpredictable than usual. We’re already seeing increases in daily market movements, and those are likely to continue over the first half of the year. That should not be a grave concern to long-term investors, but an expectation of short-term heightened volatility is reasonable.
A bit of historical perspective is in order. At the beginning of 2013, 2014, and 2015, most economists, including those who worked for the Federal Reserve, predicted increases in the Federal Funds Rate of 1% throughout the next year. In those years, the actual increases in the rate were 0, 0, and ¼% respectively. In 2016, most economists were predicting an increase of ½% to ¾% – the actual increase was again ¼%.
With all of that past inaccuracy aside, there are reasons to believe the 2017 forecasts of increases of ½% to ¾% are reasonable. First, the Fed has been far more specific than in the past in stating the conditions in which it will raise rates. Second, as we mentioned earlier, the economy has truly been showing signs of strength – that strength will support the ability to incur small changes in rates without having other indicators such as unemployment and GDP growth adversely affected.
This does not mean that investors in bonds should panic. The projected Fed Funds increases are already reflected in the yields on bonds, so it’s unlikely those rate hikes will cause much reaction in the bond market. Moreover, for a long-term investor, interest rate increases are good over the long-term – any short-term decreases in price are more than made up for in increases in income – as long as the bond investments are managed carefully.
We typically use this space to stress the importance of stability of investment policy. Even though markets might become more volatile, for most investors, our belief in stability still holds – evidence from the past 30 years of investing support the concept of a stable allocation. However, stability does not mean complacency. For investors whose investing goals and needs have become more short-term oriented – particularly those who are nearing or are now in retirement – it might be time to consider adjusting their portfolio to fit their current goals.