The U. S. stock market delivered once again in 2016, the eighth year in a row of positive returns, the best stretch since the late 1990s. The election results and the hope for lower tax rates, less regulation and a better economy have triggered another round of “animal spirits”. This optimism has driven stock prices up so far this year as well, by another 6% in the U. S. and over 7.5% overseas.
The bond market surprised many investors by returning 2% to 3% for taxable bonds in 2016 and we’re up almost another 1% just in the first quarter of 2017. It turns out bonds have provided low single digit but steady returns the last few years as we predicted they would. Cash returns from CDs and money market funds have been close to zero so avoiding bonds in favor of cash in recent years has been a big mistake for risk-averse investors.
Here is our view of the investment climate and risks we see for the remainder of 2017:
- The economy will accelerate to 2.0% to 2.5% real annual growth, up from 1.6% in 2016. Unemployment at 4.5% is very low and so further significant job growth may be difficult. Inflation is likely to remain well under control, which will allow the Fed to raise the overnight Fed funds rate two or three times in 2017, gradually pushing interest rates higher..
- S. stocks should move higher by 4% to 7%. Volatility should increase over 2017 but we feel the path of least resistance is for stocks to grind higher, amid that volatility. Stock valuation levels including P/E ratios in the U. S. are elevated now, which will require corporate earnings to grow nicely this year if these valuation levels are to be justified. This uncertainty will be another driver of volatility.
- Corporate earnings should power ahead by 8% to 10% in 2017, a big improvement, coming off six quarters in a row of declining year-over-year earnings in the 2015-2016 period.
- Historically, stocks have moved higher during periods of rising interest rates. It isn’t until the Fed completes the process of raising rates to their target, which could take several years, that stocks begin to suffer.
- Foreign stock markets look increasingly attractive based on cheaper valuations than here at home, including emerging markets. We recommend a properly diversified portfolio should include 25% to 35% in non-US stocks and about 15% to 20% of this should be in emerging markets. Did you know that over 60% of the value of the world’s stocks trade outside the U. S.?
- Beware advice to buy dividend heavy stocks as an alternative to bonds in this low interest rate environment. When a bear market arrives, you will suffer a bigger loss to your portfolio than if you had stayed in a conservative, high quality, intermediate duration bond portfolio.
- We are certainly closer to the top of the multi-year bull market cycle than to the bottom and closer to the bottom of the interest rate cycle than the top. How you navigate the next couple years will be crucial given the higher level of risk today in both stocks and bonds.
- You need alternative investments in 2017. Compared to conventional stocks and bonds, they tend to reduce risk due to their lower correlations. They will help you to “play defense” in an increasing risky investment environment.
- Now is an excellent time to rebalance your portfolio which will also reduce risk. A 60% U. S. stocks – 40% tax free bonds asset mix could over the last five years have moved your portfolio up to 70% stocks now, and to almost 78% if you were at 70% – 30% to start. Now that you’re five years older, perhaps nearing retirement, it is time to reduce risk, not take more. Rebalance back to your correct target allocation.
Investors tend to project the strong investment returns of the recent past forward into the future, but that’s foolish and wrong. What is realistic for 2017 are middle single digit stock returns and low single digit bond returns, each with increasing volatility and risk. Are you fully prepared?
Once filing your tax return is behind you, refocus on your investment portfolios. Have you reduced risk given where we are in the stock market and interest rate cycles? Sound advice on how to prudently reduce risk now from an experienced investment professional, who is a fiduciary acting solely in your best interests, will serve you well in 2017 and beyond.