Q4 2016 Client Letter

January 2017

2016 was quite a year to remember.  As the year advanced we saw some remarkable contrasts between winners and losers.  U.S. equities were big winners, with the S&P 500 Index up nearly 12% on the year, and the Russell 2000 Index of small cap U.S. stocks up more than 21%.  Consensus thinking was a big loser.  Polls and pundits missed calls on the Brexit vote, the U.S. presidential election, the balance of power in the U.S. House and Senate, and the market’s reaction to these events.

The S&P 500 Index rose less than 1% over the 18 months leading up to the U.S. election, while small cap stocks fell more than 7% over the same period.  Earlier in the year the S&P 500 Index had lost nearly 15% of its value while small cap stocks were down more than 25% from their recent highs.  Heading into the election, consensus thinking said Donald Trump had no path to victory in the Electoral College and Democrats would take the White House and Senate while gaining ground in the House of Representatives.  A Clinton win would provide a floor of stability allowing stocks to advance while a Trump victory would create dangerous instability and risk a calamitous sell-off in equity markets, or so it was thought.  In the early hours of November 9 those thoughts were turned on their head!

The S&P 500 Index rallied more than 8% and small cap stocks shot up nearly 20% in just a few short weeks following the election.  The U.S. Markets began to embrace the positive effects of fiscal stimulus, tax relief, and regulatory reform, while seeming to overlook the potential negative effects of increased trade barriers, rising interest rates, a stronger dollar, and rising inflation.

Source: StockCharts.com

As we start the year with markets at all-time highs and consumer confidence booming, one question continues to dominate our thinking: Are we in a new era in which low interest rates, low inflation, and slow growth persist for many years to come?  Or, are we in a distended phase of the same old era in which profit margins, equity valuations, and other important variables revert toward their long-term historical averages as they always have in the past? These two states of the world offer dramatically different opportunities and threats to investors.  What works well in one scenario is unlikely to work well in the other.

If it is a new era with a more muted trajectory of interest rates, then traditional portfolios of stocks and bonds will probably perform relatively well despite offering lower returns than they historically have. High quality, long duration assets are likely to provide the best outcomes in this environment.  This would be more comfortable in the short run thanks to lower volatility, but less comfortable in the long run due to reduced returns for all asset classes.

If it’s not a new era, then both U.S. stocks and bonds are expensive and vulnerable to significant and potentially simultaneous drawdowns.  Cash, U.S. Treasury inflation protected securities, and high quality, low duration assets are more likely to preserve capital as prices revert to more normal levels.  In this scenario, international equities, many of which measure as being less expensive than their historical averages, might fare better than their U.S. counterparts. Overall, the return of old-era market tendencies could be uncomfortable in the short run due to downside volatility, but more welcome in the long run due to higher, more normal rates of return for all asset classes.

Financial history is littered with examples of new era, “this time is different” arguments that turned out to be dramatically false and harmful to their investor adherents.  There are no previous historical examples quite like this one.  Central banks have collectively expanded their balance sheets by more than $5 trillion, short-term interest rates have been near zero for more than six years, long-term interest rates turned negative in Europe and Japan, price inflation has been benign, and global economic growth has been positive but well below trend.  These developments have changed the landscape enough to delay any reversion to the mean, but for how long?

Our job is to develop long-term strategies that will help our clients and their families achieve their goals and meet their objectives, no matter what the future holds.  We take that role very seriously. Rather than “one size fits all” solutions, we believe every family is unique. Each set of circumstances is different.  We continue to scour the investment universe, in both the public and private markets, for the most compelling opportunities available.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm. We wish you a happy, healthy and successful 2017.

Nicholas Hoffman & Co.