Below is a review of market sectors in the fourth quarter of 2016 jointly written by our investment team.
Energy stocks were the best performers for the year, posting gains of 25%. In the fourth quarter, the energy sector was up 8%. Over 100 oil and gas produces have declared bankruptcy since the beginning of the downturn in the energy sector, but prices appeared to have bottomed out in 2016 and are expected to be stable or higher in 2017. Oil prices closed the year at $54/barrel; up from around $29/barrel at the beginning of the year, the biggest annual gain since 2009. In September, OPEC announced plans to put a ceiling on production to reverse the decline in oil prices. The coming year could be a good one for energy stocks, the companies who survived the downturn put dramatic cost reductions into place, so they are well-positioned for the recovery. EOG Resources (EOG) is one of our best performing stocks for the year, up 42.47%. It was up about 5% in the quarter.
Material stocks were up 15% for the year and almost 6% for the quarter. The trough in the commodity cycle seems to have passed. Rising commodity prices and an expectation for an increase in infrastructure spending are supporting prices. Inflation tends to be good for material stocks as it increases the ability to lift prices. Our lone material stock is Ecolab (ECL), a company that makes cleaning and water treatment products. This material stock is more removed from the cyclical nature of materials and tends to have very steady growth. The stock was up just 2.5% for the year.
Industrial stocks gained 18% for the year and nearly 8% for the quarter. One of our best performing stocks was Cummins (CMI), up 55% for the year and 7% for the quarter. Support for this strong rally came from increasing oil prices, strengthening mining activities, and Trump’s promises of higher spending on infrastructure. The industrial sector has a positive outlook for 2017 if infrastructure and defense spending picks up as expected under the new administration. Inflation is typically a positive for industrial manufacturers. The recovery in the energy sector should benefit industrials, while a stronger dollar and weakness in Europe may be an offset.
In a year where consumer sentiment reached its highest level (in December) since January 2004, it’s a little surprising that Consumer stocks lagged the market, up about 3% for the quarter and 5% for the year. Unemployment is low and wage growth has picked up, but there are a number of disruptive forces in the sector. Increased price transparency as a result of online/mobile shopping has led to greater competition and lower margins. We sold out of Magna International, a maker of car parts, out of concern for the automotive industry, which faces multiple headwinds: Rising oil prices and higher interest rates tend to be a drag on auto sales and higher material costs may price many customers out of the new car market. Our best performing consumer stock was Priceline (PCLN), up 16% for the year. Travel-related stocks seem to be a good place to be. Disney (DIS) was flat for the year after recovering 13% in the fourth quarter. In terms of large purchases, consumers tend to be leaning toward the purchase of a new home: Rising interest rates and increasing home prices seem to be pushing potential home buyers to take the plunge and buy a home. In general, the housing market is considered strong right now.
Consumer Staples stocks were down about 1% for the quarter and are up just 3% for the year. Part of the weak performance in Consumer Staples stocks may be a good sign: Investors showed a willingness to rotate out of defensive, income-oriented stocks and into more cyclical companies like oil and industrials. There were real reasons for weakness, too: Many consumer staple stocks are large multinational companies with a large portion of sales from abroad. A stronger dollar and relatively weaker growth outside the U.S. hurt companies like Nestle (NSRGY), for example, which was down about 5% for the year. A shift in U.S. consumer appetites toward organic, whole foods is also a headwind for makers of processed foods. Also, rising rates puts pressure on richly valued dividend-paying stocks in the sector.
Health Care stocks declined 3% for the quarter and 4% for the year. The unsustainability of escalating health care costs and concerns regarding the future of health care policy in the U.S. have put pressure on the sector. Tenet Healthcare (a large operator of hospitals) was down 25% the day after Trump’s election on concerns regarding the potential repeal of Obamacare. Once the dust settles, this sector could see a recovery in 2017 driven by aging demographics and new products. Some of these products include transcatheter heart valves ; medical devices that continuously monitor glucose levels, and biotherapeutics. Lighter regulations under a Trump administration and corporate tax reform could be positives for many companies in the sector. Since the stocks did not participate in the recent run-up there are some comparably good valuations in the sector. Johnson & Johnson (JNJ) was our best health care stock for the year, up 12.43% (but down 2.23% in the fourth quarter).
Financial stocks have been on fire since Trump’s election. As a whole, financial stocks were up about 22% in the fourth quarter (and 20% for the year). Goldman Sachs has been the big winner since the Trump election (up over 30% since early November). The Trump White House includes many ex-Goldmanites including Treasury Secretary nominee Steven Mnuchin and Gary Cohn, picked as chair of the National Economic Council. Northern Trust (NTRS), a relatively new purchase, is up about 30% in the fourth quarter, too. Discover Financial (DFS) was up 27%. The general hope is that rising rates and deregulation will benefit banks. Trump vowed to dismantle Dodd-Frank; the increased cost of compliance has been especially burdensome to smaller banks. At this point, the expectations have been set so high and the pressure to outperform is so intense that it might be a good time to be cautious in this sector. Furthermore, Trump’s promises included re-regulation of banks in some respects as well, such as re-establishing the Glass-Steagall separation between investment and commercial banking.
Here’s another curiosity: Trump will be the first landlord in chief, but real estate stocks tumbled 7% in the quarter and are down 2% for the year. Bond yields have gone up, which makes high yielding stocks less attractive. But there are reasons to like Real Estate: Rising business confidence and the potential for lower tax rates and fiscal stimulus are good for both office properties and multi-family/apartment buildings. The REITs we own have done exceptionally well, particularly compared to the sell-off that many REITs experienced in the second-half of 2016: Digital Realty Trust (DLR) is up 30% for the year and 1% for the quarter. Tanger Factory Outlets (SKT) is up 9% for the year and 3% for the quarter.
Technology stocks were up about 3% in the fourth quarter and 14% for the year. It was an especially good quarter for Automatic Data Processing (ADP), which was up 17%. The company benefits from higher interest rates and stronger job markets. Apple (AAPL) was up 3% in the quarter and 7% for the year. Services such as Apple music, Apple Pay, and iCloud back-up experienced strong double digit growth in the prior year. It’s hard to believe, but the New Year brings the 10th anniversary of the iPhone. Something else that may benefit Apple shareholders in 2017: Tax reform may incentivize companies like Apple to give foreign cash back to shareholders through increased dividends or share buybacks. Microsoft (MSFT) had a good quarter up 8% and (and up 12% for the year). The company acquired LinkedIn for $26 billion. Trends in tech include: cloud computing, big data, artificial intelligence, the Internet of things. Tech stocks have record cash generation and record levels of cash on their balance sheets. Merger and acquisition activity has been accelerating especially in the software and semiconductor industries.
Telecommunication Services were up 7% for the quarter and 19% for the year. Verizon (VZ) our largest telecom holding was up 3% for the quarter and 16% for the year. The big trend in the sector has been the race for content that began when Comcast announced its intent to purchase NBC in 2009. Verizon announced its acquisition of AOL in 2015 and Yahoo in 2016. AT&T joined the party in October by announcing its acquisition of TimeWarner. As subscriber growth has slowed and further consolidation within the sector has run into antitrust troubles, telecom companies are seeking growth through using their extensive networks to enter new industries. Live video streaming and augmented reality games like PokemonGo have been driving the demand for high quality mobile phone service.
Utility stocks were down 1% in the fourth quarter, but up 13% percent for the year. Utility stocks shined during the year as investors sought out safety and income. The Trump election has significant consequences for the energy and utility sectors. The difference between Trump and Obama may be most extreme in the energy and environmental fields. Some of the clean energy trends will likely persist due to improving technologies, declining prices, and ongoing state/federal incentives. All of the major utilities have expressed the commitment to renewable energy, and tech giants, including Apple, Amazon (AMZN), Alphabet (GOOGL), and Microsoft (MSFT) have pledged to consumer nearly all electricity from sustainable sources.
Trump promised to put coal workers back to work, but he is more likely to do so by encouraging infrastructure (coal is used to make steel) or by encouraging the export of liquid natural gas (which could drive up the price of natural gas and make coal more competitive). Right now, no major utilities have plans to build coal plants, but this is largely because of the availability of cheap and abundant natural gas. Even though the trend is away from coal for electricity generation, coal still makes up 40% of the world’s energy mix. Carbon capture and storage remains an elusive technology.
A Trump administration will likely reduce regulation for the sector. Trump’s EPA pick, Scott Pruitt, fought to overturn the Clean Power Plan, which faces a Supreme Court Challenge (and could easily now die in court).
A Final thought on Earnings and Stock Prices
In a short while, 4th quarter earnings for 2016 will come into focus. Overall earnings for the S&P 500 companies are expected to be up 3.4% year-over-year on 4.1% higher revenue. For the year ahead, Wall Street analysts are predicting strong earnings growth across sectors (up about 12% in 2017 on 5.6% higher revenue). These are good numbers and cause for hope. At the same time, sell-side analysts are naturally optimistic, and one must understand that earnings alone do not determine the direction of asset prices, at least not in the short run. Higher earnings are better than not, but there are no guarantees in this business.
Comment on Bonds and Interest Rates
A relative of one of us reported over New Year’s that the rate on his adjustable-rate home-equity mortgage just reset. His old rate, which was in place for a period of years, was 2.74%; the new rate is 7.05%. Wow!
After 30 plus years of falling, interest rates appear, finally, to be moving in the other direction. The yield of the bellwether 10-year Treasury bond was 2.27% at the start of 2016. It got as low as 1.36% in the summer, which may mark the turning point. By year-end the 10-year Treasury yield stood at 2.47%. The latter is still very low compared to the historical average, which is in the 5% range. How long will it take interest rates to return to normal? Will they overshoot the mark on the way up? Will they snap back and go “lower for longer”? No one knows and it is a fool’s errand to try.
So long as bonds generate inflation-adjusted or real income and have a fixed and certain maturity date, they belong in most portfolios. We intend to conduct our bond investing in 2017 with a continued emphasis on quality (A-Rated and better) and laddered maturities. The advantage of laddered maturities is that every year a bond comes due and the proceeds can be invested at the new and higher level. The advantage of high quality is you can worry about something else. Bonds should reduce risk; they are the ballast that lets you put on sail with stocks.