Review & Outlook

Our take on the investing, financial, & economic themes of the day

Fourth Quarter 2016 Appraisal Letter

2 February, 2017 by Ben O'Brien in Quarterly Letters

Whoa! The 4th quarter was something, but then the whole year was something, with important lessons to remember. Let me start exactly one year ago. Just as 2016 was getting under way, the stock market imploded in its worst ever start to a year. Stocks appeared to be cascading into a repeat of 2008, maybe even 1929. In the first five trading days, the Dow collapsed 1,000 points. And the picture continued to darken until halfway into the 1st quarter, when suddenly it brightened.

 

Clients know by now how the story eventually ended: stock prices up 10%, which is about the historical average for a full year. There is no need to retrace the tortuous path through 2016, except to say that this is investing in the digital age. Yes, stocks and bonds can preserve and even build wealth in the global marketplace in which we find ourselves, but the price of admission is proving steep. It is a tread mill that never slows down. Investors used to be able to step off to catch their breath and earn a decent return in certificates of deposit, money market funds and bonds. Will those days ever return? Maybe but there is no sign of them now.

 

The investor’s challenge is still managing assets, of course, but it is also, increasingly, managing one’s own fears and expectations. The problem is instant communication, which has grown ubiquitous and impulsive. When combined with fear, impatience or short-term thinking, the result is the familiar and self-inflicted wound of buying high and selling low. Finding good investments is still part of the process, but more important is developing long-term disciplines and habits of mind that allow one to stay the course over stretches of bad news. To my way of thinking, this is the lesson of 2016.

 

To return to the 4th quarter: Clients who compare their account totals at the end of December 2016 to their account totals at the end of September 2016 probably expect to see more of a difference. The 4th quarter was a huge positive surprise, wasn’t it? The answer is yes and no. The big surprise of the 4th quarter was not the size of the post-election stock market rally (the S&P 500 rose 4.5%) but that it occurred in the first place. It is safe to say that nobody, repeat, nobody, saw it coming. At the same time, bonds, which are the other part of a “balanced” portfolio, fell in price in the 4th quarter as inflation fears grew. So yes, stocks on average went up 4.5% in price in the 4th quarter, but bonds went down in price over the same period and largely offset the stock market gains.

 

There is another investing phenomenon to report, that of risk-on and risk-off stock trading. Low quality stocks (those with a lot of debt, no dividends, poor earnings, or no earnings) have come to be called “risk-on” investments, while high quality stocks (those with little or no debt, big dividends, and high earnings) have come to be called “risk-off” investments. With a flick of a switch, depending on whether the news is good or bad, computerized trading programs leapt from one to the other over the course of 2016. In the 4th quarter it was the turn for risk-on.

 

The curious reader might here pause and ask if we are going to get out of our customary risk-off stocks and get into risk-on ones, since the latter are doing so much better now in the so-called Trump Rally. The answer is no. We allocate stocks and bonds on a long-term basis, with the full expectation that some quarters and years our high-quality stocks will lag the market averages and in other years and quarters they will exceed the averages. We have found that any other approach inevitably results in shooting where the rabbit just was.

 

Above I mentioned the Trump Rally. Before Election Day, a frequent debate in the financial media was whether stocks, as measured at an average price-earnings ratio of 20, were expensive or very expensive. With the historical average at about 15, no one was suggesting stocks were cheap. At the same time, both sides agreed that at least there was no euphoria in the market and thus no immediate risk. For, as everyone knows, euphoria is almost always the prelude to a pullback, correction, crash—whatever you want to call it when stock prices go down a lot.

 

But now that might be changing. Signs of euphoria are popping up. The December 26 edition of Barron’s magazine cites a Wells Fargo/Gallup survey that shows “investors at their most optimistic in nine years.” On December 15 Bloomberg News ran this headline: “Measures of economic optimism are shooting up all over the place after Trump’s win.” Columnist Holman

Jenkins, Jr., writing in the Wall Street Journal on December 20, said that “the stock market is up. Home-builder sentiment is up. Small business hiring plans are up. Consumer and business confidence show impressive post-election gains.” I could go on. The point is that Donald Trump is not even president, yet many commentators and investors are acting as though he is and, moreover, that his program—whatever that program might be—is working. This is a trend to watch, because it is excessive optimism, not pessimism that kills bull markets.

 

I have not even touched on important themes like the potential impact of corporate tax cuts, repatriation of offshore U.S. dollars, fiscal stimulus spending, deregulation, the deepening European economic stagnation, Chinese disarray and possible currency devaluation, rising inflation, interest rates and debt levels. Those interested in our view on these subjects should visit our website, obriengreene.com, which includes an extended comment on the various stock market sectors in the New Year.

 

Lastly let me say that this begins my 30th year at the helm of O’Brien Greene. It goes without saying that I owe a great debt to co-workers past and present, my wife Lisa, brokers, custodians, and most of all to you, my clients.

 

Sincerely,

 

Mark O’Brien