CKBlog: The Market

Friday, January 27, 2017

2016 Market Review

Having, and sticking to, a true long term perspective is the closest you can come to possessing an investing super power.—Clifford Asness, 2017

2016 was the year of surprises. 

January 2016 started with concerns of de-escalating economic growth in China which triggered an historic sell-off in the first five weeks of the year. Extreme pessimism reigned as global growth worries were paramount. Petroleum prices were weak and bonds rallied. Investors grew more and more concerned. Headlines extrapolated short-term weakness into a prolonged correction which amplified investor anxiety. On February 11th, the S&P 500 Index was down 10.27%. But by mid-March, the S&P 500 Index was trading in positive territory. Surprise! The pundits were wrong.

Two important votes were scheduled: Brexit in June and the US Presidential election in November. On Brexit, Britain was expected to vote to remain in the European Union. On the US election, Hillary Clinton was expected to win handily. In both cases, surprise—the pundits (and polls) were wrong.

Leading up to the votes, the analysts, pundits, pollsters, so-called “experts” and in some cases, high profile hedge fund managers, warned that should Britain vote to leave the EU, global markets would suffer dramatic and prolonged sell-offs. Stateside, the same warnings persisted. If Trump were to emerge victorious, many predicted US equity markets would drop anywhere from 10-15%. But once again, you guessed it, they were wrong. Surprised?

When it was all said and done, Britain’s equity markets, represented by the FTSE 100 Index, returned +19.15% in terms of the British Pound (GBP) in 2016 (-0.17% in USD terms). It wasn’t all rosy as the GBP lost significant purchasing power and the several days immediately after the vote to leave, the FTSE 100 Index did drop north of +5%. But the cataclysmic scenarios did not pan out. Investors were wise to stay the course.

In the US, the S&P 500 Index futures famously dropped precipitously late into the evening once Trump secured the victory but by mid-afternoon on November 9th, US equity markets were trading in positive territory. The S&P 500 Index traded higher by +4.98% from November 8th through the end of the year. 

It was a challenging year for bonds as well as they could not escape the wrath of the Fed’s interest rate hike and expected inflation as a result of Trump’s agenda. After being up by more than +6% by mid-summer, the Barclays US Aggregate Total Return Index lost roughly -4% off their highs, finishing the year up +2.65%.

Surprise outcomes were not contained solely in the US and “across the pond” in the UK. Brazil, a country where I once lived and often visit, was embroiled in a wide-ranging corruption scandal, suffering through the country’s largest ever contraction in GDP, and working through the impeachment of its president and a criminal indictment of its previous president. How did its stock market do? The BOVESPA traded higher by +42.92% in Brazilian Reais (BRL) terms (a whopping +78.24% in USD terms!). Surprise!!

2016 in a quote? In the words of famed investor Howard Marks of Oaktree Capital, “You can’t predict. You can prepare.”

2017

As we enter the new year, the equity markets have largely marked time, and as opposed to last year at this time, Chinese growth seems to be assured. The concerns have shifted to the effects of rising inflation and interest rates in the US, and a strong US Dollar due to those rising rates and possible fiscal stimulus by the Trump Administration (income tax reduction, infrastructure spending, etc.). Also concerning are possible global trade restrictions based on saber rattling on “America First” trade policies enunciated by Trump himself and by way of his cabinet nominees. 

However, the chief concern is the uncertainty surrounding a president with no political experience. There seems to be a general acceptance of the fact that with a Republican congress, there will be a quick move to unwind some of the more arduous and anti-business regulations imposed by the Obama Administration, reduce corporate tax rates (and deductions), and rewrite the Affordable Care Act. What is not clear is whether there will be a fiscal stimulus, aside from tax cuts, since the vast-majority of the Republican congress are fiscal conservatives. 

There is also general agreement that equities in the US are fully priced (assuming US corporate tax rates remain as present) and US bonds are destined to fall in price to accommodate the expected three or four interest rate hikes by the US Federal Reserve. The pundits have predicted a continued weak European economy with political “tension” caused by the populism (anti-immigration, etc.) contagion, fear of Russia, US protectionism, among other maladies. Emerging markets are either oversold or will be sold off depending whether you believe the US Dollar will crush local currencies and Trump will construct more “walls” than just on the Mexican border. Japan will either grow (at last!) or will be preoccupied with Chinese Asian aggression. Indeed, 2017 may also have surprises in store.

But when has anything been certain? The famous philosopher, Socrates, quipped several thousand years ago, “The only thing I know for sure is that I know nothing at all, for sure.”

We are not even fully certain that 2016 should be painted as the year of uncertainty. It sure felt it! However, when you dig deeper into the statistics, 2016 was quite normal. I’d like to quote a recent white paper written by Clifford Asness, the founder and CIO of a $175 billion quantitative investment fund, AQR Capital, and one of the brightest mathematical minds on Wall Street:

Annualized daily volatility during 2016 came in at 13.1%. Based on rolling same-length periods going back to 1929 this falls at the 47th percentile. You say you don’t want to compare to the craziness of the Great Depression? Maybe that leads to everything else looking calm and you don’t think that’s meaningful. That’s reasonable. Well, that same value of 13.1% is at the 54th percentile since WWII and the 42nd percentile since 1990. Pretty darn normal ...

Now you say you don’t like quant geek measures like volatility? OK. How about looking at the biggest (up or down so we are talking absolute value) rolling one-month return in 2016? That was 10.4% (the bounce back from mid-February to mid-March). How does that compare to history? That is, every year you do this same calculation and look at the biggest up or down move. Well, from 1929 to the present that 10.4% figure for 2016 comes in at the 44th percentile (i.e., 56% of the time the biggest one-month move in a rolling year is bigger than we saw in 2016). Post-war it’s the 51st percentile. From 1990 to present it falls at the 48th percentile. Even over the last five years it’s a whopping 61st percentile. Move on, nothing to see here”¦

OK, one more. Let’s look at the high over the last year divided by the low of the last year (the full percentage range in prices). In 2016 that was +24.2% (the mid-December high divided by the early/mid-February low). Wow, you could’ve made a killing buying at the low! I’m not being snarky here. Actually, yes, you could have. But was that abnormal? You know what’s coming now don’t you ... ? Comparing that 24.2% to the same figure calculated each rolling year back to 1929 it comes in at the 42nd percentile. Post-war it’s the 49th percentile. From 1990 to present it’s the 50th percentile. And, over the last five years it’s the 66th percentile. Ok, that last one is getting very marginally high but only very marginally and only over the very recent period, which again I only looked at to see if people were looking at this too short a time horizon in error (yeah, that’s not a great sentence, I know). Really, again, nothing to see here ... .

https://www.aqr.com/cliffs-perspective/2016-was-not-a-volatile-year

Mr. Asness’ note does get a bit technical. But the bottom line is, using statistics, he makes a compelling case that the volatility experienced in the U.S. equity markets in 2016 was historically average.

So what is an investor to do coming off of an uncertain 2016 that wasn’t even really that uncertain but all of the headlines and pundits told us it was and “advised” us to seek shelter even if it went against our long term plans?

First, we believe investors should embrace uncertainty and it is what creates opportunity. It affords someone the opportunity to buy Apple stock when it was written for dead in the early 2000s. It allows someone to save a couple hundred dollars per month, invest it wisely in the stock market and turn around 20 years later and call themselves a millionaire.

If the stock market was certain, it wouldn’t deviate. It would not afford us the opportunity to grow our assets at rates greater than inflation.

But it’s hard! Unfortunately, individuals are wired to be awful investors. In fact, published research in the field of Behavioral Economics describes several of our fallacies which act as roadblocks in our quest to be successful investors. I will touch on three.

The first is the concept of loss aversion. Many studies have shown that we feel loss more profoundly than we appreciate gains. In fact, empirical estimates find that losses are weighted about twice as strongly as gains. Humans simply cannot stand to see a stock we own drop in price. This causes many long-term investors to sell a stock or get out of the market during a short-term sell-off thereby locking in losses—usually at the worst time—only to invest the proceeds in cash and wait too long to get back in.

The second is the concept of recency bias. If something has happened recently, we remember it more vividly and therefore tend to extrapolate it into the future. This was happening in February during the depths of the correction. How many people sold at the lows expecting losses to continue? 

Lastly, we tend to be overconfident. 2016 proved, perhaps more than any year in recent history, that we should know our limitations and operate within them. It seems that far too many “experts” put too much confidence in themselves and made bold predictions about the aftermath of outcomes that were uncertain. The result was painful for many. Richard Feynman, a Nobel Prize-winning physicist, once said, “The first principle is that you must not fool yourself, and you are the easiest person to fool.” Focus on becoming a musician before trying to be a rock star.

Need mathematical evidence that when left to our own devices, humans are bad investors? 

According to data published by Vanguard, over the last 10 years (ending 2016), the Vanguard Value Index Fund returned 5.9% per year. If an investor bought the fund 10 years ago, did absolutely nothing for 10 years, they would have earned +5.9% per year for a total gain of 76.6%. But we know most people can’t sit on their hands for 10 years, so Vanguard looked into what the average investor in the same fund experienced over the last ten years. The average investor earned only +1.9% annually for a total return of only +20.8%. What happened?!

The average investor could not resist their own urges, and tried to time the market—only to fail miserably as they only captured 32.6% of the total return of the fund each year. Said another way, they missed out on 68% of the fund’s annual returns!

In numerical returns, if you started on January 1st, 2007 with $100,000.00 invested in the Vanguard Value Fund and looked at your statement on December 31st, 2016, with the effects of compounding returns, you’d have a value of $177,402.00. But the average investor only ended up with $120,710.00—a difference of nearly $57,000.00! We’d argue that working with a qualified advisor would help those investors stay focused and invested in the long term. Our phones did ring back in February ...

We can cite many examples of this phenomenon, but the bottom line is humans need guidance and encouragement to stick to their long-term investment game plans. For every Warren Buffett, there is a Charlie Munger right by his side for consultation.

Keenly aware that we may sound overconfident, we were proud of what CastleKeep accomplished with our clients in 2016. We built portfolios based on proven principles with an eye toward longer term objectives. We worked hard to ignore the noise, and when we found it difficult, we walked into each other’s offices and sought self-awareness. We picked up the phone back in February when clients called concerned that their portfolios were losing value. At times, all of this was challenging, but we stuck to the process. And we are proud to say we did.

So what is our advice as we embark on 2017? We encourage you (and all of us) to try to ignore the noise. Read books, not headlines. Focus on the long-term objectives and when this proves to be difficult, always seek guidance from someone you trust. We are grateful to have earned yours.

We will leave off with a quote from Warren Buffett ... surprised?

An argument is made that there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit? You know the prose: “˜Maintain buying reserves until current uncertainties are resolved,’ etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.