DON’T BELIEVE EVERYTHING YOU HEAR
- 2016 confounded the consensus at every turn
- The biggest surprises were at the ballot box
- U.S. equity markets rose in Q4 and 2016
- Volatility surprised by heading lower
2016 will be remembered as the year that confounded the consensus at just about every turn.
Nobody expected the market to begin the year in total free-fall – which is exactly what happened as the broad market index, the S&P 500, fell roughly 10.5% through February 10, making for the worst start in stock market history.
Although the downdraft was seen as a spillover from the Federal Reserve Board’s first rate hike in 10 years the previous December, the consensus quickly formed that a slowdown in China meant a further plunge in oil prices was in the cards and thus the market was in for more pain.
Of course, markets pivoted on February 11th – led by a bottom in West Texas Crude oil at $26.55 – and both headed higher never to look back throughout 2016.
By March the S&P 500 had burst through break-even for the year – demolishing the consensus belief that “as goes the first week in January, so goes the month; as goes the month, so goes the year…” – known as the “January Effect.”
Soon “sell in May and go away” would be exposed as folly as well
But the two biggest surprises to consensus beliefs during 2016 happened at the ballot box.
The world was shocked on a Thursday in June when the electorate of Great Britain voted to exit the European Union in a nationwide referendum.
Dubbed the “Brexit,” nobody on either side of the Atlantic thought it was possible that the Britisher in the street would have the temerity to spit in the eye of pan-Europeans by voting to leave the continental union – yet that is exactly what happened.
The Dow Jones Industrial Average fell 611 points or over 3.4% while the S&P 500 lost 3.6% on the news. Immediately, the consensus began to form that this was the worst thing to happen to domestic equity markets since the fall of the House of Lehman in 2007. Pundits opined that the consequences on the market’s liquidity could be just as perilous.
As it turned out, all that bluster was nothing but hot air
Yes, the pound had eroded nearly 16% vs. the U.S dollar by year-end, yet far from being an albatross on economic growth, it turned out to be a boon. The salutary effects of a lowered currency seemed to come into play far more than the consensus doomsayers were willing to admit. For example, flight bookings to the UK were reportedly up +7.1% overall post-Brexit with inquiries and bookings from Chinese travelers estimated to have risen 20%.
Investors were confident enough in the British economy to bid the FTSE 100 to an all-time high by year-end, up +14.4% for 2016. Even the more domestically-focused FTSE 250 advanced +3.7% for the year.
In many ways the Brexit vote turned out to be just a dress rehearsal for the real show which was to come to America on November 8, 2016.
Like the Brexit vote, the consensus said it never could happen here. All the polls said it was an inconceivable long shot; yet all the pollsters were proven wrong when, on that date, Donald John Trump was elected President of the United States of America.
Market pundits had called for massive losses if Trump was to prevail. The S&P 500 would crash losing “up to half” of its value, said many; the dollar would be “obliterated” suggested others. As proof they offered the fact that markets had swooned in the last week when rumors abounded that the FBI was reopening its investigation on Trump’s rival, Hillary Clinton, and her use of private email servers.
“Maybe these naysayers were right!” many concluded when the winner of the election became apparent overnight. In the wee hours of Wednesday, November 9th, after-hour stock market futures shed 800+ points on the Dow, indicating a panicked stock market opening was to be expected.
Again the consensus had it all wrong
The Dow Jones Industrial Average shocked everybody by pivoting and opening higher, ending the day up +256 points. The next day it would burst through its all-time high. For the week, the market advanced 5.4% – making it the best weekly advance since 2011. Equities moved ahead and never looked back.
Market mavens dubbed it the “Trump rally”
When the year-end smoke had cleared, the S&P 500 Total Return Index had advanced +12% for the year – with +4.6% of that return coming since Mr. Trump’s election.
The good news is that the +3.8% advance of the S&P 500 during the fourth quarter cannot totally be attributed to the “animal spirits” that have been released with the election of a new leadership party and their outspoken nominee for president. Much of the enthusiasm can be seen as a renewed market attitude towards the end of the “earnings recession” and a more aggressive fiscal growth policy especially in two areas: 1) Financials and 2) Infrastructure.
The term “earnings recession” was coined to describe the fact that year-over-year (Y-O-Y) S&P 500 earnings shrunk for six straight quarters prior to Q3, the longest such streak since 2008. The +3.1% growth in Q3, however, added to the expected expansion for Q4, should add up to positive S&P 500 earnings for 2016.
Usually it is less the past earnings and more the future earnings that dictate the success or failure of stocks and (by extension) their sectors
The perfect example for this is the performance of the Energy sector in 2016: during the past year earnings for the Energy sector have plunged more than 75%, yet Energy was the best performing sector in 2016, advancing +27.4%. The fact that analysts are expecting a +345% leap in Energy earnings in 2017 accounts for the sector’s success in the year just closed.
Financials reported a similar phenomenon; although sales advanced a paltry 0.2% in 2016, the sector reported the 2nd best sector return for the year, up +22.8%.
Much of the optimism for their earnings growth in 2017 stems from two very “Trumpian” sources: 1) the expectation of a more profitable credit spread for banks resulting from President Trump’s expansionary (and inflationary) policies causing rate hikes and 2) the loosening of regulatory constraints by a Trump administration making banks more profitable beyond the effect of rate hikes.
Both of these factors point to Financials as one of the greatest beneficiaries of the new Trump regime.
Although Industrials and Materials saw their earnings decline during 2016 they were also two of the best performing sectors in 2016, up +18.9 and +16.7% respectively. Analysts attribute that success to the fact that both of these sectors stand to gain dramatically from aggressive spending on infrastructure considered a high priority for Mr. Trump.
The idea that earnings and returns do not necessarily have a direct connection was also proven by the only negative mark on the sector scorecard for 2016 — Healthcare. This sector lost -4% during the 4th quarter making it down -2.7% for the year – irrespective of the fact it reported a +6% advance in earnings during calendar 2016.
A high profile price-gouging scandal around the popular “EpiPen” (accelerated by comments from Mrs. Clinton) got the negative ball rolling especially in the Biotech industry; regulatory uncertainty under the new regime, combined with Mr. Trump’s comments on not allowing price-gouging on his watch, didn’t help either.
For Real Estate – newly graduated to full sector status in September– it was a tale of two periods. At the midpoint of the year (on the back of historically low interest rates) REITs had advanced +13.68% making its trailing 12-month return +22.68%, nearly 6 times the S&P’s +4% return for that period. In fact, REITs had outperformed the broad market index over every meaningful period going back 40 years.
Additionally, consensus expectations were for an +18% expansion of earnings for 2016, the highest of any sector. Analysts were optimistic that, with the new attention shining on the industry with its new status, the sector was looking up.
Yet once again the consensus got it wrong. REITs reported the worst performance of any sector for Q4 (down -4.4%) making the sector up only +3.8% for the year. Higher mortgage rates led to massive profit-taking in the newest sector during a fourth quarter that was markedly bullish for most stocks, especially post Trump’s election.
Another area where the consensus was confounded was in volatility. Many market observers spoke loudly and often about how they expected volatility to climb (and the market to decline) seemingly at every turn during 2016. With the dip the stock market took in the opening weeks of 2016, the implied volatility of the S&P 500 (as measured by the VIX Index) which had closed 2015 at $18.21, surged 51% to $27.29%. In the first seven weeks of the New Year the VIX would surge above 30 three times.
Needless to say, consensus expectations only grew higher for the VIX.
Of course, like all these consensus projections, higher volatility just never came to fruition. By March the VIX had settled in below $18 and proceeded to trade between $16 and $19 for the remainder of 2016. As a frame of reference, the VIX peaked at an all-time high of $89.53 during the Global Market Crisis of 2008.
Going into the New Year the jury is still out; the consensus opinion clearly leans toward the idea that, with a new presidential regime and all the changes that are implied by that, 2017 will be a wild, nausea-inducing, 5-ticket roller coaster ride.
So we head into what is bound to be a most interesting New Year.
The consensus seems to believe that the market can’t keep up the enthusiasm it as shown since Mr. Trump’s election and that maybe as soon as by Inauguration Day equity markets will begin moving dramatically lower. The one lesson we must take from 2016 is that the consensus is often wrong; the second lesson should be: don’t underestimate the power of the president-elect.
At any rate, here’s one consensus idea with which we can all wholeheartedly agree–it won’t be boring.
I look forward to speaking with you in our next quarterly update. In the meantime, please visit us at www.alpharisksolutions.com for sector and tactical strategy updates.
This quarterly market recap is offered for informational purposes only as a review of current and historic economic and market events; no discussions or comments herein are in any way intended to be forward-looking or predictive and nothing should be interpreted that way. Although all data, information, inferences, and conclusions found within it are based on information derived from reliable sources, in no way can ARS or anyone else warranty its accuracy in any way. Also, in no way does this blog offer investment advice and nothing within it should be taken as such. At no time should this document be considered an endorsement for any investment product, methodology, philosophy, or index and always remember that indexes are not investable and most investment returns include fees whereas most indexes do not.