4TH QUARTER 2016
Revenge of the Nerds…
Not to be confused with 1984’s fine piece of cinematography, and philosophically deep script, nor for that matter with perhaps a widely held perception of the globe’s current political landscape, the “nerds” we reference live in the investment world and have been largely ignored as we’ve rebounded from the “Great Recession”…until last year. As discussed previously in this space, we posited that transitions and uncertainty would create an environment within which the laborious tortoise would once again outshine the flashy hare. Suffice it to say 2016 provided more than an ample supply of potential trepidation such that value-oriented equities from the tortoise-like side of the investment world more than won the annual race to the finish line, as the S&P Value Index was up 17.4% for the year, while the S&P 500 Growth Index came in with only a gasping 6.8% return – despite the markets’ post-election jump.
It goes without saying that last year’s elephant-in-the-room (please excuse the shameless political pun) was the US Presidential election, the concern about its outcome, and our inability to keep our eyes/ears/clicks off the tenor of the process. After May’s Brexit-surprise, the populist fervor crossed the Atlantic for the duration of the American political drama, prior to returning to Europe for December’s Italian constitutional referendum, and in advance of April’s French and then Germany’s later (date yet to be determined) federal elections. After going 3 and 0 in 2016, it’ll be interesting to observe how Team Populist fares in 2017, given that their successes last year were largely unanticipated – with the resulting tendency of allocations to gravitate to the less volatile value-side of the investment universe.
Last year’s trio of electoral revelations impacted the worlds’ capital to varying, and thus far temporary, degrees, but did contribute to the overall investor unease as we closed out the 4th quarter. The reasons for this ranged from the visceral reaction to the election to the concern about what impact the new administration would have on diplomacy, the economy and ultimately the markets – despite the usual belief that the current assumptive political leadership would support economic growth policies that would be constructive for business.
Although, in a differing time and economic circumstances, but with a similar level of fear registering on the uncertainty-meter, we saw some similarities in a comment we wrote at the end of 2008, as we were also changing Presidential administrations, and many found themselves shell-shocked for reasons other than politics:
“As we’ve noted in the past, the capital markets are by nature a forward looking mechanism discounting future events before they are realized. So in the face of this plethora of programs, we look to the broader trends and historical cycles for guidance into the future. There’s no denying the significance of this most recent economic disturbance and market downturn, but our goal from an asset allocation standpoint is to position ourselves for the inevitable recovery. Many market participants, along with our shell-shocked citizenry, can relate to the similarities about stormy weather in Kenny Chesney’s 2008 song entitled “Boats”:
“He watched his life pass before his eyes
in the middle of a hurricane.
Came out alive on the other side
that’s where "the other side" got its name.”
Back then, the following year (2009) proved to be “the other side” as the recovery started its long road back. This year, despite possible emotional feelings to the contrary, investors need to recognize that the outcome of US Presidential elections are not directly tied to future performance of the overall equity markets, as various studies have shown very little correlation with the occupants, and their political affiliations, of 1600 Pennsylvania Avenue. And the same goes for the urban legend of a divided (gridlocked) versus a united government, as there’s statistically an insignificant difference between equity returns during periods where the political parties control the White House and any of the Houses of Congress.
So with fear and Washington drama (a.k.a. Hollywood on the East Coast) not prescient guides to future returns, we find that, even now, returning to basic valuation analysis can help identify currently attractive investment allocations, with low P/E’s and comparatively high dividend yields, for prudent and patient long term investors. Within these parameters we still find some attractive domestic sectors, as well as numerous opportunities in the developed world overseas that have lagged the focused run in domestic large cap equities.
Nonetheless, we remain watchful of macro-developments on the world stage as our economic back-drop, and find it more than a little ironic that this year’s World Economic Forum, the epitome of globalization and home to multitudes of “Davos Men/Davos Women”, will conclude on the day that the new US President is inaugurated – quite the juxtaposition.
Navigating this landscape reminds us of George Bernard Shaw’s skillful thoughts in using the written word to efficiently describe a far more complex set of circumstances, somewhat apropos to today:
“The reasonable man adapts himself to the world; the unreasonable man persists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man.”
Expect the Unexpected
If there was a common theme throughout the year it was to expect the unexpected. Widely followed political events and the market's reaction to their outcomes often played out contrary to the prevailing wisdom expressed by so-called experts, pollsters, and media channels. The last three months of 2016 proved to be no different.
The surprise of the year of course was Donald Trump winning the presidential election. Nearly all the "experts" failed to forecast a Trump victory. By Election Day, according to Howard Marks, the majority of pollsters placed Hillary Clinton's "chances of winning at between 80%-99%". What was almost as surprising were the markets’ reactions to the unexpected outcome. In the early morning hours of November 9th, after a Trump victory appeared to be a lock, the futures markets, which trade 24/7, went into a tailspin as institutional investors altered their bets. Investors braced for the post-election market open, and the sure drop that was to follow. Yet when trading began Wednesday morning much of the selling pressure had eased. A slight dip in US stock prices soon reversed, and before lunch US stock indexes were in the black. As 2016 came to an end the positive momentum would continue without relent. The election would turn out to be, just as Brexit had been earlier in the year, a pivoting point for asset repricing in both fixed income and equities.
High quality bonds suffered as interest rates climbed. Yields on the 10-year Treasury bond that recently stood around 1.60% (on 9/30/16), added 85 basis points, and reached 2.45% by the end of December. As we have warned in the past, a modest rise in rates has a significant, negative impact on investment grade bonds prices. The total return for the 10-year Treasury had been over 7% through September, but by December 31st the entire gain was mitigated.
The 10-year municipal bond benchmark (as provided by Barclays) suffered the same fate as its year-to-date +4.35% return as of September 30, shrunk to -0.12% by year-end. More credit sensitive bonds in the High Yield space actually benefited rising an additional 2% in the 4th quarter as the economic outlook continued to show signs of improvement.
The primary beneficiaries of the quarter were US stocks, specifically small caps. The blended Russell 2000 index rose sharply post-election, rising a total of 8.8% in the 4th quarter of 2016. Mid-cap and large stocks followed suit but to a lesser degree increasing 3.2% and 3.8% for the quarter respectively. Within the S&P 500 all sectors but utilities climbed in the 4th quarter, with financials being the clear leader. The prospect of higher interest rates and an incoming administration actively trumpeting a more favorable regulatory environment, catapulted the sector higher, up 21.1% for the quarter. International markets, hindered by a rising US dollar largely experienced losses in the 2-3% area, depending on the benchmark. However, currency hedged vehicles such as the Wisdom Tree Europe Hedged Equity ETF had its best quarter of the year, up more than 7%.
Judging by the flow of dollars in and out of differing investment vehicles, we can reach the conclusion that the investment performance for the year, and probably the final quarter as well, were, like the election results, unexpected. The S&P 500 returned 12% for the year, yet during the year a net $40 billion (through November 2016) was pulled from stock funds and ETFs, tying for the 2nd largest amount of outflows in the last 15 years. In contrast, the US Aggregate bond index returned 9.35% less than the S&P, yet fixed income funds attracted over $250 billion in fund flows. The pattern of rear-view-mirror investing is nothing new as the masses are notorious for chasing last year’s winners. Will they get it right next time? As of this writing, fund flow trends have turned on a dime since the election, with cash fiercely flooding back into US stocks.
The top performing sectors for 2016 were all buoyed by strong fourth quarter post-election performance. Energy, Telecom Services, Financials and Industrials all received a significant post-election bump based on expected changes in regulation and policy and a rising interest rate market. Add in a resurgent Healthcare sector as we transition into 2017 and the investing landscape has changed significantly since mid-2016.
Energy continued its strength from the previous quarter and was the top performing sector at 27.36%. The pro-growth Trump Presidency with deregulation should help this sector going forward, a primary reason for its surge this past quarter.
Financials sprung ahead during the 4th quarter, having only achieved a 1.7% return thru 3 quarters. It had been undervalued and that along with rising interest rates allowed it to tack on a whopping 21.10% during the 4th quarter. Again, a pro-growth Trump Presidency, with deregulation is seen as friendly to Financials. Have the Financials gone too far too quick? Perhaps, but Financials have largely underperformed the broad market going all the way back to the early 2000s and it’s going to require more than a two-month run to begin to correct that divergence.
Healthcare ended the year being the worst performer at -2.69%. This makes sense, as changes to the Affordable Care Act and pricing concerns for drugs, have caused volatility and money to flee the sector, until such a time as a more predictable path forward can be seen.
Why the changes in sector leadership? The answer seems to be several fold including a pro-growth Trump Presidency, higher inflation expectations, higher interest rates, and pro-business friendly deregulation and tax cuts. Energy, Financials and Industrials should all benefit from these shifts in policy. Now the new eye-catching acronym to watch, according to Tom Lee of Fundstrat is C-R-A-P – Computers, Resources, American Banks, and Phone Carriers – which are all levered to the investment recovery, inflation, and deregulation expected over the next year.
If inflation does pick up, driven by fiscal stimulus and more robust economic growth, the concurrent increase in wages should not hit technology company margins as hard given their reliance on more high-skilled workers. The Energy sector for the Resources play, should continue to do well as there is still upside for the price of oil over the next couple of years and energy companies should be run a bit more efficiently after all the cost-cutting that has been implemented. Lastly, the first quarter of a year is also known to be positive for stocks, so we should see this sector leadership continue.
Fiduciary History Repeats Itself?
As I write this, House Republicans have proposed legislation that will delay the implementation of the DOL’s Fiduciary Rule by two years from the date of the legislation. That means that the April 20th deadline that many brokers were facing to comply, partially comply or disassociate with the new Fiduciary Standard rules may be delayed (or eliminated altogether, as other congressional Republicans seek to ban the DOL rule change permanently). This is relatively important as firms such as Merrill Lynch, Fidelity and MetLife among others have already enacted significant business model changes within their organizations to deal with the impending rule change.
While the new rule primarily focused on justifying advisor fees for rollover accounts taken from retirement plans or other advisors, it still pertains to retirement plans as well, requiring that advisors indicate their fiduciary status in contracts with their clients. Old Port Advisors has been working contractually as a fiduciary from the first day we offered the retirement plan fiduciary services many years ago, but many brokers and broker/dealers were not willing to be as restricted; this rule was seen as a way to get them to commit in writing to working in “their clients best interest”. As this works its way through the regulatory system, it’s a good time to review the various types of plan fiduciaries under ERISA. In case you were wondering, Old Port Advisors is typically hired as the ERISA section 3(38) Investment Manager. Stay tuned for updates.
Four Types of Retirement Plan Fiduciaries
- The ERISA section 3(21) Named Fiduciary – usually the plan sponsor, the Named Fiduciary controls the other three types of fiduciaries, and is responsible for hiring, appointing and monitoring them. The sponsor often outsources this responsibility to a 3rd party “co-fiduciary” but the sponsor is still liable.
- The ERISA section 3(16) Plan Administrator – also usually the plan sponsor, essentially a “coordinator of communications”, responsible for all plan disclosures to participants and all filings with the federal government. A Third Party Administrator (TPA) (or, in bundled service models, the investment platform) usually coordinates these tasks, but the plan sponsor is still held accountable.
- The ERISA section 403(a) Trustee – contrary to popular opinion, this is NOT the “directed-trustee” that many banks and other custodians of assets claim to be, but according to ERISA, an employee or employees of the plan sponsor with exclusive authority/discretion over management/control of plan assets. Think “Retirement Plan Committee” or “Investment Committee”.
- The ERISA section 3(38) Investment Manager – usually a third party, hired by the 3(21) Named Fiduciary with sole responsibility to select, monitor and replace a plan’s investment options. If hired, supersedes the 403(a) Trustee regarding the discretion over plan assets. This protects the plan sponsor and the 403(a) Trustee committee from liability related to selecting and managing investment options for the plan.
Steve Eddy – In November Steve was part of a panel presentation to the Maine Employee Benefits Council’s (http://www.maineemployeebenefits.org/) quarterly meeting. As OPA’s Fiduciary Consultant (and an MEBC Board Member) Steve focused on the impact of the upcoming Department of Labor Fiduciary Rule on investment firms. For firms like OPA that have always acted as fiduciaries, the impact of the rule is minimal. For others, it will be a lot of work to document that they are working in their clients’ best interest.
Chip Harlow – In October Chip, and his Dutch Shepard Izzy, competed in the Canadian National Championships for French Ring Sport (http://www.ringsport.org). They have been training together since she was a puppy, her Dad Mexx is currently deployed with the Navy Seals, and they competed in Ontario in Ring 2 (out of 3 levels) and came in 4th. After preparing regularly throughout the winter they’ll resume their competitions in May.
Erica Bly – Has joined our firm as a Portfolio Manager Associate, with her initial focus on both the administrative and wealth management aspects of OPA. Erica began her financial services career in consumer and mortgage lending at Infinity Federal Credit Union in 2002, and then was with Morgan Stanley from 2006 until joining our team in December of 2016. She lives in Scarborough with her two sons Andrew and Logan.
Community Support – As we mentioned in this space last quarter, 2016 was the alternate year for our holiday open house, in lieu of which we made additional contributions to area cultural and community organizations that our OPA Team works with. Below is a partial list of those entities, which we intend to expand in the future, along with their respective contact information:
- Big Brothers Big Sisters (http://somebigs.org/)
- Bay Chamber Concerts (http://www.baychamberconcerts.org/ )
- Mitchell Institute (http://mitchellinstitute.org/)
- Restorative Justice Institute (http://www.rjimaine.org/)
- United Way Small Business Circle (http://uwgp.org/365 )
- Lift360 (http://www.lift360.org/)
- Kennebec Land Trust (http://www.tklt.org/)
- Dream Factory of Maine (https://www.facebook.com/dreamfactoryportland/)
- Center for Maine Contemporary Art (http://cmcanow.org/)
- Preble Street (http://www.preblestreet.org/)
- Animal Refuge League (http://www.arlgp.org/)
- Community Television Network (http://www.ctn5.org/)
- The Locker Project (http://mainelockerproject.org/)
- The Jackson Laboratory (https://www.jax.org/)
- Frenchman Bay Conservancy (http://frenchmanbay.org/)
- Equality Maine (http://equalitymaine.org/)
- Ronald McDonald House Charities (http://rmhcmaine.org/)
- Gulf of Maine Research Institute (http://gmri.org/)
- Holocaust & Human Rights Center of Maine (http://hhrcmaine.org/)
- Maine Sports Hall of Fame (https://www.mshof.com/)
Old Port Advisors was founded more than 20 years ago as Investment Management & Consulting Group (IMCG), with a vision to create a boutique independent investment management firm centered on the best interests of our clients. Our principles were simple and still ground us today: a values-driven, personalized, collaborative, and strategic approach to investing, wealth management, and fiduciary consulting. We changed our name to embark on the next 20 years, but our leadership and our calling remain. We’re excited to build on our past experience and success to deliver on our promise of building a secure future for our clients.