[ Users can download a full PDF of this letter to print out here. ]
2016 was the largest year for Harshman Wealth Management in terms of assets and new qualified clients; made only possible through your referrals and commitment to our process. We continue to be a referral only firm and sincerely hope we continue to earn your referrals and support.
As we look back at 2016 and ahead to 2017 and beyond, we’ll leave the political discourse and analysis to others and focus our comments on the financial markets. Our expertise is in our objective analysis of investment opportunities and risks; the application of our analytical insights to the construction and management of diversified portfolios and the disciplined execution of our investment process over the long term. So, whether one is personally happy or horrified—or somewhere in between—with the outcome of the recent U.S. presidential election, our focus as your Financial Advisor is unchanged.
Global stocks performed well both in absolute terms and relative to core bonds this year, with U.S. stocks again taking the lead. Large-cap stocks gained 11.8% and small-cap stocks surged 21.6%. This marked the eighth straight year the large-cap S&P 500 Index had a positive return. While streaks of this length have occurred twice before, the market has never had a nine-year winning streak.
Emerging-market stocks were also strong performers, gaining 12.2% for the year. Developed international stocks were the big laggards as they returned just 2.7% in U.S.-dollar terms. European stocks did worse, falling 0.4% in dollar terms, although they gained 7.2% in local-currency terms. For the third straight year, dollar appreciation was a drag on European stock returns. The major currency decliner was the British pound as it plunged 16% versus the U.S. dollar, triggered by June’s Brexit vote. The euro fell 3% on the year. Overall, the U.S. dollar index rose around 4% against a basket of developed-market currencies.
Though core bond prices got off to a strong start with the 10-year Treasury yield dropping to an all-time low of 1.37% in early July, yields then reversed course, rising to 2.5% by year-end. In the fourth quarter, the core bond index fell 3.2%—its worst quarterly performance in 35 years—due to rising interest rates. For the year, core bonds produced a 2.5% gain, slightly above our longer-term (five-year) expected return outlook for them. Investment-grade municipal bond returns were slightly negative on the year. While 2016 wound up being a poor year for Treasury’s and core bonds, it was a good year for riskier fixed-income sectors with more credit risk and less interest rate risk, such as high-yield and floating-rate loans, which performed very strongly, gaining 17.5% and 10.2%, respectively.
Alternative strategies turned in mixed performance. Our lower-risk, diversified arbitrage strategies had solid absolute returns, ranging from the mid- to upper single digits. Managed futures, which are volatile and have a much wider range of potential returns in any given year, struggled. While one of the three funds we use had a positive return for the year, the category suffered a loss in aggregate.
We also witnessed a number of sharp reversals in market trends and consensus views during the course of the year. To name a few: value and cyclical stocks beat growth names for the first time in several years, while utilities, consumer staples, and REITs underperformed. In the commodity markets, crude oil prices rebounded sharply, doubling from their February lows and reversing a dramatic two-year slide. That pattern was true for commodity prices in general as they gained 20% from its January low and up 11% for the year.
The reversal in interest rates, as noted earlier, was also significant. Just as with the U.S. presidential election and the Brexit vote results, very few “experts” predicted these reversals. The consensus was surprised and wrong at the inflection points, as it usually is. Related to this, we often make the point that markets are prone to both momentum (continuation of a trend) in the shorter term and cyclical behavior (reversion to the mean) in the longer term. We don’t think anyone can consistently time markets—buying in just before an upswing, riding the momentum, and then selling at the top. To the contrary, there is a mound of evidence (academic and industry studies, as well as our own observations and experience) that suggests most investors destroy value over time due to bad timing of buys and sells.
Model Portfolio Updates
Our Managed Models benefited from many of 2016’s trend reversals as well as our tactical approach throughout the year as the markets dictated such action. Our short position with commodities, in particular oil, benefited all the models across the board. We continued to under-weight core fixed income holdings throughout the course of the year while over-weighting our large-value equity positions. Adding back high-yield bonds to our Moderate Model and a small weighting to Gold in the Conservative Model positioned those models to perform well against their respective benchmarks.
During times of extreme market volatility, such as the turbulence after the Brexit vote and the downside risk at the start of the year we managed market risk within the models which provided a nice spring-board for the remainder of 2016.
In our Moderate and Conservative Balanced models, roughly half of our fixed-income exposure is in non-core bond funds, including actively managed unconstrained/absolute-return-oriented funds, flexible multisector funds, and floating-rate loan funds. These positions added significant value compared to core bonds.
Our more risk-tolerant and growth-oriented portfolios have meaningful exposure to emerging-market stocks. We were therefore pleased to see emerging-market stocks rebound in 2016. Through the end of October, they were up significantly on the year (versus the S&P 500). However, they gave back some of those gains following the presidential election amid worries the Trump administration may impose protectionist trade policies and tariffs as well as negative effects from further U.S. dollar appreciation and emerging-market currency depreciation.
Having benefited from a multiyear period of small-cap underperformance, we unwound our relative underweight to smaller-cap U.S. stocks versus larger-cap U.S. stocks in the second quarter. We subsequently profited from small caps’ strong rebound during the remainder of the year.
Our active large-cap U.S. equity managers, in aggregate, outperformed the market index. The turnaround in value and our active managers’ strong performance—in absolute terms and versus the market index—support the argument we made last year that the underperformance of value stocks and value-based strategies relative to growth and momentum stocks and related strategies had likely been a cyclical headwind to our active managers in aggregate. It also gives us optimism that this cycle may be turning in our favor, with further active management outperformance to come. There are no guarantees, of course.
Given our modest tactical under-weight to Europe, we were not hurt by the continuing trend of U.S. stocks outperforming other regions. This marked the fourth straight calendar year and the sixth in the past seven that the S&P 500 has beaten the global ex-U.S. index. Going back to 2008, this is one of the longest stretches of U.S. outperformance on record. U.S. stocks also meaningfully outperformed European stocks in 2016.
Assuming an economic regime shift takes hold next year, what are some likely implications for our portfolios?
The most straightforward impact from a reflationary regime shift would be a continuation of the poor performance core bonds have delivered starting in July. As an example, we estimate that a 100-basis-point (1%) increase in the 10-year Treasury yield next year from current levels would mean roughly a 1.5% loss for the core bond index for the year. In contrast, we’d expect our actively managed flexible and unconstrained bond funds to produce at least solid mid-single-digit gains, helped by the improving growth outlook—which should be good for their corporate credit exposure—and their lower duration (less interest rate sensitivity) compared to the benchmark. Floating-rate loan funds should once again meaningfully outperform core bonds, although the double-digit returns from 2016 will not repeat in 2017.
The outlook for equities as a whole and U.S. versus foreign stocks is much less clear. It’s easy to assume that improved economic growth would coincide with a rising stock market, but that’s not necessarily the case. Over the shorter-term and in any given year, stock market returns have multiple drivers. Not only is there a lot of uncertainty about the timing and magnitude of policy changes, the U.S. stock market has already discounted a lot of potentially good economic news. In that sense, it may have “pulled forward” some 2017 returns into 2016. There is also the risk that too rapid a rise in interest rates (e.g., in response to heightened inflationary concerns) would hit valuation multiples. But should the existing U.S. reflationary trend continue in 2017, we think our active stock pickers will continue to benefit versus the market index, consistent with what we saw play out so strongly in the second half of 2016.
While the storyline that foreign stock markets will continue to under-perform next year seems clear cut, there are other plausible scenarios. For example, if the new administration’s trade policies are more bark than bite, there’s a good chance of an emerging markets rebound. More broadly, to the extent that reflation extends beyond just the United States, that will undoubtedly benefit foreign stock markets, where, unlike in the United States, growth expectations and market valuations are low.
The U.S. dollar remains a wild card in terms of its short-term direction and therefore its short-term impact on foreign equity returns to dollar-based investors. When viewed from a longer-term valuation perspective, it looks overvalued relative to both developed and emerging-market currencies. Still, there are sound reasons to expect continued depreciation of the euro, yen, and many emerging-market currencies (including the Chinese yuan) against the dollar. Yet just as the dollar’s post-election rise coincided with a selloff in emerging-market assets, we’d expect the reverse to be true as well.
Expect the unexpected. Prepare to be surprised. Stock markets will be volatile; they will go up and down—probably a lot.
We don’t bother guessing what the markets will do next year. An important part of our portfolio risk management process does analyze the impact of various short-term (12-month) stress-test scenarios. But those are neither forecasts nor predictions. If we had to make a forecast for the financial markets next year, or for any year, it would be this: Expect the unexpected. Prepare to be surprised. Stock markets will be volatile; they will go up and down—probably a lot.
In closing, we would like to thank you and our family of clients very much for an outstanding year. 2016 was the largest year for Harshman Wealth Management in terms of assets and new qualified clients; made only possible through your referrals and commitment to our process. We continue to be a referral only firm and sincerely hope we continue to earn your referrals and support.
We are motivated more than ever to take Harshman Wealth to the next level of top tier firms and this will be accomplished by continuing to adhere to our core competencies, roles and commitment to our clients.
We will continue to perpetually address the need for furthering your knowledge of investments, markets and capital strategies. We will strive to continue being a student of human behavior, life dilemmas and transitions while also focusing on our communication and relational skills to our diverse group of clients. We do this with intentionally seeking to move you closer to your goals and best possible outcomes.
Our continued role will be to provide exceptional value to individualize each plan of advice around the unique attributes of a client’s life situation and objectives. We will continue to be the philosopher as well as the capitalist and not only will we continue to ask the questions that need to be asked but the questions that are often not.
I take all of these competencies and roles with great care and diligence. Thank you for your continued support and referrals and welcome to a new year!
~ Shawn Harshman
[ Users can download a full PDF of this letter to print out here. ]
The views expressed are not necessarily the opinion of Cambridge Investment Research, Inc. and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein. Investing is subject to risks including loss of principal invested. No strategy can assure a profit nor protect against loss. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs or expenses.
The Annual Letter is mailed to our clients and friends to share some of our views. Certain material is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Harshman Wealth Management, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.