What advisors need to know to manage 2017 dangers

By Chief Investment Officer, Chuck Self on December 9, 2016

2016 was the Airline Year since many markets made round trips.

The ten-year Treasury note yield was the round trip poster child.  After beginning the year at 2.27%, the yield fell to 1.37% in July and breached the year’s opening levels in November after the U.S. elections.

Below is the graph of the Standard & Poor’s 500 that made its round trip in the first quarter before moving to new highs.

On the other hand, gold prices did not quite complete its round trip although they rose $300 an ounce from January to July before falling almost $200 an ounce in the second half of the year.

Finally, the US dollar/Euro exchange rate rose from $1.07 to $1.15 in May and back to $1.07 in the course of the year.

Since the market has been trading on hope of future growth (by future, we mean 2018 and beyond), it is helpful to look at the more medium-term outlook. Doug Short at Advisors Perspectives closely follows the four indicators generally believed to be emphasized by the National Bureau of Economic Research when marking the peak and troughs of U.S. business cycles (the Big Four):

• Industrial Production
• Real Income
• Non-farm Employment
• Real Retail Sales

Below is a chart of the cumulative growth of the Big Four since the June 2009 trough of the last recession by successive month.  You will notice that Employment (blue) declined into 2010 and then started a slow climb. Real retail sales (green) have had a volatile rise but produced a few good months recently. Real personal income’s (red) increase has been steady but with a flattening trend in the past few months.  Finally, industrial production (purple) has had a significant decline from its late 2014 peaks with little signs of a turnaround.

Although real retail sales have accelerated in recent months, the growth trend is declining.  The chart below presents the year-over-year percentage gain in the series.  Before the last two recessions, real retail sales grew over 5% from the previous year before dropping below zero in front of recessions. At the current level of 2.6%, there is no need to worry about a near-term recession.  Since this is currently the strongest of the Big Four, a declining trend in current months could forebode trouble in 2017’s second half.

Employment growth accelerated into 2015 but has begun to decline as the economy reaches full employment.  The chart below presents the percentage change from the previous year in total non-farm payrolls. At the beginning of the three previous recessions, employment growth declined from over 2% on a year to year basis to around 1%.  Since the current level is 1.7%, this series is still flashing positive economic growth.  Again, if this trend begins to decline, the economy could be in trouble.

The Real Personal Income series (which excludes Transfer Receipts) has started to flash warning signs.  After peaking in December 2014 at close to 5% year-over-year growth, the series has declined to a 1.9% growth rate currently as indicated in the chart below. Declines under a 2.0% growth rate, if sustained, may be an early sign of an oncoming recession.  This series bears watching in coming months.

Finally, it is no surprise that industrial production has already flashed recessionary signs.  The percentage change of industrial production from a year ago chart presented below indicates that when the series turns negative, the U.S. is already in a recession during most periods.  We are currently not in a recession since industrial production is becoming less important. The consumer, which is now 65% to 70% of gross domestic product, has kept the economy moving forward. If the trend to lower manufacturing continues in the U.S., industrial production may become a less important leading indicator in the future.

The bottom line is that we are in the late stages of the current economic recovery. Although we are not forecasting a recession in 2017, there are many risks to U.S. economic growth. The Federal Reserve and fiscal policymakers will need to be careful not to implement actions that will negatively affect the precarious state of the economy.

Market participants will need to manage risk carefully in the coming year:

• Commodities had a great 2016 in spite of the recent dollar rise. The Rogers Commodity Index is up almost 9% year-to-date.  Investors should own some real assets in their portfolios to diversify equity and fixed income risks.  Although there are economic risks in the forecast, selected real assets, such as energy, will continue to be attractive in 2017.

• Interest rates have risen to absurd levels in recent weeks due to the U.S. election results and the view that economic growth is accelerating. Given the steepening of the yield curve (long rates have increased more than short rates) over the past few months, it can be inferred that investors expect that long-term inflation has risen by 0.50%.  This comes at a time when U.S. Treasury yields are at record spreads to the German Bund yields, as indicated below.  This will drive significant foreign demand to U.S.
  The combination of these factors makes long and intermediate term Treasuries attractive at current levels.

• The U.S. equity market has become overvalued in 2016’s fourth quarter. Earnings growth has just begun to climb out of recessionary levels.  Federal Reserve rate increase speed, recent dollar strength, and potential trade restrictions and retaliations could hurt earnings growth in upcoming quarters.  Attractive sectors are not dependent on strong economic growth:
  • Utilities became overvalued in the late summer because of investors reaching for yield. From its high in early July, the sector has dropped almost 9% in value. Utilities have become attractive as the economy remains slow, inflation continues to be moderate in nature, and the Fed will need to increase interest rates more slowly than anticipated. Investors in the sector may receive price appreciation while earning an above-average current yield of over 3.50%
  • After rebounding in third quarter, energy prices dropped due to inventory increases and concerns that OPEC will not reach a production agreement. Given that demand and supply will naturally come into balance next year in the oil and natural gas markets, and that OPEC has come to an agreement on production limits, energy stocks should be bought at current prices.
  • After performing well as the market rediscovered growth stocks in the third quarter, technology has come under pressure lately. Investors sold technology stocks to buy sectors expected to more directly benefit from the GOP sweep, including financials, health care and infrastructure. But tech earnings have increased steadily and the IPO market could heat up, making the sector attractive to investors.

Recommendation:  Although the broad stock market looks to earn around 10% in 2016, the ride to get there has been heart-stopping. The recent rally is pricing in perfection on the earnings front, a Federal Reserve that will move interest rates at the right speed, and legislative actions that can be implemented in the next twelve months.  We doubt that this combination of factors will take place as anticipated.  Being at the end of an economic recovery is best played by carefully managing portfolio risk and increasing diversification.  Advisors are counseled to recommend to their clients that one-half of their equity weightings be invested in a truly diversified tactical allocation with an equity market benchmark.  This will provide a baseline of exposure to the stock market that is required of all investors while varying equity weightings based on the market’s outlook. In addition, given the possible inception of stagflation in 2017, increasing diversification by buying investments that may benefit from a rise in inflation is warranted at this time.

iSectors® Implementation: This recommendation can be implemented with a 50% iSectors Domestic Equity Allocation/50% iSectors Post-MPT Growth Allocation for the equity portion of the portfolio. Over the past five years, Domestic Equity is one of the top three Large Core allocations in the Morningstar ETF Managed Portfolio database (past performance is not indicative of future returns.)  The strategy is always fully invested in US stocks with a tilt toward high or growing dividend securities.

Post-MPT Growth has a longer track record.  Over the past ten years, Post-MPT Growth has outperformed all other Global Allocation portfolios in the Morningstar database. Throughout its eleven year history, Post-MPT Growth has shielded portfolios from the full effect of market declines by allocating to low and uncorrelated asset classes such as utilities, bonds, real estate investment trusts and gold stocks, when necessary.  The strategy has participated in bull markets by owning leveraged ETFs.  The ability to make these shifts in allocation may provide the insurance necessary to participate successfully in the 2017 equity market.

Given the mixed pictures for equities, advisors should allocate a portion of client assets into diversifying strategies such as the iSectors Inflation Protection Allocation.  Inflation Protection holds a diversified portfolio of publicly-traded securities that historically have been resistant to inflationary pressures. Fund holdings within the model include U.S. Treasury inflation protected bonds, precious metals (including gold & silver), real estate, and commodities (including timber, agriculture & energy). Due to heightened concerns about inflation and its potential effects on the equities and fixed income markets, investors have flocked to these securities this year. Through October, Inflation Protection has risen over 15% in 2016 on a total return basis.

iSectors Portfolio Recommendation: Given the ongoing bull market (2016 may be the sixth year out of the last eight to have 10%+ returns in the S&P 500), many clients are likely to have too strong of an equity allocation.  To increase potential principal protection over the volatile market period ahead, we believe that all portfolios should be enhanced by including:

• Tactical allocation with equity benchmark such as Post-MPT Growth
• Conservatively invested fixed income allocation such as the iSectors Domestic Fixed Income Allocation which hold short to intermediate laddered U.S. corporate and high yield bonds
• Enhanced cash equivalent allocation such as the iSectors Capital Preservation Allocation that owns only short term U.S. bonds with under three years to maturity. The number one goal of the allocation is principal preservation with a secondary goal of higher yields than cash equivalent securities
• Publicly-traded diversifying alternative allocation such as Inflation Protection

Since each client has different objectives and risk tolerances, it is difficult to create model portfolios that are applicable in most cases.  Financial advisors are best able to take this information and determine the best investment program for each client.  As a benchmark from which to start, an advisor with a moderate risk tolerance client that has historically been invested in a 60% stock and 40% bond portfolio (minimum $250,000) may wish to consider the following allocation design:

• 30% – iSectors Domestic Equity (Strategic U.S. broad equity market with a dividend tilt)
• 30% – iSectors Post-MPT Growth (Risk-managed equities)
• 15% – iSectors Domestic Fixed Income (Conservatively invested U.S. fixed income)
• 15% – iSectors Capital Preservation (Enhanced U.S. cash equivalents)
• 10% – iSectors Inflation Protection (Publicly-traded diversifying alternatives)

If you are a financial advisor and would like to discuss a client’ specific portfolio needs or if you wish to find a financial advisor that has access to these strategies, please contact Scott Jones at 800-869-5184 or [email protected].