Perspectives
Volume 9, Issue 4 | Year End 2016
“We have two classes of forecasters: Those who don’t know and
those who don’t know they don’t know.”
John Kenneth Galbraith, Economist
If 2016 has taught nothing else, it is the failure of pundits and the frustration
that becomes all who rely upon such “expert guidance”.
Palladium Partners
•
The year Twenty Sixteen… We might simply write “Whattha?!” and stop there.
•Recall… January 2016 ushered in a 10% drop in stock prices. The worst start to a new year in history.
•
The pundits said… (1) “The economy is failing; recession is imminent; oil prices and interest rates will
continue to fall!”
•
And of course, there were the elections… in Britain, the U.S. and in Italy.
•
The pundits predicted… (2) “Ignore the bluster, the status quo will prevail.”
•
And, in the off-chance they were wrong, the pundits further predicted… (3) ”The effect would be
disastrous for the financial markets!”
•
“And it’s One, Two, Three strikes you’re out!”… You know the tune.
•
So let’s review:
1. Recession? Nearly 2 million jobs have been added to the economy in 2016, wages have shown
signs of growth, real estate continues its recovery, household net worth has hit an all-time high
and oil prices have risen.
2. Status quo? Britain chose to exit the European Union. Donald J. Trump was elected to the
United States’ Presidency. Italians voted against constitutional reform.
3. And the response by the financial markets? Just the opposite of what the pundits predicted.
Indeed, by year-end the S&P 500 Index was up over 10%. Bonds, which had risen in price from
pundit-based-fear, reversed course and finished with flat returns.
•
There’s a not-so-subtle lesson here… All those flat-screened talking heads are not your friend.
•
Fear and anxiety is their recipe… With the evolution of the 24-7 news cycle, hysteria is the order of the
day. Objectivity has gone the way of the dodo bird and little in the way of useful information can be found
on those screens which seem to surround us.
•
The future cannot be predicted… and premising one’s investment strategy on the unpredictable is more
than just folly, it virtually assures failure.
•
Not convinced? Here is a list of the significant crises in economic and financial history over the past 100+
years: The Panic of 1907, the Depression of 1920-21, the Crash of 1929, the Great Depression followed
by a decade of deflation, ultra-low interest rates, no economic growth and collapsed housing prices. Then,
following two decades of prosperity, the Oil Crisis ignited inflation, interest rates and commodity prices
soared and stocks were viewed as pariahs. Black Monday in 1987 was followed by the Savings and Loan
crisis, the dot-com bubble, the sub-prime lending debacle and the Great Recession.
•
And we didn’t include… wars, acts of terrorism, or extraordinary weather events.
•
And yet…somehow…through it all… the economy continued to advance, the average quality of life
improved and those who saved and patiently invested were rewarded.
•
As unpredictable and emotionally terrifying as were many of these events…
Investments in the U.S. Capital Markets
Year-end 1925 = $1.00
$10,000
$5,317
Large-Cap Stocks
Long Term Bonds
$1,000
T-Bills (Cash)
Inflation
$100
$132
$21
$13
$10
$1
$0
'25
'32
'39
'46
'53
'60
'67
'74
'81
'88
'95
'02
'09
'16
Source: Strategas
•
The formula for success… time+patience+discipline
•
The ingredient most likely to undermine this formula… EMOTION. And 2016 was nothing if not
emotional.
•
The advice most likely to be ruinous… comes from anyone who suggests they know what will happen
in the future. Distrust anyone with an ego and a microphone, especially if they are espousing fear of the
future.
•
What you see/hear/tweet is not always what you get… We appreciate passions are running high over
the outcome of the U.S. presidential election, but history and experience have taught us repeatedly that
campaign rhetoric and reality are rarely the same thing.
•
Expectations… Since Election Day, stock prices have risen and bond prices have declined. While you
won’t hear us complain, we would offer some caution. Talk of deregulation, tax reform, and infrastructure
spending have reshaped expectations about future economic growth. Not only do these expectations vary
widely, but implementation will take months, if at all. In the course of less than two months, bond and stock
prices have reflected outcomes that cannot be assured…
•Still... we do get a sense that behaviors are changing. For nearly six years we have observed that the
Great Recession imprinted a behavioral influence not unlike its Great Depression predecessor. Following
each, caution dominated the financial decisions of individuals and businesses. This caution, along with
increased regulation, may have kept what John Maynard Keynes referred to as “animal spirits” at bay. While
future legislation can’t be predicted, the improvement in employment and the prospect of a more relaxed
tax and regulatory environment certainly appear to have thawed the years-long bias toward caution:
Conference Board: Consumer Expectations
120
120
100
100
80
80
60
60
40
40
20
20
07
08
09
10
11
Source: The Conference Board
12
13
14
15
16
17
•
Indeed caution has its own risks. We’ve referenced over the past eighteen months an increasing concern
that the search for safety and income was creating something of a safety “bubble”. Bond prices and stocksthat-look-like-bonds (Utilities, Telecoms and Staples) were all rising in price as investors sought the security
of their income. As prices rose, so too did their risk.
•
Double-whammy… Post-election expectations of an accelerating economy have driven interest rates
sharply upward, pushing down the price of bonds as well as stocks having bond-like characteristics. Now,
to the extent investors realize their safe investments aren’t so safe, there is risk of an exodus, driving prices
lower still. With interest rates having touched historically low levels just six months ago, even a small rise in
interest rates has had a profoundly negative influence on bond prices:
Bond Yield vs. Bond Market Value:
Equal and Opposite Reactions
2.65%
10yr Trsy Yield
$11,534.90
2.25%
$11,000
2.05%
$10,500
1.85%
$10,000
1.65%
1.45%
1.25%
$9,493.38
1.36%
10yr Yield
•
$11,500
$9,500
Bond Value ($10,000 face)
2.45%
$12,000
2.60%
$9,000
Value ($10,000)
Source: Bloomberg, Palladium
Active versus Passive… 2016 has also been rife with the “proof” that active stock managers simply
cannot outperform passive investments such as exchange-traded index funds. To be sure, we’ve grown
a little chippy on this subject, but much like the trend toward perceived “safe” income, there has been a
popular trend out of mutual funds into ETFs. While we very much appreciate the low cost of ETFs, the
resulting ETF performance has been self-fulfilling. As money has migrated to index shares, the shares of
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the stocks within the index have outperformed.
•
Hey, don’t let risk get in the way of the numbers! We are reminded of the housing market in 2007. Once
everyone concluded that home prices could only go up, everyone piled in, driving prices skyward. You know
the rest of the story. The only thing missing from the love affair with ETFs is bank-funded leverage. Relative
performance figures will quickly be forgotten if (when) this trend changes.
•
And let’s not forget the influence of emotion-led decision-making. It isn’t enough to simply identify the
best investment; what you do with it still matters. Witness:
20-year annualized returns by asset class (1996 - 2015)
9%
8%
8.2%
7.3%
7%
6.7%
6%
5.3%
5%
4.8%
4%
3.4%
3%
2.1%
2.2%
Avg. Investor
Inflation
2%
1%
0%
S&P 500
60/40
40/60
Bonds
EAFE
Homes
Source: J.P. Morgan Asset Management, Dalbar Inc.
Indexes: S&P 500 Index, Barclays U.S. Agg Bond Index, MSCI EAFE Index, Median sale price of existing single-family homes, 60/40:
60% invested in S&P 500 and 40% invested Barclays Agg,
40/60: 40% invested in S&P 500 and 60% invested Barclays Agg.
•
Emotions are running high. We have spoken to those who are pleased with the election’s outcome as
well as those who are disconsolate. In between, most are holding their breath.
•
For our part, we are, as ever, hopeful.
•
Farewell dear friend… Founding partner and long-time colleague, John Benedict, will retire within days. It
was John’s mathematical genius which brought discipline to our investment process some three decades
ago, the imprint of which will last forever. John’s work ethic, his humor and his profound intellect have
touched us all in ways his modesty would never allow him to admit. Palladium’s family will miss him dearly.
•
To John and to all whose eyes may fall upon this letter, we send this traditional Irish blessing…
May the road rise to meet you.
May the wind be always at your back.
May the sun shine warm upon your face.
And rains fall soft upon your fields.
And until we meet again,
May God hold you in the hollow of his hand.
Year End 2016
999 Waterside Drive, Suite 1000
Norfolk, VA 23510
Phone: 757-305-1500
Toll Free: 866-495-6498
Fax: 757-305-1538
www.palladiumllc.com
This newsletter represents the opinions of Palladium which are subject to change from time to time and which do not constitute a
recommendation to purchase or sell any security nor to engage in any particular investment strategy. The information contained
herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.