2016 Model Strategy Review

A goal of any wise strategist is to pick assets that won’t under-perform for the foreseeable future.  Interesting choice of words, don’t you think?  In the search for assets to add to a portfolio, one finds that in a highly correlated world, it is best to identify the possible laggards and discard them from the pool of possibilities quickly.  In the worst case, we want a portfolio to match the comparable market index and at best we want the portfolio to exceed index returns.  A common mistake is to chase returns (FOMO) and getting trapped in a nasty valuation correction.

The US stock market in 2016 was incredibly frustrating for much of the year.  Asset valuations were expensive in the eyes of many, though stocks remained resilient, despite the plethora of threats to stability appearing on many fronts.  You name it:  the US presidential race, Brexit, Italy banking instability, terrorist attacks, the re-emergence of Russia as a relevant power, Chinese currency devaluation, pension fund shortfalls, student debt, USD strength, etc.  The promise of a more insular United States may be good for jobs in the US, but stepping back from the global stage creates voids in geopolitics that can be filled by less predictable players.

So, market reaction to the Trump election was nothing short of incredible, climbing the proverbial wall of worry to the tune of 9.54% in the S&P 500, and 18.73% in the S&P Mid-cap 400.  The NASDAQ only rose 7.5%, due in large part to the headwinds faced by the healthcare sector.

At the end of 2015, Hillary Clinton began to rail, justifiably, against abusive drug pricing in the US.  Humira, a popular treatment for Arthritis and psoriasis, provides over $12.5 billion in sales globally to AbbVie (ABBV).   Users of Humira in Switzerland will spend around $881 a month.  In Canada, it can cost up to $1,950 a month.  In the US, it can cost over $4,000 a month!  According to usuncut.com, the popular acid reflux treatment Nexium can cost $30 per month in Canada, but in the US it can cost as much as $305.  Yes, the extreme pricing might have something to do with subsidized medicine in other countries, but the difference in pricing across borders is alarming.

Clearly, the possibility of an HRC presidency weighed heavily on the biotech and pharmaceutical sectors, beginning in August of 2015.

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The stock market rallied most unexpectedly following the US elections.  Trump is commonly viewed as a loose cannon, but it is becoming increasingly clear that it is best to focus on what he does, not what he says.  So far he has given the impression that fiscal stimulus is on the way and is catering to a forgotten middle class that is confronting  rising medical costs, yet little job growth.

The civilian unemployment rate in the US is misleading.  It is at a cyclical low of 4.6%, but the labor participation rate in the US below 1970’s levels at 62.7%.  This implies a low participation that makes it difficult to understand real levels of productivity, but it is reasonable to think that the US has room to improve productivity.

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So, given the focus the PEOTUS has placed on bringing back industrial jobs to the US, the forgotten manufacturing sector may well get its mojo back.  This is what has helped the major indices climb the wall of worry and markets are pricing in a much more positive economic trend.  A popular valuation method, the Shiller PE Ratio (CAPE Ratio) of the S&P 500 is at 28.06.  It is still a ways away from the all time high set in 2000.  At first blush, it seems expensive, but remember that the numerator and denominator in the P/E Ratio can change and the market is projecting growth in the denominator, which could make the ratio come down.  Only time will tell.  My sense is that the market wanted, needed, a change in leadership and until we see a serious policy blunder, the stock market will continue to rise.

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Being the fan that I am of the predictive capabilities of the yield curve, the rally in Treasury rates has been unexpectedly swift.  All throughout 2016, the spread between the 30 yr and 2 yr Treasury bond kept bouncing off the 2.8 line, almost daring the Federal Reserve to raise rates.  My sense was that the Fed had long accepted the fact that it needed to raise rates at least once in 2015.  As I have said multiple times, they need that arrow in their quiver.  The ZIRP/NIRP laboratory of monetary policy has overstayed its welcome.

30y2y-spread Now that the elections have passed and the Fed has raised another 25bps, curve flattening has continued, though it is important to note that it is a long ways away from an inversion.  An inversion is historically is an excellent indicator of impending recession. By this measure, there is nothing to fear for the moment.

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Suffice it to say, the bond and stock markets reacted violently to the elections and rate decision, but the result has been very logical.  Stocks and bonds represent opposite ends of the risk spectrum.  When things are good, it is best to be in stocks and when things are bad, it is best to be in cash or bonds.  My model focuses on identifying momentum and choosing whether QQQ or TLT are best at a particular point in time.  These two assets were highly correlated for the first two weeks of November, causing my model to lose -10.3%, after being up +10.85% on the year.  It closed the year with a 2.29% gain, or 0.76% after including a 1.5% annual fees.  The return of the S&P Mid-Cap 400 rose an incredible 18.73% and the S&P High Yield Dividend Aristocrats, a popular pick for 2016, rose 17.25%.

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Still, the strategy has managed 11.47% annualized return in price since July 18, 2003, compared to the next best index, the S&P Mid-Cap 400 with annualized returns of 9.42%.

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Recently, the  NPR Planet Money podcast released an episode that discussed whether or not Dow 20,000 was relevant.  I highly recommend listening to it here.  Those that know me have heard my rant on how the Dow Industrials is a lousy index to use as a barometer of economic and market health, because 30 companies are a poor reflection of the overall economy and its construction does not allow for much rotation.  The S&P 500 provides a better cross section, though the Russell 3000 is even better.  Still, my preference is to use an index that reflects the performance of the most innovative and growth focused companies.  This can be done via the Nasdaq 100, which reflects the stock price performance of companies in a number of major industry groups, excluding financials.  It just so happens to be the best performing index over the longer term.  Therefore, I am setting a high bar for performance by using the Nasdaq 100, expressed through the Powershares QQQ exchange traded fund.

Interestingly enough, after 8 straight weeks of allocation in the QQQ, recent performance in the long bond index, expressed in my model with the TLT ETF, has surpassed the performance of stocks in general and is now indicating a rotation back into long bonds.

Obviously, the timing of the rotation and Presidential inauguration is completely coincidental.  Some analysts opine that the honeymoon started too soon and the market rally is a little over extended.  A breather is healthy and my sense is that the market may mark time until after inauguration. PEOTUS Trump has promised to launch several initiatives on the first day in office, such as corporate tax reform, repealing Obamacare and bringing jobs back to the US.  For a broader discussion regarding his plans please read here.  These are bold moves and promise to shake up the status quo, and quite possibly the markets.


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