5 Things You Need to Know for 2017

Part 1 of 2

 

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit. "Such bad luck," they said sympathetically. 

"Perhaps," the farmer replied.

The next morning the horse returned, bringing with it three other wild horses. "How wonderful," the neighbors exclaimed.

"Perhaps," replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

"Perhaps," answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son's leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

"Perhaps," said the farmer.

 

Many years ago, I was introduced to this fable by a mentor that was deeply talented in being as pragmatic as one could be.  His level of pragmatism seemed to stem from a steadfast belief that the true outcome of things is rarely what we think they will be.  Years like 2016 make me very grateful for being introduced to such a story and for the traits that mentor attempted to instill.  Now that 2016 goes down in the history books as the year of surprises, it is time to look forward to see “Perhaps” what 2017 may bring to investors.

Every year as part of our “Quivercation” process of diversifying investor assets, we pause to take a pulse of the cycles behind the 5 Pillars of The Market:

  • Equities
  • Interest Rates
  • Currencies
  • Real Estate
  • Commodities

Most likely, these 5 markets have the most influence on your net worth. Understanding where these different markets may be within their cycles of growth and decline can help you understand where and how much of your money should be influenced by each.

Similar to previous years, in order to avoid putting you to sleep we have split this piece into two parts.  Starting with the two markets that delivered the most surprises throughout 2016 – Equities and Interest Rates.  I should also mention that considering the majority of individuals that we provide guidance for have a time frame greater than 3 years we like to use some longer term charts and focus our attention for turning points within the longer term patterns that may be developing.

 

Equities

Each year when we look forward and attempt to project future directions of markets we like to take into consideration these few things:

  1. The Fundamentals – this includes where we may be within earnings cycles, the economy as well as expected changes in fiscal policies.

  2. The Technicals – this is where the graphs come in handy.

  3. The art behind the science – This takes into consideration that markets are forward thinking and they attempt to price in what they already know.  This can set up instances where expectations become more important than the facts. 

The 2016 election was a good example of a time when fundamentals can seem to change overnight. (Perhaps)  Since the election of Donald Trump, markets have been adjusting according to how participants feel Trump’s agenda will influence markets.  Equity market indexes have pushed to all-time highs on the backs of Financial, Industrial and Materials stocks.  A clear sign that investors believe Trump will reduce regulations and taxes while stimulating the economy with greater infrastructure spending.  All this positivity is at the root of why I opened this missive with the “Perhaps” fable.  While all these potential changes do seem to be the recipe for a stronger economy and hence improving fundamentals, it is still yet to be seen if these things can get done and if so how they will truly look in the end.  Perhaps, one thing investors are not speaking of, which may have a greater influence on the fundamentals is the fact that the rest of the world appears to be in a weaker economic position than the U.S.  As a result, 2017 could be a year where money is attracted to U.S. based equities and bonds as they will be relatively more attractive than assets in other parts of the world.

From a Technical (chart) perspective I offer the images below.

As you can see in the charts I am voicing some caution for equity investors.  It’s important to note that the technical evidence shown on the charts, such as volume declining as the market makes new highs and the relative strength index not making new highs as price does, can all correct itself.  However, it has been my experience that these signs point to a market being closer to a top than a bottom.

The art in blending the fundamentals and technicals for 2017 may be found in the saying, “Buy on the Rumor, Sell on the Fact”.  Right now market participants are buying in anticipation of what may be to come.  They are essentially buying the rumor.  It wouldn’t be too surprising to see some selling in the early months of 2017 as the facts may not meet the current rumors and expectations.  If this were to occur, it may set up a very nice buying opportunity in the early part of 2017.  

Based on all this, if I were an owner of equities and was inclined to reduce risk, I would consider lightening my load into the current market strength.  If I had cash and was wishing to buy equities as a longer term investment, I would be patient and look for a better entry point as we enter into 2017.  History has shown that forward returns for buy and hold type of investments are very low when equity markets are at current valuations.  It may take some time but there will be a day when valuations will be more attractive to capital that is looking for longer term resting places.  If you can’t resist and have to be in equities then it is best at these stages to use some type of hedged equity exposure or money manager that specializes in a tactical approach to managing equities with an emphasis on risk management and low volatility.

 

Interest Rates

Throughout 2016 interest rates have swung more than an elephant’s trunk in the Sahara.  This time last year when expectations were for higher interest rates, the 10 Year Treasury bond was hovering near 2.25%.  Through June of 2016, contrary to popular belief the yield slid down to as low as 1.4%.  At this time, the narrative changed from higher rates to the possibility of negative rates.  Now, the 10 YR yield sits in the 2.5% range (all according to Bloomberg).  No doubt Interest Rate prognosticators should keep the “Perhaps” fable in mind as they become steadfast in their next prediction.

Fundamentally it should be brought to mind that the U.S. 10 Year Treasury being around 2.5% is comparably higher than countries such as Italy, which are at roughly 1.78%.  I would imagine that as investment committees for pension and sovereign wealth funds meet in January to allocate funds for 2017, they will be more attracted to getting 2.5% from U.S. based debt as opposed to the lower rates more stressed countries are currently offering.  Perhaps this creates a flow of capital to the U.S. supporting both Govt. Bond prices as well as equities throughout the year. 

From a technical side I offer you two charts of Govt. Bond prices.  The first is a longer term view so you can see how well this market was trending until the election.  After the election this market broke a long term trend line.  In most cases, when trend lines of this nature are broken the market will have a tendency to revisit that trend line from the underside, a process that could take many months if it were to happen. 

The second chart is shorter term and may be showing some signs that the decline in prices is coming to an end or at least a pause.  If this were the case, it would speak to the possibility of seeing rates decline (contrary to current popular belief) into the first portion of 2017.  Again this could fit the buy the rumor sell the fact concept.  Markets have priced in higher interest rates (lower government bond prices) anticipating pro-growth policies from the Trump administration.  Time will tell if markets have priced in too much expectation for growth.

I would continue to watch this market very closely as it may have a greater effect on your net worth over the next year than you know.  The ultimate longer term path for interest rates is still to be seen.  Perhaps we are at the edge of a secular change and the direction of rates for the years ahead is higher and June of 2016 will mark when that change began.  That is a possibility and one that most gurus seem to be thinking.  As always it will come down to the numbers.  If economic growth becomes stronger, higher rates are in front of us.  However, don’t fool yourself into thinking that central banks won’t go right back to the quantitative easing play book and push rates as low as they can when and if the economy shows any signs of weakness. 

The bottom line for rates is this:  In the short term rates have probably moved too far too fast and seeing a reversal in the first few months of 2017 would not be surprising.  Projecting further than that is probably an exercise in futility as there will be a lot of information coming our way in the next few months that will help us determine whether there has been a historical shift in this market.  As always, we will keep you informed especially when we get to midyear and do our “5 Things Revisited” to update all ya all on whether our current thoughts are on track or if something changed in real time to alter our path.

It is two days before Christmas and the office is pretty quiet as most are on their way to spend time with family and friends which is what I am going to head our to do now. Before I do, I would like to wish you and your families Happy Holidays and for those that are inclined to read a heartfelt Christmas Story filled with some good life lessons I encourage you to check out this story by "Perhaps" one of the most talented market prognosticators you'll find.

http://www.pretzelcharts.com/2013/12/a-christmas-story-reflections-on-what.html

 

Colby McFadden

Quiver Financial