Starting 2017 with a Fresh Perspective and a New Motto

The 2017 new year: A time to refresh one’s perspective on the financial markets, both past and future. If you heard on the radio or saw on TV or a website that the Standard & Poor’s 500 Value Style Index was up 17% or more than 5% greater than the Standard & Poor’s 500 Index, would you expect your whole portfolio to have performed the same? If you read that the Standard & Poor’s 600 Index of U.S. small company stocks was up 26.5%, would you expect your total portfolio to be up 26.5%?

Hopefully, your answer is no because you understand that although your portfolio may emphasize value-style and small company stocks, they are only parts of the total portfolio.

Likewise, if you read that foreign developed market stocks were up 2.45%, would you expect your total portfolio to be up 2.45%? If you read that the Bloomberg Barclays U.S. Aggregate Bond Index was up 2.65% for the year but down nearly 3% in the fourth quarter, would you expect your total portfolio to have done the same?

In all cases, the answer is no because a broadly diversified portfolio provides a smoother ride and more comfort for investors by minimizing the peaks and valleys along the road. Your broadly diversified portfolio won’t top the charts in any given year, but it is designed to provide a competitive return above inflation to increase your purchasing power over five-year and longer time periods.

ACWI: Write it down or enter it in your smartphone or computer. It is the stock symbol for an ETF (exchange-traded fund) that tracks the MSCI ACWI IMI global stock market index. ACWI stands for All Country World Index, which includes U.S. and foreign stocks of all sizes. For the record, the ACWI was up 8.4% in 2016. We need to start a campaign to have TV, radio and internet outlets announce this index every day and not just the Dow, S&P 500 and NASDAQ, which are all U.S. large company stock indexes.

Calendar 2016 provided the swing in the pendulum that we have been waiting for in terms of superior returns for two of the factors we emphasize in our portfolios: value-style stocks and small company stocks.

Dividend growth has also rewarded stock market investors in 2016, albeit more modestly than in 2015. Companies increase their cash dividends as revenue and profits increase, and this rewards investors separately from share price changes. Stock dividend income has also proven to be a pretty reliable source of income and offers growth in income better than bonds.

Here are the annual dividend growth percentage increases for 2016 versus 2015 for commonly held mutual funds:

One Year Five Year Annualized
Vanguard Total Stock Market Admiral Shares: +7% +5.5%
Vanguard 500 Index Fund Admiral Shares: +5% +4.8%
Vanguard Dividend Appreciation Fund: +1% +7.8%

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Turning to the future, what is our outlook? Our crystal ball is no clearer than yours, and we do not make future forecasts. Nonetheless, some basic data serve as indicators.

Inflation remains low but perked up in 2016, measuring 1.7% for the 12 months ending 11/30/16, compared with 3% to 4% long-term historical averages. Inflation is projected to be about 2% annually over the next five to 10 years. Low inflation is good, but it can result in low interest rates for investors.

The S&P 500 P/E ratio is 25, which is high and indicates below-average future returns.

The S&P 500 dividend yield is 2.1%, which is low, but close to five-year U.S. Treasuries.

International stocks, both developed and emerging markets, provide better stock market valuations than U.S. stocks and therefore better future growth potential. Time will tell when the pendulum will swing back in favor of international stocks, and patience may be required over the next few years. The strength of the U.S. dollar versus foreign currencies continues to weigh down international profits converted back to U.S. dollars.

Emerging markets are particularly affected by low commodity prices in oil and metals.

Interest rates remain low, and any future increases are expected to be slow and modest.

The key benchmark for any investment portfolio should be inflation and maintaining and increasing purchasing power through price appreciation and increased dividend income.

With low inflation and a slow-growing economy, investment returns are likely to be lower in the years ahead. While historically inflation was 4% and investment returns of 6% to 8% were targeted, with an expected 2% inflation rate, portfolio investment returns of 4% to 6% will achieve the same result.

Our motto for 2017: Investors should adjust investment return expectations to be more modest but be confident that long-term goals are still achievable given low inflation.

Remember a few key lessons for 2017:

  1. Successful investing is a contrarian process. Sell high, buy low and be willing to do what your gut tells you not to do. Don’t follow the crowd.
  1. Successful investing requires a tolerance for volatility and a long-term focus.
  1. A strategic asset allocation in a broadly diversified, multi-asset portfolio emphasizing passively managed funds is a sound investment strategy.

As always, please contact us with any questions, news or comments.