Overall Market Commentary
The fourth quarter of 2016 reminded investors that there are no certainties in life, or financial markets, as the upset victory of Donald Trump over Hillary Clinton left many political and investing professionals speechless. Dow Jones Industrial Average futures initially reacted with an 800-point free fall, but market sentiment quickly shifted and domestic equity indices surged to end the year near all-time record highs. Seemingly overnight, the narrative shifted; dire warnings against Trump’s isolationist policies gave way to a wave of enthusiasm that the potential for reduced taxes, pro-business, anti-regulation administration would usher in a new era of infrastructure spending and domestic growth. Which of these scenarios plays out, or if we end up somewhere in between, remains to be seen.
US equity markets trended sideways for most of the summer and remained fairly flat through October. The post-election surge resulted in strong quarterly gains for US equities, with the S&P 500 gaining 3.82% in the quarter. The Dow Jones Industrial Average fared even better – up 8.66% in the quarter – due to its proportionately larger sector exposure to the Financials and Industrials, which stand to benefit from deregulation and domestic growth initiatives. Small-cap US equities were another beneficiary of the election result. Investors wagered that the incoming administration would act swiftly to repeal and replace Obamacare, lower corporate taxes, and gut other regulatory agencies such as the Environmental Protection Agency, easing the burden on small and mid-sized companies. The Russell 2000 Index of small-cap US equities posted an impressive 8.43% fourth quarter return and closed out 2016 up 19.48%.
The S&P 500, Nasdaq, Russell 2000, and Dow Jones Industrial Average all recently set new record highs and the uptrend remains intact heading into 2017. With the Dow within striking distance of the historic 20,000-point mark, one has to question – are stocks overvalued? The Shiller Cyclically Adjusted Price-to-Earnings Ratio, or Shiller CAPE, is an oft-cited barometer for stock market valuations. The Shiller CAPE compares the current level of the S&P 500 to the average trailing 10-year inflation-adjusted earnings of the index. As shown in the chart below, the December Shiller CAPE reading of 28.26 is much higher than the post-war average of 18.7, which may seem unsustainable.
Looking at just the last 20 years valuations seem relatively in-line with average levels. Aside from the dot-com spike in the early 2000s, and the financial crisis in 2009, the current CAPE ratio looks pretty much in-line with those of the last two decades. One can argue that the higher valuations we have experienced in recent history are the product of aggressive central bank interest rate policies. Stock valuations are high because bonds are not providing adequate yield as an alternative. While rates are finally beginning to rise, the Fed is going to be careful to implement slow and measured increases, and therefore stocks maintaining or even exceeding current valuations is not out of the question.
Data from http://www.econ.yale.edu/~shiller/data.htm. Charts, commentary, and opinions are those of Hanlon Investment Management.
Looking abroad, developed international equity markets commenced the quarter still reeling from 2016’s other upset, the UK Brexit vote. Concerns over America’s new direction and uncertainty about looming Eurozone elections in 2017 resulted in a slight quarterly loss of -1.36% for developed international markets, as measured by the iShares MSCI EAFE ETF (ticker EFA). Emerging markets, which are also particularly vulnerable to the strengthening US Dollar, fared even worse. The iShares MSCI Emerging Markets ETF (ticker EEM) registered a -5.44% loss in the fourth quarter. Hanlon has maintained very little to no exposure to international equity and bond markets in our tactical models.
Fixed income market performance was mixed in the quarter, with Treasury yields surging on expectations that the incoming administration will aggressively increase the US debt burden, as well as stoke business and economic growth. The 10-Year US Treasury Note yield rose considerably during the quarter, from 1.60% to 2.49%. The Bloomberg Barclays US Aggregate Bond Total Return Index ended the quarter with a (2.98%) loss. High yield bonds proved resilient registering a 1.88% gain in the quarter, as measured by the Bank of America Merrill Lynch US Master II Index. Spreads on high yield bonds, which is the difference between the interest rate high yield bonds pay versus the interest rate similar maturity US Treasuries pay, tightened to their lowest levels in over two years, ending 2016 at 4.22% after starting the year at 7.10%. High yield bonds benefitted from the stabilization of oil prices during the quarter, which should result in a much lower default rate for energy company bond issues. The trailing twelve-month default rate for energy company bond issuers, which reached 18.8% in November, is predicted to fall to just 3% in 2017 according to Fitch Ratings. Outside of energy, high yield defaults were minimal in 2016, and the worst case scenario in which the oil-related weakness spread to financials and other sectors never materialized. As a result, high yield bonds enjoyed a stellar year, outperforming equities and posting their best returns since 2009. While double digit returns may be tough to achieve again in 2017, high yield remains in a strong uptrend heading into the new year.
After dominating the financial headlines for the past few years, the US Federal Reserve was somewhat overshadowed by the US election. The Fed’s interest rate policy was fairly easy to determine as early as September, with market participants correctly wagering that the Fed would not hike rates in advance of the election but rather hold off until December. The only surprising detail of the December policy statement was a slightly more aggressive forecast for 2017, with three proposed interest rate hikes rather than two. It remains possible that we will not see three rate hikes in 2017, as the Fed was similarly aggressive with its predictions in 2015 and 2016 and only managed one rate hike during those previous years. Furthermore, comments made by Chairman Yellen after the December rate announcement have been dovish, being interpreted by markets as an expectation for less than three rate increases in 2017.
Ideally, Fed decisions on the timing and scope of interest rate hikes are tied to economic growth and employment data. After years of slower than historical economic recovery, economic growth finally picked up a bit in 2016. Through Q3, the US GDP growth rate accelerated each quarter; although we will likely see a pullback from Q3’s 3.5% rate when the final Q4 numbers are released. The latest estimates are around 2.9%. The unemployment rate fell to 4.6% in November, the lowest level since August of 2007. The jury is still out on whether or not the incoming administration’s plans for aggressive tax cuts and deregulation will translate into tangible growth and new jobs. Many economists remain skeptical that such policies will be sufficient to revive the manufacturing sector, as many of those jobs have not been lost to foreign competition, but to domestic technological efficiencies.
Hanlon in 2016 and beyond
2016 was a big year here at Hanlon. It marked the first full year that we included our two new mutual funds, the Hanlon Managed Income Fund (HANIX) and the Hanlon Tactical Dividend and Momentum Fund (HTDIX), in our strategies. Overall we believe the Managed Income strategy achieved its goal of protecting investors from large drawdowns early in the year by correctly shifting to defensive cash positions while the high yield market was melting down in January and February. Through February 11th, the Bank of America Merrill Lynch US High Yield Master II Index was down -5.14% but the strategy remained positive. The tactical signals that kept the strategy in cash suggested continued caution until the high yield market made a more complete recovery, and the strategy lagged as high yields bounced back aggressively in March. Eventually we returned the strategy to risk-on status but the strategy did sacrifice some of those quick gains during the sudden rebound. The strategy ended the year fully invested, primarily in high yield bonds, and we believe that the strategy delivered on expectations for 2016.
Our equity strategies rotate in and out of the various major equity markets and economic sectors. The strategy had a challenging year due to several instances where the strategy was positioned in cash, as our signals said to get defensive, only to see equity markets quickly change to a positive direction. One such instance was shortly after the June Brexit vote, when our tactical signals exited several sectors and missed an aggressive upwards move in equity markets. Later in the year, the Growth strategy was similarly positioned in cash in advance of the US Presidential election and did not fully capitalize on the November surge. The strategy ended the year down mid-single digits which was disappointing considering it was a generally positive year for US equity markets. We invested a considerable amount of time analyzing the underlying trading signals that drive the strategies tactical decisions. We modified several of the parameters for these signals beginning in November and are optimistic that these changes will yield better performance in 2017. It already has as of the date of this publication.
Our other major initiative is the introduction of the Hanlon All-Weather Models. For over 15 years, Hanlon has offered tactical models to provide protection of a portion of client’s overall investment portfolios. The client’s risk profile and time horizon can vary the portion of the portfolio devoted to Hanlon tactical models. Advisors have often asked for guidance on how to best allocate the rest of the portfolio, the portion invested in buy-and-hold, long term investments. The All-Weather models are our response. Each Hanlon All-Weather model contains a diversified, low cost mix of ETFs designed to be held throughout market cycles over a longer term investment horizon. The All-Weather models also allocate a portion to Hanlon’s Tactical mutual funds, offering a degree of downside protection in the event of market turmoil. With the introduction of the All-Weather models, our message remains the same – investors should have a mix of buy-and-hold and Tactical – but now we are providing a simple, all-in-one solution. They are multi-asset class, multi-strategy, using both mutual funds and ETFs.
The All-Weather models are aligned with investor risk tolerance and investment time horizon. There are five variations ranging from Growth (most aggressive) to Income (most conservative). The All-Weather Growth model contains the smallest allocation to Tactical solutions, since a typical Growth investor would have a longer time horizon and have more years to recoup any large drawdowns in their portfolio. The All-Weather Income model, on the other hand, has a larger Tactical component at roughly 30%. The Income model is ideally suited for an investor preparing for retirement who is looking for their portfolio to generate cash flow and also protect them from sudden market crashes. We are very excited to offer the All-Weather models – they are the culmination of years of research, and represent our best thinking on how to blend Tactical strategies with traditional asset allocation.<>
This Quarterly Report contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. The Standard and Poor’s 500 (S&P500) is an unmanaged index of approximately 500 common stocks that is widely used as an indicator of market trends. Indices are unmanaged and investors are not able to invest directly into any index. The Bank of America Merrill Lynch US High-yield Master II Index is a composite index for high-yield U.S. Corporate Bonds. The iShares iBoxx High Yield Corporate Bond Fund (HYG) tracks the Markit iBoxx USD Liquid High Yield Index, which is a composite index for US high-yield corporate bonds. The iShares MSCI EAFE Index ETF (EFA) tracks the MSCI EAFE index, which is an index of foreign stocks, from the perspective of a North American investor. The index includes a selection of stocks from 21 developed markets, but excludes those from the United States and Canada. The iShares MSCI Emerging Markets Index ETF (EEM) tracks the MSCI Emerging Markets Index, which is an index that measures the equity market performance in global emerging markets, and cannot be invested in directly.
The performance of an index does not reflect any fees and charges associated with individual investments or investment advisory accounts. It is not possible to invest directly in an index. Past performance is not a guarantee of future results. There is no guarantee that the views and opinions expressed in this Quarterly Report will come to pass. Investing in the stock and bond markets involves the risk of gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice. Hanlon has experienced periods of underperformance in the past and may also in the future. Hanlon is an SEC registered investment adviser with its principal place of business in the State of New Jersey. Hanlon is in compliance with the current federal and state registration requirements imposed upon registered investment advisers. Hanlon may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This Quarterly Report is limited to the dissemination of general information pertaining to its investment advisory services and is not suitable for everyone. Any subsequent, direct communication by Hanlon with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about Hanlon, including fees, services, and registration status, send for our disclosure document as set forth on Form ADV using the “Contact” link at the bottom of www.hanlon.com or visit www.adviserinfo.sec.gov. Please read the disclosure statement carefully before you invest or send money.