BCN ADVANTAGE: 2016 ANNUAL REPORT
For 2016, the S&P 500 rose 9.5% to 2,239, the Dow 13.4% to 19,763 and the Nasdaq 7.5% to 5,383. The IBD Mutual Fund Index gained only 4.7%. Stocks began 2016 with one of the worst Januarys on record, a reaction to the Fed’s first interest rate hike in a decade. But markets quickly recovered as the Fed backed away from further rate increases, then remained mostly flat through October. An election night panic pushed Dow futures down 800 points and S&P 500 futures down to their -5% limit. But by morning stocks had reversed yet again, and charged ahead to close out the year 9% higher from Election Day. The sluggish US economy expanded 1.6% in 2016. Q4 missed estimates at 1.9%, and slowed considerably from the 3.5% rate in Q3. The Trump administration hopes to jolt the economy with a dose of fiscal spending, tax reform and deregulation. Vast new mega-projects will be required to significantly affect the $18.9 trillion U.S. economy – or even absorb the $1 trillion in planned infrastructure spending. A plan likely would not become law until late 2017. Kick-starting large projects from scratch takes two years to plan and design prior to construction, which suggests 2019-2020 before significant benefits filter through to the economy. Combined with estimated 9% earnings growth in 2017, lowering the top corporate rate from 35% to 20% theoretically could lift the S&P 500 to 2500, roughly 8% higher than today. But tax “stimulus” may not work that well in practice. According to the Government Accountability Office, the average tax rate paid by large, profitable U.S. corporations is 12.6%. Conservatives will push hard for revenue neutrality over worries about the nation’s $20 trillion debt. As a result, there may be no real impact – and possibly adverse impacts on those companies currently paying less than 20% – if existing corporate deductions are eliminated to offset the tax cut. Back in 2007 Q3, the S&P 500 Index peaked at 1,576 and sported a price-to-earnings ratio of 18.5 times earnings. Today, the S&P 500 Index just wrapped up 2016 at 2,239, with a price-to-earnings ratio of 23 times earnings. What makes the S&P 500 truly stand out is how U.S. stocks have performed versus the rest of the world. From mid-2007 through the end of 2016, the S&P 500 Index is now more than +75% above its pre-crisis highs. Developed international markets (as measured by the MSCI EAFE Index) are still lower on a nominal (non-inflation adjusted) basis. For the S&P 500, 2016 Q4 would mark the end of seven consecutive quarters of annual earnings declines. The rate of year-over-year decline troughed at -15.4% in 2015 Q4 and has since been improving to just -1.7% in 2016 Q3. If the final quarter of 2016 holds up as expected, earnings would break out with a +12.9% year-over-year increase. Investors are scrambling to get ahead of Trump's economic proposals that many are comparing to those of Ronald Reagan. But the economic environment and potential growth of 1982 was vastly different than today (table). The U.S. stock market has been sustained all along by a steady flow of monetary stimulus (chart). As we enter 2017, monetary policy is fading at the same time that fiscal policy remains uncertain. After years of zero interest rate policy (ZIRP), the Fed has managed two 1/4 point rate hikes since December 2015. But no major economy has ever exited the ZIRP experiment successfully. In the latest report from the Institute for International Finance, global debt increased by $11 trillion in the first 9 months of 2016, hitting a new all-time high of $217 trillion. As a result, debt levels are now roughly 325% of the world's gross domestic product. Credit binges are cyclical and the bigger the binge, the bigger the fall. The current economic expansion began in June 2009, nearly 8 years ago. The longest expansion in history lasted exactly ten years from 1991 to 2001. It was fueled by technology advances and low inflation, falling interest rates, and massive spending on technology driven by the internet. The odds of a recession grow larger as the recovery runs longer, and no one can forecast recessions with any precision. In March 2009, we moved 100% into growth stocks. Part of our rationale then: If we're not buying stocks after they've fallen 50%, when would we? Conversely today, if an old, very expensive, highly leveraged stock market doesn’t make us cautious, what would? Yet the level of cash being held by individual investors is near record lows. The benefits of having capital to invest at lower valuations has produced substantial outperformance over waiting for previously destroyed investment capital to recover. The BCN Advantage service offers substantial proof of the benefits of minimizing losses in actual practice. When risks begin to outweigh the potential for reward, smart investors raise cash. They buy low and sell high. When you sell high you raise cash. And you can't buy low if you don't have any capital to buy with. Looking forward, we realize that patience is waning as stocks move higher. One quarter does not make a trend, but if downward pressure continues to build on S&P 500 valuations (from the 2016 Q3 peak of 24 x earnings), we will move more aggressively into stocks – likely 70% by summer. But don’t be surprised if a significant market correction occurs before then.
