2016 Review and Outlook for the Next Decade or Two

Well, if you were expecting a forecast for 2017, sorry to disappoint, but that is a fool’s errand that we refuse to undertake. The first image that comes to mind when we hear “2016” is a black swan. After all, this was the year of Brexit, Trump, and the Cubs.

So far, the U.S. stock market appears to have responded quite positively to the election results combined with the announced cabinet appointments. As of 12/16/2016, the year-to-date return of the S&P 500 Index is 12.8%, making it a better-than-average year. One of the biggest market stories of 2016 is the surge in small cap stocks which are up 19.0% (based on the CRSP Small Cap Index). Value stocks also have delivered strong performance at 17.8% (based on the CRSP Large Cap Value Index). Portfolios tilted towards the risk factors of small cap and value have benefitted substantially. Although real estate investment trusts (REITs) have taken a hit from higher interest rates, they still have delivered a respectable year-to-date return of 6.7% (based on the MSCI US REIT Index).

International developed equities suffered from Brexit and a stronger U.S. dollar. They are only up 2.0% (based on the FTSE All-Cap Developed Markets Index). Emerging markets, on the other hand staged a nice comeback from 2015’s poor performance. They are up 10.8% (based on the performance of the Vanguard Emerging Markets Index Fund).

Although bonds have suffered since the election, it is important to note that they were up beforehand. The Bloomberg Barclays Aggregate US Bond Index is up 1.5%. Based on the yields at the start of the year, we could not have expected much more than that. Treasury Inflation-Protected Bonds (TIPS) delivered a slightly higher return at 2.7%. Actual inflation for 2016 (based on the CPI through 11/30/2016) appears to be coming in at 2.0%. This lines up nicely with the implicit forecast of inflation in comparing the yields between nominal and inflation-protected bonds. The bond market appears to be forecasting a breakeven inflation rate of 2% for the next few decades. The current 10-year Treasury bond yield of 2.5% is, in our opinion, a good proxy for bond returns going forward. As of today (12/19/2016), an investor can get the 2.5% with either the 10-year Treasury or a 5-year corporate with an “A” rating (which basically amounts to trading term risk for credit risk). As always, we recommend a diversification of bond risks.

For long-term equity forecasts (which we must have for financial planning purposes) we defer to the conclusions drawn by Vanguard’s research team that are based on the Vanguard Capital Markets Model (VCMM). Like Vanguard, we believe that market forecasts are best viewed in a probabilistic framework. Similar to last year’s forecast, Vanguard’s medium-run outlook for global equities over the next decade remains guarded in the 5-7% range. As the researchers note, “our long-term outlook is not bearish and can even be viewed as positive when adjusted for the low-rate environment.” Vanguard’s probability of a 0-4% return is about 17%, and the probability of a negative return is a little over 10%. As Vanguard explains, “Our conservative outlook for the global stock market is based primarily on market valuations, such as the price/earnings (P/E) ratios.” It is important to note that the commonly used Shiller cyclically-adjusted P/E ratio is now the highest it has ever been since December of 1999 (just before the bursting of the dot-com bubble).