Dec 312016

While the headlines announced huge returns for investors, 2016 will be remembered by financial professionals as the year of dispersion.  The Dow Jones, a price weighted average of 30 significant stocks which are traded on the NYSE and NASDAQ, returned 13.4%.  The S&P500 (comprised of 500 large US companies and calculated in a way where movements in the prices of stocks with higher market capitalizations have a greater impact on the index than those with smaller market caps) returned 9.5%.  Meanwhile the most aggressive allocation reported by Morningstar reported a “mere” 5.3%.  A well balanced, diversified and responsibly allocated portfolio didn’t seem to work in 2016.

Great returns make great headlines. The typical investor experienced little of the stated headline returns due to significant investment dispersion which occurred during 2016.   The following is a list and the corresponding returns as reported by Morningstar for calendar year 2016:

Inflation Protected Treasuries -1.60% Morningstar Conservative Index 2.80%
Short Term Bonds 0.79% Morningstar Moderate Index 3.50%
Long Term Bonds -1.55% Morningstar Aggressive Index 5.30%
Cash 0.02% International Developed Markets 3.40%
U.S. Large Cap Growth 3.16% Healthcare -9.87%
Hedge Fund Average 3.10%

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.

During 2016, long-held relationships across asset classes appeared to be breaking down. For investors seeking to build conventionally diversified portfolios, this challenges some conventional wisdoms. The negative relationship between stocks and bonds (the key ballast in balanced portfolios) has notably weakened, making it harder to buffer equity market swings. Further, assets that have historically moved in near lockstep like oil and large-cap domestic equities no longer did.

Investors use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away, typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market’s short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put their money in a more conservative allocation despite a long-time horizon.

The critical importance of asset allocation within a portfolio is rarely argued during down markets as sound asset allocation can buffer declining or volatile markets.  However, in flat to up markets, when a segment of the market (the S&P500 in this case) significantly outperforms other areas of the markets, it’s tempting to shift most if not all investments in that direction, participating in a common investor error of chasing returns.

Harding Financial Group clients came into the 4th quarter of 2016 conservatively invested.  The market had been flat for nearly two years, the election seemed to be owned by Hillary Clinton and the market was trading in a downward and volatile trend into the election.    The surprise result may have created much needed clarity on a 4-year time horizon but caused chaos over the following several weeks causing bonds to lose as much as 5% and the sleepy industrial sector to jump 20%.  Performance for most clients was in line with their respective index as reported on the Portfolio Overview page within this report, but not nearly as high as the pure stock S&P500.

I know of no one, individuals and professionals alike, who wanted to be aggressively allocated prior to the election.   The risks were too great.  In my commentary for 3rd quarter 2016, I wrote to clients I planned to complete a significant reallocation of client portfolios following the election and a significant reallocation has occurred.  HFG has trimmed conservative investments such as the James Fund and has significantly reduced cash and short term investments in favor of Financials, Industrials, Energy, Small Caps and Aerospace & Defense.

Generally, clients are now more invested in equities than they have been in a couple years. Not because of the movement of the market over the past several weeks but because of the greater clarity we have on the economic direction the country may be heading as it relates to personal and corporate tax reform, regulatory reform, infrastructure improvements and defense spending.  Existing and new investment has been focused in the areas mentioned in the prior paragraph but we are also excluding areas of the market such as Brick and Mortar Retail, FANG stocks (Facebook, Amazon, Netflix, Google), and Chinese or European holdings.  Old tech bellwethers – IBM and Cisco, could see significant investment this year as both are leaders in cybersecurity. One significant takeaway from the election is the importance of cyber security and the potential damage the lack thereof could cause.

There has been a paradigm shift in the market.  What worked the past eight years will not be what works the next four.  I have attempted to position clients to benefit from the flow of both Government capital and private investment. The Trump Administration has not taken office nor have they begun in earnest the anticipated conflict with both sides of the aisle.  This change in power could be fraught with more conflict and resulting market volatility than has historically been the case because of the substantial change in perspective this administration will bring to Washington.  Nevertheless, there has been a measurable change in market sentiment and the engine of the United States Economy could be pushed into gear after idling for far too long.  Progress may come in fits and starts but we have the opportunity to move forward, and in a different economic direction. My goal remains to have everyone positioned properly for the next four years rather than the next four weeks.

Happy New Year to you and your family.  I anticipate 2017 will be a dynamic year with significantly more investment activity.  I appreciate working with you as we navigate this changing economic and political landscape.


Michael R. Harding, CFP
President / Portfolio Manager