2015 Retrospective

January 4, 2016

Spent much of the holidays pondering the year's market machinations. A period in which the S&P 500 was as flat as an M. Night Shyamalan plot. Tons of action. Little progress.
Following six years with the spigot on, we were due. A pullback. A lateral trend line. A seventh straight year higher would have been nothing short of miraculous. That said, the index finished down about one percent. With dividends, it gained about a percent. Hardly a slap in the face. Yet, investors felt as if the results had been worse.
Because 2015 was about mega caps. If you didn't own the market's biggest stocks, especially those with a technology orientation, results could have been awful. The largest 100 stocks finished up 3.5 percent. The Nasdaq 100 rose 8.5 percent. The Vanguard Mega cap fund increased 4.5 percent. After that? A cliff's edge.

The Russell 2000 small caps sank 4 percent. Mid caps, a traditional favorite, fell 3 percent. Foreign developed markets dropped 2.6 percent. Foreign emerging markets lost 17 percent. European stocks sank 2 percent. The Chinese FXI index declined 13 percent. Japanese equities, the big winner, managed an 11 percent gain.
Fixed income? Not helpful. Thanks to the Fed's Zero Interest Rate Policy and incessant uncertainty over the first rate hike.
The U.S. aggregate bond index added less than half of a percent. Corporate bonds were lower by 1.25 percent. Long-dated Treasurys lost 2 percent. And high yield bonds gave up 4 percent of their value.
From a sector standpoint, multiple economic arenas conspired to drag indexes lower. The obvious suspects? Energy and materials. Both careened lower amid sector-oriented bear markets. Followed by conventional retail. Industrials. Utilities. Each manhandled. Like Justin Bieber at girls camp. Financials? Less so. Ending the year flat.
Large caps. Mid caps. Small caps. Foreign. Domestic. Emerging markets. Energy. Materials. Retail. Industrials. Utilities. Financials. All down... But, other than that, Mrs. Lincoln, how'd you like the play?
Even Apple, a veritable one-stock asset class since the Credit Crisis, finished 3 percent in the hole.
Had it not been for healthcare and technology, the year could have really gone south.
The so-called FANG stocks -- Facebook, Amazon, Netflix and Google -- were 2015's cool kids. And their performance helped to mask a slew of underlying weaknesses. With each posting outsized gains amid a sea of mediocrity.
So, bet big on FANG stocks in 2016?
Not so quick. The market has a long history of making mincemeat of last year's caviar. Of course, the reverse holds true, as well. With last year's dogs oft landing in the new year's winner's circle. Remember the Dogs of the Dow strategy? Reductive. But, effective.
So, what's attractive?
We remain technology buyers. Even as the FANG stocks remind us of Ulysses' sirens on the rocks. Having achieved their loftiest prices. They sit there. Radiating sex appeal. Sweetly beckoning to passing ships. "Buy us... Buy us..." Don't do it, sailor. Lest your boat be smashed against the jagged cliffs.
Jumping on the FANG bandwagon has all the luster of a Phish concert. Pricey. Redundant. And anachronistic. That said, there are a lot of Phish knockoff bands. Less expensive. Less crowded. Easier logistics.
A number of indices hold these and other tech stocks. Some of which we anticipate will be the FANGs of 2016. And, if the FANGs do continue to outperform? Well, they're accounted for. In less risky concentrations.
Like technology, we believe healthcare will also outperform the broader markets this year. Valuations remain low enough so as not to raise concerns. And, like tech, healthcare continues to be an innovative area. Where creativity and life-enhancing products and services are focused. To the mutual benefit of patients and investors.
People will pay for life-enhancing products and services. Investors will pay for growth and innovation. Tech and healthcare offer both.
Stock prices generally follow earnings growth and PE expansion. Both of which derive from new discoveries and upside surprises. Precisely what good healthcare and technology stocks can deliver.
What happened last year?
Profit growth stalled. Blame it on a strong dollar. Falling prices for oil, steel and other commodities. The result? S&P 500 companies saw net-income drop three percent. While sales fell four percent. Meanwhile, companies stopped spending. Nervous over the lack of growth and economic clarity. Capital expenditures fell in the third and fourth quarters. The first consecutive drops since 2010. Resulting in a vicious cycle, as it caused companies to further cut costs. Squeeze suppliers.
Going forward?
A recent survey of the National Federation of Independent Businesses revealed that only 25 percent of small companies plan capital outlays for the next two quarters. Well below the historical average.
The data points to a cooling economy. Manufacturing has slowed. Industrial production has dropped. Home sales have slowed. Consequently, the Atlanta Fed's real-time GDPNow tracking estimate puts Q4 GDP at a lowly 1.3 percent.
Not exactly a pro-growth equation.
Analysts expect Q4 earnings to decline 4.7 percent year over year. Energy and material earnings remain the primary culprits. But, outside of healthcare and technology, the rest of the market has not helped.
This economic recovery has never evolved past the meager-at-best stage. For six years, companies slashed budgets and expenditures. Improved margins. Avoided hiring. In order to bring earnings growth back online. But, without real economic growth, there's only so much to be done before earnings growth stalls.
In lieu of such evidence, the Fed chose to begin raising rates. And plans to do so four more times throughout the course of the year. While European stimulus measure will help offset a lack of our own, the diminishing liquidity will have an adverse affect on Wall Street. Much as the increasing liquidity of the last six years served as a rising tide that lifted all boats.
So, what's in store for 2016? Well, multiple theories on that regard.
One theory suggests that the market has judged the current administration's lack of interest in achieving real economic growth. Accordingly, it has recalibrated its expectations for the year ahead. That is, until November's election sweeps in a new administration willing, at least in the short term, to place the nation's economic priorities ahead of environmental and cultural ones.
Another theory holds that 2016 represents the final year in what has been a 17-year secular bear market. Which, considering the facts, isn't entirely unbelievable. Today's S&P 500 sits only 29 percent above the levels it attained in July of 2000. Nearly 16 years ago. Adjusted for inflation? The disparity narrows further. Following 2016, a new secular bull will take over. Propelling stocks higher for the foreseeable future.
Of course, I'm sure the fortune teller down the street has an opinion, as well.
As the late, great Yogi Berra said, predictions are hard. Especially ones about the future. But let's discuss some of the trends that will light our path this year. We think these to be especially interesting as the previous year was so, well, trendless. So devoid of big themes.
Our firm believes the following four trends will benefit investors in 2016:
First, defense contractors and safety concerns. 2015 bore out the idea that the world is a dangerous place. One result of America's shrinking foreign policy was an increase in global conflict. And not just wars between nation states. The real outlier has been violence propagated by non-state actors. Terrorist organizations. Mostly aligned with radical Islam. Which used 2015 to fill every void left by the contraction in Western power projection.
Accordingly, the world appears increasingly hostile to U.S. interests. Leaving current and former U.S. and NATO allies to increasingly take defense and security measures into their own hands. They will continue to arm themselves in order to assure the success of such efforts. Defense contractors will be beneficiaries of those initiatives.
While we like some of the American companies, we're especially fond of some of those overseas. Specifically, a couple located right in the middle of the hornet's nest. Israel. Diversified arms, munitions and military grade equipment manufacturers. Producing everything from drones to night vision goggles. Such companies will meet the needs of an increasingly unsafe world.
Second, the Internet of Things. The encompasses the idea whereby all of your devices communicate via the internet in an effort to better personalize and simplify your life. It will take a while to play out. But don't let the grandiose size of the theme and the slow speed of its roll out fool you. This is happening. And its impact will be huge.
Many areas of the technology and consumer products universe will participate. Hardware. Software. Infrastructure and components. In the future, companies will have an "Internet of Things" (IOT) strategy. Much like they have one for websites and mobile apps.
Third, healthcare. You think healthcare has been shaken up thus far? Get ready for the main event. Drug prices. Rising medical costs. Telemedicine. These trends will continue to capture headlines, even as the companies competing therein attempt to capture market share.
Joining them will be some new twists that should interest investors.
In response to rising drug prices and Federal investigations into major providers, big pharma has been discussing new alternative financing models as well as outcomes-based reimbursement models that could have a major impact on the industry this year.
Additionally, 2015 saw a number of massive mergers in the healthcare industry. Considering that consolidation begets more consolidation, you likely see many healthcare companies in the crosshairs of the industry's larger acquirers. Especially those small- and mid-cap concerns that bring less regulatory scrutiny and more ease of acquisition.
Finally, healthcare has joined the rest of the world in its focus on consumer ease and mobility. Telemedicine apps made their debut in the public markets last year. And this trend has boomed. As more people want to manage their own care -- such as when and where they get it.
Patient adoption of the technology doubled over the last two years. Per Moore's Law, we only expect that trend to accelerate.
Fourth, low-correlation alternative assets. These investments will play a big role in portfolio success. Especially as the market continues to navigate the opaque economic environment. With interest rates low, and volatility promising to rag doll stocks throughout the year, alternatives will offer the possibility for yield. Not to mention targeted absolute returns. With the ability to act independently of stock and bond performance. See here and here.
On top of all this, consider that the U.S. population increased by 2,472,745 over the course of 2015. An increase of 0.77 percent. Meaning that each of the above trends will impact a rapidly growing consumer audience in the years ahead.
So, what's the bottom line?
The current trend line appears flat to down. Market breadth has become bearish. The Fed's era of accommodation is ending. Risk taking, as seen by the patterns within the small-cap Russell 2000, appears negative.
All of which is to say that 2016 marks the first year in seven where the calendar flipped while the bears were in charge. Does not mean they'll remain there. They've surrendered such advantages many times these last few years.
Moreover, Goldman Sachs -- alternating between roles as Wall Street's greatest soothsayer and most dastardly henchman -- projects the following:
"From its trough in March 2009, the S&P 500 index has returned 249 percent through yearend 2015. U.S. GDP is 14.4 percent higher and going into 2016, we see no recession on the horizon. This bull market is the third-longest since WWII and this economic recovery is the fourth longest. The U.S. has become the largest producer of oil and natural gas liquids globally, substantially reducing a historic reliance on the tinder box that is the Middle East. The U.S. private sector has deleveraged significantly and the gap between the U.S. and the rest of the world continues to widen across human capital, economic and financial market metrics. Over this recovery, the U.S. budget deficit has decreased from a high of 9.8 percent of GDP to 2.5 percent. The trade-weighted dollar measured against major currencies has rallied 38 percent since its trough on May 2, 2011. The country remains the number one destination for immigration and its pace of innovation remains unparalleled."
So... Up? Down? This market remains poised to head in either direction. But remember, market declines are temporary. Advancement is permanent. Every historical drop, dalliance and disaster has seen capital achieving a means of overcoming it. Working around it. Providing returns in excess of those produced by debt. Which is to say, history provides the best rational for a long-term investment outlook.
Still, we forecast a possibility for a challenging year in stocks. Though rife with the opportunities outlined above. We further believe that there will be chances to play the turns. Which, like Formula One and other high-stakes events, is often where the race is won.
Happy New Year.

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