It’s finally happened! In case you are wondering, I am referring to the Fed finally raising the funds rate again last Wednesday. Of course, other events also fit this pronouncement, such as the stock market is finishing the year with a strong upswing, or, of course, Donald Trump is now President-Elect.
As the fourth quarter of 2016 draws to a close, we are enjoying a third quarter in a row of strong stock market returns for almost all stock categories. The rate increase was largely expected, although the markets seemed to lose some steam upon hearing that the individual Fed governor forecasts seemed to suggest that three rate increases are in store for 2017 instead of the previous expectation of just two. I enjoyed Robert Johnson’s, MorningStar’s director of economic analysis, tennis analogy that markets are currently in no-man’s land. The possibly positive impacts of Trump’s potentially stimulative policies have largely been priced in, but current economic data are now going nowhere fast. A lot of the month-to-month economic data that looked so strong in September and October (which the Fed officially mentioned in its release) suddenly looked just OK in November. Month-to-month retail sales, housing starts, and industrial production, all released this week, faltered some and generally missed expectations. The year-over-year data in these three key reports was less worrisome but certainly didn’t indicate a big boom ahead.
While US stocks continue to substantially outperform foreign, we are definitely observing a changing trend for growth vs. value stocks. After years of disappearance, the value premium has finally re-emerged for both large-cap and small-cap stocks. Year-to-date, large value stocks have returned almost 16%, while large growth are at about 5%, and small value stocks are returning about 26% in contrast with 12% for their small-growth counterpart. While bond returns have been fairly low, most categories still have positive returns for the year despite the rate increase. Real estate, one of last year’s top performing categories, is showing low returns in the single digits. Rising interest rates, which increase the cost of mortgage rates, put a damper on values.
The outlook for 2017 is bullish, but uncertain. Earnings could accelerate higher if the plans to lower corporate taxes and loosen regulations boost corporate America’s profit margins (or, at least offset lower profit margins caused by higher inflation). That said, policy uncertainty and higher inflation may cause valuation headwinds in 2017. The dynamic between earnings growth and valuation will be a tension point for markets in 2017. In addition, the risk of an overshoot in rates and the dollar will be important to watch for in 2017. As always, it is important to take a disciplined approach to investing. Always consider it “a win” if you sell some portion of your investments during rebalancing as it is experiencing market highs.