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Investment Letter Commentary

by Caldwell Trust
economy.jpgWith the Dow Jones Industrial Average (DJIA) crossing the 20,000 level we realize what a difference a year can make in domestic capital markets. At this time last year the domestic equity markets were off to one of their worst yearly starts ever. The S&P 500 corrected almost 15 percent between the first of January and mid-February before reversing and gradually moving higher through mid-year. The correction culprit was investors’ fears of a global slowdown. That fear of a slowdown was the result of weak economic growth numbers coming out of China and the U.S., as well as crude oil prices declining into the mid-$20 range and general fragility in the energy sector. As crude oil and commodity prices reversed and more favorable U.S. economic releases occurred, markets stabilized and moved higher. By mid-2016 most domestic equity markets had slightly positive returns. 

In late June the Brexit vote signaling the U.K.’s intention to leave the European Union took world markets by surprise. Most importantly, the benchmark 10-year U.S. Treasury bond yield declined to 1.36 percent, reflecting general uncertainty about implications of the vote. The yield on the 10-year had commenced 2016 at 2.27 percent and most pundits had projected higher levels by year-end 2016. Domestic equity markets were initially down on the news but recovered quickly. Through the end of the second quarter of 2016, S&P 500 earnings had declined on a year-over-year basis for six consecutive quarters.

Domestic equity markets once again moved slightly higher through October and generally had realized low single-digit returns just prior to the presidential election. While bond yields moved slightly higher (and bond prices moved slightly lower), the 10-year Treasury bond stood at about 1.80 percent prior to the election and down markedly on the year. Energy and crude oil prices continued to stabilize through the third quarter of 2016 propelling S&P 500 earnings to reverse their decline and realize growth once again.

The election of Donald Trump marked a significant inflection point in investor sentiment on the hope that many of his platform promises would be implemented, particularly corporate and individual tax cuts, infrastructure spending and regulatory reform. Markets rallied meaningfully into year-end with the S&P 500 posting a total return of approximately 12 percent for the year with around half of the return realized in the last 7 weeks of 2016.

Unlike the pervasive pessimism that greeted 2016, the financial markets domestically commence 2017 with much hope and optimism as the post-election rally continues. Both stock prices and bond yields have continued to move higher on the hope of increased economic growth and corporate profitability. Not considering any positive impact from Donald Trump’s election, earnings are expected to grow in the mid- to high single digits this year. While the S&P 500 has rallied, its valuation based on projected 2017 earnings estimates is reasonable within a historic context.

In retrospect it appears that domestic bonds may have put in a bottom in yields subsequent to the Brexit vote last June. If so it marks the end to a 35-year bull market in bonds, which witnessed the yield on the 10-year Treasury bond trending lower from a high of approximately 14 percent in the early 1980s to just north of 1 percent last year. While rates are expected to rise, we believe the yield on the 10-year Treasury will remain below the 3 percent mark for 2017. It currently stands at around 2.45 percent.

Given the above backdrop we continue to favor equities over fixed-income investments. The strong dollar will be a headwind for large multinational companies and favors mid- and small-capitalization companies domestically. While returns in the fixed-income markets will be challenged, we believe the high-yield corporate market should continue to offer relative value.

If the Trump administration is able to implement its pro-growth initiatives, domestic equity markets may perform better than is currently anticipated. A final note on the current equity market rally: markets seldom go straight up and are notoriously difficult to predict over short periods. A market pullback or a correction in the short term would not surprise us, and if a pullback occurs we are currently inclined to buy the dip. 

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