Note from the CIO: 2016 Review, 2017 Outlook

Post Series: Investment Committee Commentary Q1 2017

Happy New Year everyone! The first six weeks of 2016 will go down in stock market history as the worst first-six-week-start to any year ever. Yes, even worse than 1929 and the Great Depression, and even worse than 2008 and the Great Recession. The S&P 500 declined over 11% from January 1 through February 11. Ironically, few can even remember those six weeks at this point – let alone the countless other “apocalypse du jour” events in the markets of yesteryears. Please do take a moment to let it sink in that the many seemingly calamitous events in the market and economy are largely transient and ultimately irrelevant to the achievement of our goals. Now back to our 2016 run-down.

In June, the market sank nearly 6% over two trading days following the vote by the citizens of Britain to exit the European Union (“Brexit”). It may turn out to be a vote for more freedom and less controls on the U.K. economy; or it may turn out to be a vote for controls manifested in different forms, namely nationalism and migration restrictions. So far the market seems to be signaling the latter.

In the run-up to the U.S. election with heightened uncertainty, the market closed down on nine consecutive trading days, an occurrence not seen since 1980. By around 11:00pm on election night, the Dow Jones Industrial Average futures contracts were down 800 points in after-hours trading.

Despite these seemingly apocalyptic events and wild short-term swings in the market, the S&P 500 finished last year 12% higher than its start, dividends included. If I were tasked with creating a training clinic for investors, I could not think of a better syllabus than that provided by 2016, which highlighted the wisdom of not making investment decisions based on current events and their attendant emotions – however shocking they may be.

With that recap of 2016, let’s now briefly take a slightly deeper dive into what the U.S. election might mean for investing. From the market’s perspective, the most important thing about the election may be that it ended. Many people feel that with the election results known, a tremendous amount of uncertainty was removed, and the markets were most likely able to advance, independent of the election outcome.

2016 wrapped up with no shortage of financial journalists claiming the market is overvalued heading into 2017. Are they right? Taking the 2016 year-end value of the S&P 500, 2,249, and dividing by the 2017 consensus earnings estimate of $132.79, we enter 2017 with a forward-looking price-to-earnings ratio of 16.9. The 25-year historical average of this ratio has been 15.9. So the market is currently priced slightly above the historical average, hardly a cause for alarm based on this metric.

We could go on and on analyzing the events and the market data of 2016, but at a certain point we ought to remind ourselves of the general principles that guide us to equanimity.

In our experience, successful investing is goal-focused and planning-driven, and most unsuccessful investing is market-focused and performance-driven. In other words, successful investors continuously act on their financial plan, the one thing that is entirely in their control. By contrast, unsuccessful investors continuously react to economic and market news, which is entirely out of their control.

At Abacus, we do not forecast the economy and we make no attempt to time the markets or predict which investments will do the best, nor do we believe anyone else can consistently do these things. A good plan is designed to weather significant market declines. We are planners rather than prognosticators. We believe our highest-value service is planning and behavioral coaching – keeping our clients from overreacting to market events, both positive and negative.

The Nobel Prize-winning behavioral economist Daniel Kahneman said “All of us would be better investors if we just made fewer decisions.” Once you and your advisor have put a long-term plan in place—and funded it with the investments that seem historically best-suited to its achievement—we very rarely recommend changing the portfolio beyond its regular periodic rebalancing. In brief, our principle is: if your goals haven’t changed, don’t change the portfolio. The more often people change their portfolios, the worse their results become.

During any given calendar year, the market goes up and down. Over some period (of days, or weeks or months) in a given year, the market will experience its worst drop during that year. Going back to 1980, the average of these so called intra-year declines in the S&P 500 has exceeded 14%. Yet even without counting dividends, annual returns have been positive in 28 of these 37 years, and the Index has gone from 106 at the beginning of 1980 to 2,249 at year-end 2016. We believe the great lessons to be drawn from the data are that— historically, at least—temporary market declines have been very different from permanent loss of capital, and that the most effective antidote to the roller-coaster-like ups-and-downs in the market has simply been the passage of time. We can’t predict that it will always work out this way. We can only fall back on the wisdom of the great investor and philanthropist John Templeton, who said that the four most dangerous words in investing are “this time is different”.

The nature of successful investing, as we see it, is the practice of rationality under uncertainty. We’ll never have all the information we want in terms of what’s about to happen, because we invest for an essentially unknowable future. Therefore, we practice the principles of long-term investing that have most reliably yielded favorable long-term results over time: planning; a rational optimism based on experience; patience and discipline. These will continue to be the fundamental building blocks of our investment advice in 2017 and beyond.

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