SPECIAL INVESTMENT UPDATE
Dear Clients & Friends,
Donald Trump’s November victory took Wall Street by surprise. From Election Day to January 19, President in-waiting Donald Trump teased the media and tweeted up a storm. But now, President-elect Trump is President Trump. He’s making real decisions with the force of the law. Obviously, Trump is a man with no small ego. He enjoys the limelight and will play to an audience whenever he can. As his early appointments and his first acts in office demonstrate, however, he is not utterly devoid of guiding principles. While his economic ideas do conflict with free-market thinking on some significant points, he certainly leans more toward capitalism than socialism. We need to recognize him as the consummate deal-maker since he is constantly negotiating. Trump is a hard-nosed businessman who has negotiated throughout his career, by means of bluster and threats. As a businessman, though, he cherishes above all the prospect of “closing the deal”. Understanding Trump’s fundamental identity as a deal-maker can help us to react wisely when the President issues one of his frequent strongly worded statements.
All of our portfolios turned in an excellent performance in 2016. As we look forward to the next twelve months and beyond, it is important to note that our expected future returns will most likely be less robust than the 2016 results. With our “balanced” style of investing, we place great emphasis on stocks but also a sizable component of bonds or bond equivalents. We have maintained this strategy since our firm’s inception and continue to embrace it. However, since stocks are historically expensive and high-grade bond yields remain very low, we have to be concerned about both these factors but especially the high-grade bond yields which dictate the direction of interest rates. The purpose of this Special Investment Update is to discuss these two factors.
As far as bonds are concerned, back in late April 1990, you could earn 9% on a 10-year Treasury note, the safest paper in the world. That turned out to be the high-water mark for bond yields over the next 27 years. Not only did we start out with a plumb yield in those good old days but we also enjoyed a tailwind from falling interests over the subsequent quarter century. As rates tumbled, our bonds racked up price gains on top of the interest coupon, bolstering our total return. Today, the shoe is on the other foot. With the 10-year Treasury note yielding a mere 2.5%, the income component of most high-quality bonds makes only a modest contribution to total return. Also, if interest rates climb significantly in coming years, the resale value of longer-dated bonds will erode. The tailwind of the past will shift to a headwind for the future. Given this risk, we should expect a total return of approximately 2.5% annually for a typical bond index fund over the next five to ten years.
As far as stocks are concerned, they have put on a fabulous performance over the past eight years, since the climatic March 2009 low. Currently, all the major stock indexes are posting continuous all-time record highs. We continue to be long-term “bulls” on the U.S. economy and stock market. However, share prices have climbed so dramatically that most valuation benchmarks such as price-to-earnings and price-to-sales stand at or near their highs of the past decade. History shows that lofty valuations lead to mediocre long-term returns or less. Thus, even if we increased our equity exposure to 100% of our portfolios, we probably would not earn nearly as much, in the coming decade, as investors used to make with traditional balanced portfolio of 60% stocks and 40% fixed income.
Even though the return for both stocks and bonds are likely to fall short of historical norms in the next five to ten years, we continue to embrace our balanced portfolio strategy. The safety aspect of a balanced portfolio continues to be very important to all of our portfolios. However, we have to be creative to be able to achieve our financial goals in the years ahead. This creativity is developed by being flexible in widening our allocation range of our stock weighting. Since our firm’s inception, our stock exposure varied between 40% and 80% of the total portfolios. We do not expect to follow either of these extremes in the near future.
As far as our investment strategy is concerned, we continue to maintain our standard two-pronged strategy, which is to maintain a substantial exposure to common stocks (and mutual funds) as long as there is a reasonable prospect for double-digit returns. We continue to maintain an average asset allocation mix of 45%-50% Equity, 45-50% Fixed Income and 0%-10% cash for most of the portfolios.
We have come a long way since Election Day without a significant pullback. We should expect a 3%-4% pullback on the Standard & poor’s 500 Index. However, we feel confident about the stock market for the first and second quarters but will have to wait and see what kind of legislation will pass under Donald Trump before we can re-evaluate our investment strategy.
We want to thank all of you for giving our firm the opportunity to serve you. We thank you very much for the trust and confidence you have placed in our firm as it is always appreciated. Please contact us should you have any questions or comments. Also, we want to invite you to visit our website at www.farmandinvestments.com for a quick Retirement calculator, our latest firm news, and Market Commentary archives.
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