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Q4 2016 Commentary

2016 will go down as quite a historic year.

We had a highly significant election, which was followed by a notable equity rally (more on that below), but things were historic from day one.

As you may recall, equity performance at the start of 2016 was the worst on record.  Just twelve trading days into the year, the S&P 500 was already down over 9%.  Stocks languished for weeks, bottoming a couple of percentage points lower. 

The rapid drop set the tone for countless headlines questioning the implications of such a start.  Data tells us that the start of the calendar year has very little bearing on subsequent returns, but the data does not always make for the best headlines.  Instead, the widespread fear mongering spread to the public, who sold stocks at a brisk pace.  The erosion of confidence was so rapid and dramatic that sentiment survey results showed less optimism in mid-January than during the darkest days of the financial crisis. 

We bought into the brief, panicked decline, which rapidly reversed.  Equities were back into positive territory by mid-March.   

After that, 2016 turned fairly quiet.  We had the brief Brexit-fueled panic in June, but from March through September, stocks generally climbed slowly higher, settling at record highs.  The rise allowed us plenty of opportunities to capture profits, and by the third quarter, clients saw their smallest allocation to stocks since 2007.

When we last updated clients in October, we had just begun buying again.  Even though valuations remained high, stocks had lost momentum and investor confidence once again began to wane.  These trends continued until the Friday before the election.  Investors were pulling money out of equity funds, option implied volatility was climbing, Put/Call ratios spiked – investors were seeking protection in a dramatic fashion.  At the same time, the CNN Fear/Greed index was showing the most fear since the January/February decline.

It is no surprise that investors were scared.  Heading into election week, major investment banks issued dire warnings about the threat of a Trump presidency.  Meanwhile, stocks put together a nine day losing streak – the longest since 1980. 

Though the total price decline was shallow, sentiment was flashing a clear buy indication.  In the two months ahead of the election, our domestic accounts increased their market exposure to near 70% – still a somewhat conservative position, but taking on more than twice the market exposure we had late in the summer.   

While we would like to take credit for a brilliant election call, this was not an election call at all.  This move was based purely on price movements and the underlying shifts in investor sentiment.  Absent a Presidential election or any other major event, we would have interpreted and acted upon the data the same way. Of course, the sentiment shifts were largely election driven, but we took an agnostic approach to the election itself, instead choosing to capitalize on any clear opportunities that would result from markets’ interpretations of expected/realized outcomes.

From our perspective, the post-election rise in equity prices was a not clear-cut consequence of the actual outcome of the election, but largely an unwind of the anxieties that built ahead of the election – anxieties that were likely to unwind regardless.

Certainly there is price action that can be attributed to the election outcome, namely the rise in financial stocks, small-caps and commodity related names, but post-election relief was likely a strong component of the broader action. 

Though the averages have been quiet in recent weeks, we have seen some ebb and flow in leadership, allowing us to capture profits in select positions.  This will likely continue into early 2017, with our short-term goal being a return to a conservative, low market exposure position on par with where we stood this past summer.

We are simply not inclined to maintain high market exposure in an environment of high valuations and a tightening Federal Reserve. 

There is plenty of temptation to latch onto narratives on the implications of a Donald Trump presidency.  It is my personal opinion that President Trump presents a flattening of the risk curve.  In other words, there are higher probabilities of above average and below average outcomes, depending on which fights he chooses to pursue and the dispersion of his successes and failures. 

Our data driven view does not include my personal opinion, however, and we will wait for any consequences of the Trump presidency to play out in our data sets before taking associated actions.  Anything else would be speculation – something that does not comport with our investment approach.

Though tax cuts and deregulation should be net positives for stocks, there are plenty of headwinds building.  With many significant data sets pulling in different directions, we anticipate 2017 to be another year that will reward patience and restraint.  I will continue to work hard to protect our clients’ capital as we see which influences prevail.

Wishing you all a happy and prosperous New Year,


Robert B. Drach

Managing Member

Drach Advisors LLC

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