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CLS: The Presidential Election Cycle, 2016 Investment Themes and More

12/02/2015

November Market Review
November’s gains in the stock market extended the strong gains earned in October and have set the stage for a good  finish to the year. Seasonal tendencies and short-term momentum suggest more gains in the closing weeks of 2015.

Here’s the breakdown of the numbers for November. The overall U.S. stock market (Russell 3000) gained nearly 2% last month. Large-cap stocks (S&P 500) gained a bit more than 1%, while U.S. small caps (Russell 2000) gained 5%. International stocks (MSCI ACWI ex-U.S.) meanwhile lost 1%. Developed economies (as expressed by the MSCI EAFE Index) lost 1% and emerging market stocks (MSCI Emerging Markets Index) lost 5%.

Diversifying asset classes, such as commodities (Bloomberg Commodity Index), lost 5% and alternatives (Morningstar Diversified Alternative Index) gained 2%.

The bond market (Barclays Capital Aggregate Index) lost 1% last month, with the U.S. Treasury bond yield ending the month at 2.22%.

Market Outlook – Review the Building Blocks
It’s that time of year when money managers and  financial pundits start offering their outlooks for 2016. We’ll take the bait and do the same, but for regular readers our views shouldn’t be too much of a surprise given that we’ve been talking about them for a while. In short, our expectation is that the U.S. stock and bond markets will remain expensive. The markets will likely continue to generate positive returns, but the returns will probably be below long-term averages.

Let’s review the building blocks that we regularly use in our Quarterly Market Outlook.

Currently, we expect returns for the U.S. market to be 6% at best. Most likely, due to overextended valuations, returns will be lower. Why?

1. First, the forecasted dividend yield is half the long-term average. Currently, yields are closer to 2% than the long-term average of over 4%.

2. Regarding growth expectations, it seems reasonable to expect the same sort of growth and inflation we’ve seen over the last ten years – and over the last 150 years for that matter. That puts inflation at about 2% and “real growth” (i.e., growth adjusted for inflation) also at 2%.

3. The last building block is the change in valuations. Currently, the market is expensive by nearly every valuation measure. The only measure that suggests the market is not rich is valuations adjusted by interest rates. But if rates rise in 2016, which is a good possibility, then this valuation measure will also come under pressure. Valuation compression should haircut returns.

In sum, returns are likely to be lower than 6% per year in the years ahead for the U.S. market, below the 9% long-term average.

It’s important to note that this is an overall market view. There are parts of the market that are more attractive – such as high- quality stocks or technology stocks – than others. And there is significantly more potential in overseas markets. I’ll have more on that later.

Presidential Election Cycle
Aside our concerns that valuations are a bit expensive for the U.S. market, and nominal growth isn’t likely to bust out to above-average levels, one of the top questions we are addressing these days is, “How will the presidential election impact the stock market?” This is a hot topic, and I have written and spoken on it quite a few times over the years.

Here are the key points:

1. First, be aware that a lot of analysts are using market data to support conclusions they probably had before they started to look at the data! Besides, there really aren’t a lot of data points to review when analyzing elections. And even when there are, it’s not as simple as looking at a single variable, such as who is running for office. Underlying economic conditions, interest rate environments, valuations, and more will differ in every election.

2. There are 36 relevant data points going back to 1900. I would argue some conclusions can be made about the presidential election cycle on stock market returns, and they do make intuitive sense. For example, the year after the election is usually the most difficult as the monetary/fiscal backdrop tends to be less accommodative when votes don’t need to be won. And, conversely, the market typically does best in the year before the election (though not necessarily this year) as the monetary/fiscal backdrop is more accommodative when the incumbent tries to favorably in uence the electorate.

3. The political uncertainty does often cause increased stock market price volatility in election years.

4. The first half of a presidential election year typically does not generate stock market gains, and sometimes experiences a small loss. Once there is more clarity on political platforms and who may win, the stock market generally does much better in the second half of the year.

5. So, when does the stock market generate the best gains? Is it when Republicans win the White House or when the Democrats win? Actually, it’s when the incumbent party wins. Again, it comes back to the idea that the stock market responds better to perceived certainty.

CLS 2016 Investment Themes
Heading into 2016, we are introducing three primary investment themes. We are still positively biased to our investment themes from 2015, but we have folded them into our new and improved themes for the new year. These new themes effectively capture our thinking and overall major portfolio views.

First, given our expectation for lower returns but higher volatility in the year(s) ahead, we are calling our first theme “X-Factor,” which means a few things:

1. To start, we will emphasize factor-based ETFs and smart beta ETFs. We believe these are tools to enhance returns.

• Smart beta, in its simplest form, refers to ETFs that are weighted by any measure except capitalization-weighting.

• Many smart beta ETFs use factors such as growth or value. What is exciting about factor-based ETFs is they capture the essence of actively managed mutual funds (since portfolio managers often emphasize a factor in their investment processes) but at a fraction of the cost. Examples of factor-based ETFs that we currently use include the various high-quality ETFs we have successfully emphasized in recent years.

2. Second, factor-based risk management is another way to manage risk in portfolios. We have spent a considerable amount of time over the last year building out this risk management capability to complement our risk budgeting methodology. We believe this work will indeed help us improve our risk- adjusted performance over time.

3. Lastly, this theme takes advantage of CLS’s talent, as we have three exceptionally strong portfolio managers who specialize in smart beta ETFs: Scott Kubie (who has been speaking and writing about smart beta for years), Joe Smith (who has deep knowledge and passion for factor analysis) and Grant Engelbart (the CLS whiz-kid who leans heavily on factor analysis for his investment decision making). Each of these PMs has spent a considerable amount of time incorporating factor-based analysis and risk management into money management.

Our second theme is “International Opportunities.” This is a high-conviction view. Expected returns for international markets – both developed and emerging – are substantially higher than they are in the U.S. Yes, we held this view a year ago, and it hurt our relative performance this year, but the conviction is even stronger now. As the saying goes, “Value will out.” Valuations will eventually play out, and they will likely do so in favor of international markets in the years ahead.

The last theme is a repeat from a few years ago, “Creative Diversification.” This folds in last year’s theme that a tactical approach is needed in  fixed income positioning, but it also incorporates other diversifying asset classes, such as alternatives and commodities, which is an important distinction. Regarding the former, there are many alts that look attractive to us, especially some of the lower-volatility options, such as managed futures. As for commodities, many of our PMs continue to be intrigued by the only asset class that has been hit even harder than emerging markets. On balance, expect that we will be better buyers (i.e., more likely to buy than sell) of this asset class in 2016. We will be picking our spots.

Thanks for reading. Stay balanced.

 

The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The Bloomberg Commodity Index is made up of 22 exchange-traded futures on physical commodities and represents 20 commodities that are weighted to account for economic signiffcant and market liquidity. The Morningstar Diversified Alternatives Index is designed to provide diversified exposure to alternative asset classes while enhancing risk-adjusted portfolio returns when combined with a range of traditional investments. It allocates among a comprehensive set of alternative underlying ETFs that employ alternative and non-traditional strategies such as long/short, market neutral, managed futures, hedge fund replication, private equity, infrastructure or inflation-related investments. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.

The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not affiliated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, nancial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report. Investors should seek  financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may uctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest- rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies.

An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in.

2808-CLS-12/1/2015

 

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