Top 3 Surprises For 2017

January 26, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Mark Eshman, co-founder and CIO of ClearRock, an SEC-registered investment advisor with offices in San Francisco and Sun Valley, Idaho.

 

We often decide that an outcome is extremely unlikely or impossible, because we are unable to imagine any chain of events that could cause it to occur. The defect, often, is in our imagination.”

Amos Tversky and Daniel Kahneman

We can find some scientific solace in an otherwise-wildly unpredictable year through the words in yet another brilliant Michael Lewis book, “The Undoing Project,” in which he brings to life the remarkable friendship of two Israeli psychologists whose ideas changed the world.

Tversky and Kahneman’s partnership that began in the 1960s—and ultimately won them the Nobel Prize in Economics—produced the foundation of what we now call “behavioral economics,” helping us understand why human beings repeatedly misjudge probabilities when making decisions.

As Lewis writes, “The more easily people can call some scenario to mind … the more probable they find it to be. Any fact or incident that was especially vivid, or recent, or common … was likely to be recalled with ease and so be disproportionately weighed in any judgment.”

Recognizing Biases

In other words, instead of rationally calculating the correct odds of the outcome of an election, people tend to focus on “mental models they’ve formed in their heads.” Clearly, predicting anything, much less a “surprise,” is a difficult task, but by studying behavioral economics, one should at least be able to recognize and identify these biases before making unwise decisions.

It is once again in this spirit that ClearRock has created our “Top 3 Surprises.” The idea is to hang our hat on three predictions that may be at odds with Wall Street’s conventional wisdom for the coming year. We may or may not find investable ideas in these “surprises,” but we feel they are worth pondering nonetheless.

Our hope is that by considering ideas outside the mainstream and by consistently applying a thoughtful decision-making framework to our process, we can improve our investment outcomes each year.

 

Our Top 3 Surprises For 2017

Interest rates are not going to rise significantly higher in the next 12 months

The post-election conventional wisdom around Wall Street goes something like this: The new administration’s pro-growth agenda will include massive fiscal policy measures that will increase borrowing and push rates significantly higher.

Even though we think some of the president-elect’s agenda will move swiftly through Congress, much of the proposed spending will be kept in check by a Republican caucus committed to offsetting any new expenditures with budget cuts. The net result, in our view, will be less pressure on interest rates than expected.

The current Federal Reserve is notoriously conservative, and although it has targeted three rate increases for 2017, we think it will be resigned to a similar destiny as in 2016—a single rate hike—due to less-than-stellar demand as we enter the late stages of this economic expansion.

Many pundits are quick to make decisions based on short-term events (such as a new administration’s proposed policies), but there are long-term structural issues such as wealth inequality, low productivity, excess debt levels and unfavorable demographics that extend beyond our borders. In our view, these are leading contributors to sluggish worldwide consumer demand and will weigh heavily against the Fed’s willingness to aggressively raise interest rates anytime soon.

Diversification will regain favor among portfolio managers and investors

While diversification is part of ClearRock’s DNA, many investment advisors and investors have drifted into market timing, chasing performance and generally taking more risk than is prudent for their clients.

Those who have successfully pivoted into 100% U.S. stocks over the past three years have been rewarded with an annual return for the S&P 500 of more than 8.80%. Few investors, however, actually realized these returns. Studies by Goldman Sachs and Dalbar prove that most individual investors consistently underperform the market benchmarks due to market-timing decisions. (This “behavior gap” is usually motivated by emotions and a lack of sound judgment.)

 

In fact, as of the end of the third quarter of 2016, mutual fund flows (an excellent indicator of small investor behavior) showed that the average investor was underexposed to the U.S. stock market and overexposed to the bond market. Hedge funds and other expensive “alternative” investments have also recorded generally dismal returns, leaving many investors to wonder why they are paying high fees and taxes for such mediocre results.

We favor a more broadly diversified approach, incorporating foreign markets, commodities and bonds to balance out the volatility that will surely result as a new administration and Congress attempt to sift through an audacious agenda of tax, health care and regulatory reform. We think investors should get used to diversified-portfolio returns in the mid-single digits as rates stay relatively low and stock market returns don’t match levels of the past three years.

US foreign relations improve and help drive global markets higher

This is our boldest prediction. We believe the character qualities and personality traits that make a political leader unlikeable can be the same factors that sometimes make one successful.

Harsh rhetoric aside, we believe Trump will realize that shutting off the rest of the world to the U.S. in the name of holding onto Rust Belt jobs is counterproductive. We think he will seize on an opportunity to improve international relations rather than risk global calamity. His intense desire to be a “winner” should propel him to improve trade relationships with China and Mexico.

He also sees the benefit of a unified Europe and in cementing ties with Merkel. The U.S. can help Germany avoid political turmoil, bringing stability to the EU in the face of Brexit. He recognizes that he can’t unilaterally break the Iran nuclear deal, and instead will work with Putin to negotiate a permanent cease-fire in Syria, thereby marginalizing ISIS.

As these geopolitical tensions ease, investors should see value in markets outside of a fully priced U.S. stock market, and as a result, push foreign markets higher.

No one, including Nobel Prize-winning psychologists, can consistently predict what’s going to happen, and more importantly, when it’s going to happen.

Staying diversified and paying attention is a time-tested way to preserve and grow your investment portfolio.

Mark Eshman is co-founder and CIO of ClearRock, an SEC-registered investment advisor with offices in San Francisco and Sun Valley, Idaho. ClearRock clients currently own JNK, ITA and STIP. Contact: [email protected]For a full list of disclosures, please click here.

 

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