4th Quarter 2016

In the business world, the rearview mirror is always clearer than the windshield.
–Warren Buffett

Donald Trump’s surprise election victory spurred a rally in stocks and a corresponding selloff in bonds. The market expects that a combination of tax cuts and reduced regulations will result in improved economic growth and higher inflation. Financials, Telecom and Energy were the best postelection performers. Cyclical, low quality stocks drove the rally while defensive stocks lagged, erasing the outperformance of higher quality stocks for the year. The dollar rallied to all-time highs, negatively impacting the returns of foreign stocks. Developed non-US stocks managed to overcome the strengthening dollar and erase losses from earlier in the year. The MSCI Emerging Market Index ended the year with an 11.2% return, despite some fourth quarter erosion from a stronger dollar and Trump-related declines in Mexico and China.

Energy and MLPs rallied after the OPEC decision to limit production sent oil prices above $50 / bbl. The Saudis believed in 2014 that by temporarily depressing oil prices they would squeeze out the US shale producers and then be able to raise prices later with reduced competition. They lost this bet, conceding last fall with the announcement to curtail production. As oil prices fell, the technology to extract oil and gas from shale continued to improve, increasing productivity and reducing breakeven costs. Also benefitting American producers, the US is beginning to export meaningful amounts of natural gas through new liquefaction facilities. These factors bode well for the continued growth of MLPs. Misplaced fears over the death of the MLP business model have faded and the current 7% yield of the Alerian MLP Index offers a return difficult to match by the S&P 500 at its current valuation.

The bond market reacted to Trump’s election with a half-percentage point increase in the 10 Year Treasury Bond Yield, indicating higher expected economic growth and deficit spending. Concerns over losses in bond portfolios prompted many investors to re-examine their interest rate exposure. Rising rates drove the yield on the Barclays Aggregate Bond Index – more or less the ‘S&P 500’ of investment grade bonds – to a 2.6% yield to maturity. The index duration, a normalized measure of the length of bond maturities, is approximately 5 years. This number is useful in a couple of regards. First, it is a rough estimate of the percentage point price change to a one percent change in interest rates. So if future changes in interest rates cause the current 2.6% yield on the index to rise to 3.6%, the value of the index will decrease by approximately 5%. The second, and less appreciated, aspect of duration is that it corresponds to the time period an investor would have to hold an investment in the index after an interest rate increase for the total annualized return to equal the original yield. So if one bought a Barclays Aggregate index fund today yielding 2.6%, then the yield increases to 3.6% (with the corresponding 5% drop in value) and rates never changed again over the following 5 years, the annualized return would converge to 2.6%. This is due to the effect of bond maturities and reinvestment into new, higher yielding bonds. However, rates might increase further, causing additional future declines in value. It can be proven mathematically that no matter what the future path of interest rates the return on a bond portfolio will converge to the beginning yield over a time period slightly less than twice the duration (one year less to be precise). So if one is prepared to hold an investment in a Barclays Aggregate index fund for about 9 years, no matter what interest rates do in the future, the return over that 9 year period will average to 2.6% per year. The annualized return of a typical client bond portfolio with a 3-4 year duration will converge back to today’s yield over 5-7 years – no matter what interest rates do in the future. This should provide comfort for investors with long term allocations to fixed income.

Comstock’s strategy of overweighting US stocks, underweighting other developed foreign markets, and maintaining approximately a global market weight in emerging markets added value compared to the MSCI All-Country World Index. While in hindsight, the best performance would have come from a 100% allocation to US stocks, we continue to believe in the opportunities available among non-US companies and the importance of diversification. While the S&P 500 trades at moderately expensive multiples, foreign stocks are relatively cheap. Many of these companies will benefit from a stronger dollar and higher US growth. Consumption data remains strong for emerging markets and the 2014-2015 China-led economic slowdown appears to have ended.

While we believe that markets with growing middle classes, particularly in South and Southeast Asia, offer superior long term opportunities, less developed corporate governance and problems with corruption argue for active management. Passive investment strategies assume the existence of a diverse, competitive pool of active investors whose buying and selling activity ensure that security prices reflect anyone’s best guess of fundamental value and that corporate management respects the interests of shareholders. These assumptions become challenging when applied to emerging markets. The largest names in the index include quasi-state entities such as the Russian energy producers, Chinese banks and Brazilian natural resource companies. As the recent corruption scandal with Petrobras illustrates, these firms do not generally operate with the interests of outside shareholders as their primary motivation.

While purchasing a broadly diversified ETF may appear to be the most effective way to access the growth potential of emerging markets, in fact the emerging market indexes lack effective diversification. China comprises nearly 25% of the MSCI Emerging Market Index. Currently the index excludes the local Chinese A-share market. If that market was added, China would constitute over 40% of the index. Korea and Taiwan, markets which have per capita incomes comparable to many developed countries and the largest companies in these markets are global technology and industrial firms such as Samsung and Taiwan Semiconductor. Within most emerging markets, the largest companies tend to be quasi-state run natural resource companies and banks. Before the crash in commodity prices, banks and natural resource companies comprised over half the index. The entrepreneurial companies meeting the demands of the growing middle class tend to be small weights within the index. Comstock’s strategy has been to diversify exposure to this volatile, yet attractive opportunity. With a combination of active stock-picking and systematic diversification strategies, large country, sector and security exposures are avoided. We look to participate in economic growth and rising household incomes across these regions through investment strategies focused on products and services consumed by local consumers and businesses. These sectors have lower leverage ratios and more stable revenue streams.

As the opening quote indicated, too many people tend to take the false comfort of relying on the immediate past as a guide to the future. Navigating with the rear view mirror is dangerous both on the freeway and in the financial markets.

Diversification remains the only answer to an uncertain future. When financial markets enter a period of higher volatility, knowing what you own becomes critical. How many investors got flushed out of their MLP positions at or near the bottom because they did not understand the structure or the industry when they originally purchased the securities? How many of the new converts to ETFs will cut and run during the next bear market? Investment strategy should focus on maximizing the probability of achieving an investor’s financial goals.

– Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer

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