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Stocks close lower but S&P 500 posts 12% return for 2016

The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing. – Seth Klarman

In a year that was characterized by surprises and unpredictable events, it should probably be no surprise that the Dow Jones Industrial Average closed lower last week by about 1%, the first negative week for this major stock average since before the election. History tells us that the last five trading days of the year are typically positive ones for stocks as the S&P 500 Index has averaged a gain of 1.1% during this period since 1928. But in a very quiet week of trading marked by low volume and an absence of any potential market-moving data or earnings reports, all three major stock averages slumped and ended the year on a sour note. Despite the down week for stocks, investors had to be pleased with the returns for the year as the Dow finished higher by 13.4% with a total return of 16.5% while the S&P 500 Index rose 9.5% with a total return of 12% that included dividends. The technology-laden Nasdaq Composite Index also performed well with a gain of 7.5% for the year. Among the best-performing sectors of the market were energy (up about 24%), financials (up about 20%) and telecommunications (up about 18%). The worst-performing sectors included health care (down about 4%), real estate (down about 1%) and consumer staples (up about 3%). Although there were no significant pieces of economic data released last week, the data that were reported were generally positive and confirmed an economy that remains relatively strong with the potential to get even stronger heading into 2017 with the pro-growth policies of president-elect Donald Trump. The question remains whether or not he can deliver on his promises and how soon he can make his economic agenda a reality.

Last Week

Housing sector data was mixed last week as the S&P/Case-Shiller U.S. Home Price Index rose over 5% in October from the previous year while pending home sales in November fell more than expected. Weekly jobless claims declined by 10,000 to 265,000 and marked the 95th consecutive week that claims have been below 300,000, the threshold considered for a healthy labor market. The trade deficit widened in November as imports grew by $2.2 billion and exports shrank by $1.2 billion as the dollar strengthened since the election. The Chicago Purchasing Managers Index (PMI) for December was slightly lower than expected but still indicative of an expanding manufacturing sector. The biggest surprise last week was the consumer confidence index for December, which came in at the highest level since August 2007.

The U.S. announced sanctions against Russian individuals and organizations thought to be involved with interfering in the U.S. presidential election by expelling 35 Russian diplomats and closing 2 facilities.

For the week, the Dow Jones Industrial Average dropped 0.9% to close at 19,762 while the S&P 500 Index lost 1.1% to close at 2,238. The Nasdaq Composite Index tumbled 1.5% to close at 5,383.

This Week

The most important economic release this week is the December employment report, which is expected to show that about 172,000 new jobs were created and that the unemployment rate ticked higher to 4.7% from 4.6%. November factory orders are expected to decline after posting a healthy increase in October while construction spending in November is forecast to rise modestly in line with the previous month. The December ISM manufacturing PMI should confirm a sector that is expanding solidly and slightly better than the November reading. The Federal Reserve also will release the minutes from its December meeting.

It figures to be a quiet week for quarterly corporate earnings reports as the most notable companies on the agenda include Monsanto, Walgreens Boots Alliance, Constellation Brands and restaurant chains Ruby Tuesday and Sonic.

Portfolio Strategy

While the S&P 500 Index posted a total return of 12% in 2016, a portfolio that was well-diversified by the various asset classes to include small and mid-cap stocks and overweighted in so-called value stocks or high dividend-paying stocks performed significantly better. The outperformance of dividend-paying stocks would have been even more pronounced had interest rates not risen by such a large amount in the second half of the year. The yield on the 10-year Treasury rose from 1.37% in July to 2.45% at the end of the year, making dividend-paying stocks and dividend growth stocks less attractive. Funds that emphasized high dividend-yielding stocks generally held on to beat the S&P 500 while funds that invested in stocks with a long history of dividend growth wound up slightly trailing the benchmark. Across all domestic equity classes (large cap, mid-cap and small cap), value stocks, which are characterized by their below market price earnings ratios and above-average dividend yields, trounced the performance of growth stocks, which trade at much higher multiples and pay little or no dividends as companies tend to reinvest their earnings back in the business rather than pay them out in dividends. The biggest disparity occurred in small cap stocks, where a typical value fund returned about 25% compared to only about 11% for a growth fund. Similarly, the average mid-cap value fund returned about 15% compared to just 7% for a mid-cap growth fund. For large cap funds, value returns were approximately 17%, easily beating growth returns which were only about 6%. Not only is diversification among individual stocks an important way to reduce risk and increase the potential for higher returns, but it is also important to diversify among various asset classes and styles as a way to augment the total return of a portfolio.