Dear Mr. Market:

The entertainment and shock value you provide us with the stock market might meet its match over the next few weeks. Are you ready for some surprises and wild finishes? That’s what March Madness brings each and every year! It’s also an opportunity to take a high level view of the current investment environment with what lies ahead.

Six years ago we became the first Registered Investment Advisor to use the NCAA basketball tournament as a way to show our readers a forward-looking view on the stock market. We break down and assign each of the four “regions” with an asset class and then pick teams (companies) that we think have the best chance at doing well relative to others.

This year we will dive right into our investing bracket looks and how we think the remainder of 2016 will play out.

Click here to see the entire bracket.

To set the table let’s take a quick moment to recall last year and the undefeated Kentucky team. They came into the Final Four 38-0 and were a virtual lock to win it all but as you may remember the Wisconsin Badgers shocked everyone and provided the surprise millions of fans tune in for every year! This type of “upset” is exactly how we think 2016 will pan out in the Large Cap asset class.

Large Cap

Five years from now people will look back at 2015 as a year that the stock market extended its bull market run for one more year. Investors will exhibit a short-term memory lapse and forget that it actually was a very rough year with heightened volatility, the first correction, and a market that actually turned in negative numbers if you looked “under the hood”. The problem is…most people will not remember this and only look to see the S&P 500 finished positive +1.38%.

Without the “FANG” stock phenomena, however, 2015 would have been very negative. In other words, the index was falsely propped up by some mega cap names like Facebook, Amazon, Netflix, and Google (ergo the acronym “FANG”). Without the massive performance that these companies returned, the average breadth of the market was negative and dismal.

Key Match-up:

#1 Amazon (AMZN) vs. #6 Lockheed Martin (LMT)

As you’ll note in the above bracket we have Amazon (AMZN) continuing to outperform the vast majority of the market until it runs into Lockheed Martin (LMT). Simply think of Amazon as last year’s Kentucky and Lockheed Martin as Wisconsin… In other words, the overwhelming favorite gets knocked out by a fundamentally sound company that in our opinion will continue to outperform the broad market in good years and bad. Along with a dividend of 3% take note of how the stock has performed versus the index; not just this year but going back as far as you can (since 1995 it’s up +721% vs the S&P 500 at +312%).

Small and Mid Cap

The committee that seeds and chooses which teams should be in each bracket does their best to create intriguing match-ups with some level of parity. That being said, there is always a region that simply looks weaker than the others. If there is an asset class that we have collectively become lukewarm to, it’s Mid Cap and especially Small Cap.

The rationale for this is simple and you saw it best demonstrated during the market correction last August as well as what happened in January. We believe that as we enter the mature phase of an aging bull market, you’ll see Mid and Small cap underperform Large Cap. This is the type of year where we could easily see a very adept and competent manager make nimble picks that could outperform an index. Again…the chances are slim but we picked one mutual fund that at least is doing its job and earning their keep (for now!).

Key Match-up:

#5 Queens Road Small Cap Value (QRSVX) vs. #3 U.S. Cellular (USM)

If you’re a regular reader of My Portfolio Guide you’ll quickly know that we are typically not fans of very many mutual funds. Long story short, since most are expensive and drastically underperform their passively managed benchmarks, you better have a really good reason to buy one!

There are some rare instances, however, where taking a more “active” investment approach might prove wise. Over time we’re still convinced you’ll want to lean towards an index but at least over the last year the Queens Road Small Cap Value fund has handily outperformed the Small Cap index (+2.87% versus -9.80%).

We have United States Cellular (USM) screening out as a great value stock that is on the rise right now. Although it’s up almost +15% this past month alone, our opinion is that one should leave the individual stock picking to a proven value manager in an environment like this. Regardless if you lean towards the “active” or “passive” camp, both the Mid and Small cap asset classes are ones where we’ve tapped the brakes a bit. We would remain weighted more towards larger and more economically resilient holdings in what could still prove to be a very volatile environment.

International

We’ve all been on a flight and heard the pilot announce, “we’ve put the seatbelt light on as we are expecting some turbulence, could be in for a bumpy ride”.  Investors would benefit from hearing this statement as it certainly applies to investing in International (both developed and emerging) Markets!  Investors have been underweighting their overall allocation to international markets based on recent performance – looking back at the last 20 years this could be a decision they will regret.  Over the last few decades there are time periods where international stocks drastically outperform U.S. stocks.  A recent example of this is from 2000 – 2009 when the S&P 500 posted a compounded annual loss of -0.9% while international investments had returns of +12.8%. Investors that focused on domestic investments during that time frame are still playing catch up!  Currently more than half of the world’s market capitalization is outside the United States and we expect this to only increase.

Key Match-up:

#4 iShares Brazil Index (EWZ) vs. #10 Vanguard Emerging Markets Index (VWO)

This match-up features two ETFs that were beat up in 2015 but are showing signs of life!  iShares Brazil ETF (EWZ) offers access to 85% of the Brazilian stock market.  Brazil has been hit hard recently with high inflation, low worker productivity and the drastic decline in commodity prices.  It wasn’t that long ago that Brazil was a proud member of the BRIC (Brazil, Russia, India and China) investment play that dominated the international investment scene.  This summer Brazil will capture the world’s attention with the Summer Olympics in Rio de Janeiro but we expect the impact to be short lived and for the most part already priced into the economy.

Vanguard Emerging Markets Index (VWO) is a “team” much like Wichita State – you don’t want to bet against them as they’ll come through with a win when you least expect it! When an asset class is getting beat up it is important to monitor it but jumping out is a move that often will come back to haunt investors. After sporadic performance in in the late 90’s Emerging Markets became the #1 performing asset class from 2003 to 2007 and returned to the top spot in 2009 and 2012! Whenever a new business cycle begins to occur you can expect asset class rotation where yesterday’s laggards become leaders of the pack…

These two investments surprise many as they decide the winner of the international bracket this year.  While Brazil will see a sudden inflow of tourism with the Olympics there are simply too many negatives surrounding Brazil on a long-term basis.  The diversification that VWO offers propels it to the victory in this matchup.  As investors have moved out of the international space based on 2015 performance many have failed to realize that VWO is actually up over 10% in just the last month!  VWO takes the win, cashing in a ticket to the Final Four… 

Bonds and Alternatives

One golden rule of thumb that we hold is to “never completely abandon an asset class”. This area of our bracket speaks to both sides of that coin!

With regard to Bonds it won’t take an investment genius to let you know that this asset class holds little promise in being your top performer with interest rates on the rise. That being said, however, it’s foolish to dump the entire asset class since you’ll need it during increased periods of volatility. If you periodically rebalance portfolios like we do, you’ll clearly know that during the last market correction there was no better feeling than being able to sell some bonds (which held up decently) and buy beaten up stocks.

Conversely, even the most seasoned investment managers have sold out of the one thing they should be ramping up their exposure to….Alternatives! OK…let’s get the obvious part out of the way; if the brutal beating energy stocks imposed on the broad market didn’t hurt you it sure did in areas like managed futures or any direct exposure to commodities! Once again though…the old adage of “buy low sell high” should be adhered to now.

We firmly believe that this part of the “bracket” (specifically alternatives) should now make up about 20% of your overall portfolio in 2016. If the way the markets sold off in late summer or the first part of the year rattled you, now is the time to reallocate and increase exposure that is not strongly correlated to stocks or bonds.

“The best time to repair the roof is when the sun is shining.”

-John F. Kennedy

Key Match-up:

#2 Merk Absolute Return Currency (MABFX) vs. #9 Powershares Currency Harvest Fund (DBV)

OK…so the operative word in this match-up is “currency”! Don’t be immediately scared of currencies (or even commodities). Investing in currencies is an area that does indeed take expertise and one that we farm out to Merk Absolute Return Currency Fund (MABFX). There was a period last summer when the market was down about -9% and this fund was up about +3%. That’s the type of inverse correlation you should seek for and especially in a market that has wobbly legs. Whether you choose to use a passive managed index like Powershares Currency Harvest Fund (DBV), or something like MABFX, just make sure you have something in this bucket.

We have seen the dollar reach extreme levels and that can only last for so long. Within the commodity arena everyone knows the oil story and although it may not happen overnight, that too will revert back to some level of normalcy. Lastly, you’ll note that we have a similar stance on what is happening in the global markets. As we describe in the International bracket, we’re obviously not out of the woods yet but this is not the time to give up on asset classes like Emerging Markets but rather take advantage of their relative valuations. In summation, expect parts of 2016 to offer investors the opportunity to be aware of a reversion to the mean. We’ll explain more of this in our Final Four Summary.

Final Four Summary:

The New Year started off with a brutal hangover! Although the stock market has clawed its way back a bit with a strong beginning in the month of March, nobody really trusts tomorrow! Finding news and articles that are of the doom and gloom variety has been easy. From the start we pointed out on page four in Q1 2016 edition of “the Guide” (our free investment newsletter) that we believe this year won’t be one with a dramatic “up or down” year. We stated early on that we’ll likely finish slightly positive on the year and at the time this was written the stock market was down -12%.

In an environment when stocks may not seem appealing and bonds are due to get blasted, you need to not bank on just one asset class. The other, and perhaps most important strategy you need to employ, is having ample exposure to asset classes that are not highly correlated to either stocks or bonds.

Another huge factor that only savvy investors will understand and take advantage of is the “reversion to the mean”. Mean reversion is a contrarian investment strategy where prices return to a “normal” level after they’ve reached extreme highs or lows. There is no better analogy of market psychology than what happened to the Kentucky Wildcats last year. In stock market terms it provided us the example of herd psychology. Just about every office pool (and countless bets in Las Vegas) had Kentucky winning it all easily.

We believe this year wants to bait you into this same type of mentality. There will be times when you’ll be tempted to sell every stock you own and never come back. There will be other times when you’ll read or hear something that convinces you that the sky isn’t falling after all and it’s safe to come out from your bunker. All that said, make sure you’re diversified and able to shelter yourself from as much “market noise” as possible. We’ve outlined some investment themes and choices to enable you to do that…now enjoy the rest of Big Dance!