Russ Koesterich, CFA

Disposable income refers to the income available to a household or individual after paying off personal current taxes. Disposable income is still below historical averages.

Today, most measures of credit conditions are positive, with tight spreads across all of fixed income. Even high yield spreads have come in after a short scare last month.

The great American deleveraging has largely been limited to the financial sector (XLF) (IYF). Non-financial debt is still much higher than historical averages.

Valuations are at the higher end of their historical range. Investors should avoid defensive sectors, which are highly sensitive to interest rate changes.

According to estimates by EuroStat, Greek debt stood at more than 315 billion euros at the end of September 2014.

After September’s strong jobs numbers, a Fed rate hike could be on the horizon early next year. Russ explains two equity market implications.

We’ll explore whether record highs signal a top for equity markets or whether there’s still some room for growth in the current bull market.

Lower interest rates have an inverse relationship with stock prices, so when interest rates are lower, the S&P 500’s trailing price-to-earnings multiple rises.

With yield likely to be a scarce commodity due to the global slowdown, utilities and other high-dividend paying sectors like staples (FSTA) are gaining investor attention.

I would pay particular attention to the Shiller P/E Ratio, which is a variation on the Cyclically Adjusted P/E or CAPE. This indicator is worth watching as it has historically correlated with long-term stock market returns.

The CBOE Volatility Index suddenly rose 6.0% on November 9, 2016, after it was clear that Trump had unexpectedly clinched the election.

Rising stocks have been buoyed by various factors, including the accommodative monetary policy of the Federal Reserve and robust US corporate earnings.

So what should investors be doing today? While inflation may take another year or more to get going, it’s not too early to start implementing long-term inflation hedges.

Recent readings have shown that inflation has stabilized, which is a good thing, but signs of an imminent acceleration in inflation are still scant.

While 2016 is likely to be another year of slow global growth, I don’t foresee a global recession. China remains a genuine threat, but the government has additional tools to manage a slowdown.

After a year with relatively less drama, European politics are likely to return to center stage next year.

In the past few years, value stocks haven’t posted impressive gains. Many of them look cheap and have trailed the broader market as investors lap up growth stocks.

Utility sector valuation appears stretched. 2014 was a great year for utilities, which gained 26.62% ex-dividends and were the best-performing sector.

Equities slumped worldwide after the shocking Brexit vote, but US equities had already become directionless. We’re definitely living in a low-return environment.

The number of people above 65 years is expected to triple from 531 million in 2010 to 1.54 billion in 2050—the population of seniors in the U.S. (IVV) (SPY) is expected to more than double and increase from 41 to 86 million in the same time period.

Unconstrained bond funds use leverage and derivatives in their portfolios, which magnifies their risk. They have exposure to both credit and interest-rate risk.

Holding cash is risky, as it provides negative real returns in the long run.

With growth projections of most major economies falling, it is likely that volatility will stay elevated.

Major central banks are now diverging in their monetary policies, a dynamic we saw vividly on display last week with the Federal Reserve ending its quantitative easing (or QE) program, while Japan expanded its version of QE.

Large caps will be in a much better position to navigate through this period given their cash positions.

While these exotic markets are not for everyone, more aggressive investors should consider having a small strategic allocation to the frontier.

The US economic recovery is truly on. This is great news for the US stock markets, which went up after the news.

Weakness in the labor market means low interest rates. The US economy is gaining momentum with stellar growth rates in the last two quarters. It grew by 4.6% in 2Q14.

Wage growth could cause rates to rise. A hike in wage rates could boost consumption and encourage individuals outside the labor force to join. This will increase disposable income.

In addition, many market watchers are concerned about slowing growth in the Eurozone. While the region is unlikely to boom anytime soon, there are some signs that any further slowdown there should be modest.

Diversification: Finally, companies in frontier markets tend to just focus on demand in their local countries and thus are less tied to the global economy than emerging markets like China and Brazil. As my colleagues Del Stafford and Daniel Morillo pointed out last fall in blog posts, this means frontier markets have exhibited a low […]

Developed markets are offering value. The Eurozone has come out of the recession and is seeing some green shoots of growth.

Weak global demand and a strengthening dollar have affected oil prices.

With classic safe havens providing little protection, turn to financials and healthcare sectors for opportunities. Healthcare stocks usually hold up well in the run-up to a rate hike.

While valuation is important, investors should also pay attention to sentiment. The goal is to gauge how – to steal a phrase – “irrationally exuberant” investors have become.

Much like US consumers, Australian consumers are in the process of repairing their balance sheets.

The last three months have seen subdued retail sales despite lower oil prices.

A weaker euro could lead to inflation in Europe. The depreciation in the euro was initially due to the appreciation in the dollar.

Although not considered safe haven assets, in the current context of high geopolitical risk and consequently volatility, investors could consider investing in sectors like energy and large cap companies.

Inflation remains subdued by all measures. Since inflation is way below the Fed’s long-term target, the Fed can afford to keep interest rates lower for a little longer.

Slower growth has a silver lining: the potential for greater monetary and fiscal stimulus.

Commodity (DBC) prices have been heading lower since 2011, and commodities have been the worst-performing asset class of 2015.

DJTI’s price-to-earnings ratio climbed from 15.7x at the start of 2013 to 20.2x at the end of 2014. This year, transportation stocks (IYT) have taken a hit, leading to multiple contractions.

A stronger dollar is a headwind for export-oriented stocks. The US economy is relatively robust.

The three-month Volatility Index (or VIX), which measures the implied volatility of options on the S&P 500 stock market index, is approaching record lows.

While volatility fell over the course of August, the VIX’s daily average for last month was approximately 15% higher than its average over the previous three months.

Small-cap banks have been underperforming due to the yield curve that has been flattening since the start of 2014.

The Chinese market slump is not likely to dampen consumer spending or affect the economy. Stocks make up a mere 15% of Chinese household financial assets.

Truth: Emerging markets offer value. Given that they’re generally growing faster than their developed world counterparts, emerging markets still look cheap by most metrics.

Real US rates have been climbing, while rates are falling in much of the rest of the world. As Russ explains, this divergence has a number of implications for investors.

The market may be too complacent about inflation expectations at the moment. If this is true, this makes TIPS attractive at the moment.

The Fed has already ended the quantitative easing (or QE) program. It could increase rates in mid-2015. This could be another headwind for equities.

A market rebound of more than 12% from the depths seen in October has left investor sentiment buoyant.

As earnings reports and analyst call transcripts show, many of the companies reporting sales misses cited the strong dollar as a contributing factor.

In an environment of generally decent, albeit recently disappointing, growth and gently rising yields, high yield offers attractive potential in a yield-starved world.

Soft European growth could affect US stocks. Growth in Europe (EZU) has been weak for a while now, which is concerning.

The fact that volatility levels remain as low as they are today suggests that the market hasn’t factored in the possibility of geopolitical risks picking up.

Keeping with his annual tradition, Russ compares the year that was to the year that he expected.

As we’ve suggested throughout this series, US stocks don’t have a clear growth catalyst once interest rates rise. Still, you may find value in select sectors such as financials and technology.

Another possibility is that an adverse reaction to Federal Reserve (or Fed) tightening could rattle markets. But here again, the risks are likely overstated.

The fraction of total gold output held by central banks around the world has continued to decrease over the last decade and a sharp reversal in this trend is unlikely.

European euphoria captured markets in Europe and took them by storm. The Stoxx Euro 600 Index surged 5.1%, marking its biggest weekly increase in almost three years.

Currently, the S&P 500 is giving year-to-date (or YTD) returns of more than 8%. It posted gains for seven consecutive quarters. The S&P 500 Index (SPY) closed at a new high 34 times in 2014.

Increased mergers and acquisitions activity in the past couple of weeks has supported US equity markets (SPY).

Although tech stocks have been buoyant in 2015, we don’t think that this means the advent of dotcom bubble 2.0. There are some key differences.

Many structural considerations are likely to keep yields low in the future. Demand for Treasuries and bonds is likely to be more than the supply in the next two years.

Of course, a strengthening U.S. economy may have a downside. If the Federal Reserve (or Fed) increases interest rates too soon or by too much, markets could be rattled.

There are no truly reliable measures of future growth. That said, certain economic statistics have historically led overall growth.

While a traditional emerging market benchmark is up 1.5% year-to-date, frontier, or “pre-emerging” markets, have been performing well.

Mega caps outperform small caps when interest rates rise. The last two rising rates scenarios took place during the late 90s and in the mid-2000s.

Not all emerging markets (EEM) seem investment-worthy. Only some consumption-driven emerging markets appear attractive.

High-dividend emerging market funds offer a cushion when you face market volatility.

While no longer cheap per se after their extraordinary run in 2014, municipal bonds continue to look attractive versus both Treasuries and corporate bonds.

The federal funds rate is a tool that the Fed uses to control the interest rate in the economy. The rate has been close to zero for over six years.

Finally, the majority of the emerging market countries have much less “fiscal baggage” than their developed market counterparts.

Favor credit over duration as interest rates rise. Look for tactical opportunities within fixed income.

REITs are providing an average dividend yield of 3.5%, so investors are drawn to them. This is causing rich valuations and making REITs look overpriced.

A softer rebound could move markets in the second quarter. If the economy remains weak in the second quarter, the Fed has some leeway to maneuver the rate.

For example, at least historically, small cap valuations have been more sensitive to changes in monetary conditions than their large-cap counterparts, and this was evident last week.

Bad news may be good news for international stocks. Europe is struggling with deflationary headwinds and Japan is suffering under the burden of last April’s hike in the consumption tax.

Although inflation is low, it’s a good idea to have a small amount of inflation hedge in your portfolio. A small inflation hedge adds diversification.

Municipal bonds (or munis) were the best performers in 2015 with returns of 3.2%. Meanwhile, investment-grade corporate bonds (LQD), long-dated Treasuries (TLT), and high-yield bonds (HYG) all gave negative returns in 2015.

Emerging market dividend payers are offering value, given their high volatility.

So-called frontier markets (FM) – those markets that are still at a very early stage of development — have been among the best performers in 2014, outperforming global markets (ACWI) year to date.

And while firms in frontier markets are less profitable than emerging market companies, frontier stocks look inexpensive even when this difference in profitability is accounted for.

Within the United States, I recognize opportunities, particularly in large cap, cyclical names. On the fixed income side, high yield now represents an attractive option given recent spread widening.

For now, we continue to expect a world in which U.S. growth overshadows that of other developed countries, resulting in a strong dollar and weaker commodity prices.

Focus on relative value. Given that most asset classes look expensive, I continue to prefer market segments that offer relative value.

The performance of gold as a contrast to the S&P 500 is reflected during periods of high and low volatility. The S&P 500 has always outperformed gold since April 10, 2013, during periods of both high and low volatility.

Diversify your portfolio for better risk-adjusted returns. From a portfolio diversification point of view, the correlation between two asset classes should be close to zero.

If you’re preparing your portfolio for the short term, the allocation to cash should be high. As the horizon increases, allocation to cash should go down.

U.S. stocks are no longer cheap, and that has stocks outside U.S. borders looking even more reasonable. Specifically, I see opportunities in Japan.

Where can you invest if the strength of the dollar is likely to continue? The stronger dollar is going to hurt the performance of large-cap stocks that have exposures abroad.

The economic make-up of the US has changed significantly over the past century, making the Dow Theory less applicable today than it might once have been.

EM currently trades at a big discount to DM. Emerging market (EM) equities are trading at 1.5x book value, while developed markets (DM) are trading at 2x.

The longer term outlook for Eurozone banks does look more positive than a year ago given reasons including the substantial deleveraging, capital raising by local banks and the European Central Bank (or ECB)’s recently announced ABS purchase program.

Today, small-cap indices are trading at a relatively expensive level versus large-cap companies. When real rates were negative, this premium was more justified.

Industrial commodities are likely to see lower prices as demand falls with slowing global growth. Yet a decent entry point doesn’t seem to be on the horizon.

Last week, the Bank of Japan unexpectedly expanded its own version of quantitative easing. This announcement came shortly after an inflation report showed that Japan’s CPI has dipped to 1%, meaningfully below its target.

Oil prices are expected to be lower for longer. This is bad news for high yield bond funds (HYG) (JNK) in the United States.