Category Archives: Blog Post

Rearview Mirror

In December, 2008, a client transferred his account to my practice.  He was in cash.  I advised that he had a special opportunity to, in all likelihood, double his account in about 5 years by buying cheap stocks during a market panic.  I couldn’t convince him.  He was nervous.  Just when I thought I’d saved him from himself, he ordered me to sell everything I’d implemented, on March 6, 2009.  Perfectly bad timing.  C’est la vie.

Since the U.S. stock market hit bottom on March 9, 2009, the S&P 500 Index had risen 248% as of the first quarter of this year. In little more than six years, the present bull market achieved third-place rank among the top 10 bull markets.

Bull Market Chart

 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, since you cannot invest directly in an index.

Market Cycles

Many are questioning the duration of the current market cycle. Aren’t stocks due for a correction?  We are conditioned to expect a bear market periodically.  Commentators remind us of the average duration of bull markets, with the implication that the current expansion is long in the tooth.

While pressures that can trigger recessions can build over time, those pressures are largely absent in this bull market.  Post financial crisis recovery has been at a glacial pace.  Persistent unemployment, the anemic housing recovery, interest rates in extended remission, the specter of deflation looming as a threat; these factors point to a weak but gradually improving economy.

The increasingly interconnected global economy creates potential for macro risk, but it also creates new opportunities.  The US no longer dominates the world economy as it did in the post WWII era, but it is positioned to lead the expanding global economy with the increasing opportunities of a growing middle class abroad.

How to Prepare for the Next Crash

First let’s define “Crash”.  To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover?  Another consideration is stock market valuation.

By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years.  The risk of a crash depends on valuation.  The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield.  That’s reasonable.  Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal.  It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.

So how do you prepare, just in case?  The conventional approach to hedging the stock market is to incorporate bonds to a portfolio.  You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio.  Currently the ability of bonds to generate income is diminished by Fed policy.  While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons.  Choose your poison.

An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time.  A key benefit of financial planning is that it identifies liquidity needs.  During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist.  This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.

The Benefits of Rebalancing

If stocks historically have higher returns than bonds, then selling stocks to buy bonds reduces portfolio returns over the long-term.  Conversely, for those with the fortitude to sell bonds and buy stocks when there’s blood in the streets, the process reverses.  The effect is more likely reduced volatility than increased returns.

I’d rather build a portfolio by planning for liquidity needs rather than putting the client’s emotional IQ in control of his asset mix by managing to control volatility.  Warren Buffett doesn’t rebalance.  I prefer to manage risk in the context of valuation.  That, I can control.

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.

The Taper Effect

As of 7/25/2014, the S&P 500 is up over 7% YTD. That’s on top of last year’s 29.6% gain. It’s enough to make some people nervous.

I believe an important consideration that seems to have eluded the Breaking News focused media, is the reduction in the Fed’s bond-buying program to $35 billion. The program has already been reduced from a high of $85 billion/month, with five straight cuts of $10 billion each month since November. I think the dramatic reduction in the bond-buying program greatly reduces the risk of unintended consequences of continuing large purchases in the unprecedented program.

But there is another shoe to drop, and that’s the eventual rise in interest rates. As long as fundamental indicators continue to improve, the market should be able to sustain current “normal” valuation levels despite higher, but “normal” interest rates. Steady as she goes.

Financial Engineering, a Personal Example

In 2002 I refinanced my house to lower the interest rate but kept the payment the same.  This allowed me to get a larger mortgage and walk away with cash.

On 11/20/2002, I deposited $10,000 of the refinancing proceeds to a College 529 Plan for my then 1-year old son.  By 1/1/2003, the value of the account had declined to $9,797.07.  As of June 30, 2014, the account was worth $30,365.04.  There have been no other additions to the account.   Using 1/1/2003 as the start date, the annualized return has been 10.4%, despite the worst financial crisis of my lifetime.

The best part is, it didn’t cost me a penny out-of-pocket.*

* Net cash flow impact of both transactions.  Investing involves risk of loss.  Past performance is not a guarantee of future performance.  This example is intended to illustrate a creative solution to long-term investment goals.  This strategy might not be available currently for numerous reasons, including changes in mortgage underwriting standards.

Great Ideas, Bad Timing

The stock market is setting new highs, but fundamental economic data remains subpar. For the past several years, we have expected “next year” to finally break out to a GDP growth rate of at least 3%, representing an escape velocity to grow our way out of the credit crisis doldrums.

The zero interest rate policy sustains the slow growth scenario, but there is only so much Fed monetary policy can do. The fundamental problems are fiscal in nature, and until Washington decides business and rich people are not the cause of the problem, we’ll continue to trudge along. Policies to stimulate business and job creation would be a nice start. Can you name one pro-business policy? Requiring businesses to offer health-care helps some people with medical issues, but does it stimulate job creation? Raising the minimum wage has noble intent, but if you are running a business, you’ll sharpen your pencil again before expanding.

No one can say how long the divergence between disappointing GDP growth and a rising stock market will last. Either the economy’s pent up demand overcomes Washington’s bureaucracy and grows faster, or we’re in for a correction. Let’s ignore the possibility of change in Washington for the meantime.

The key takeaway is, plan for liquidity, lean toward equity with the balance, and hope Washington will get out of the way. Lyndon Johnson pushed his Great Society programs at the same time as he funded the Vietnam War. We had a miserable decade in the stock market. Obama is pushing social reforms at the same time we try to recover from a credit crisis. Great ideas, bad timing.

Where the Wild Things Are in the Economy

One takeaway from 2008 – 2009 is that sometimes diversification does not work as planned. Most investment asset classes declined in the credit crisis.  Cash is the conspicuous exception.

As noted in last Friday’s post, reserving for liquidity is even more important than usual (given my perception) of the elevated prospects for a market convulsion, as we make our way back to the old normal.  There’s a lot to be said for cash as an alternative to bonds.  If interest rates or inflation spikes and bond prices plunge, and if cash is available to scoop up the bargains, losses on long positions can be mitigated.

Holding cash means accepting a negative rate of return on an inflation adjusted basis.  Long-term, this is a losing strategy.  As a tactical allocation, it means not being greedy.  And if you need liquidity, it’s just common sense.

Finally, if the US dollar falls in a currency crisis, the price of imports will rise.  Perhaps the best way to hedge against the currency risk of cash, is an expanded international allocation denominated in foreign currency.  But if the “correction” is global, then the US dollar will be as good as other currencies and might prove to be a safe haven.  If this seems like a circular argument, that shows how interconnected things have become.

Bubbles

During the past 20 years, we suffered 2 vicious corrections, 2000 and 2009. Attribution is simple. In 1999, tech stocks took off to the moon on the back of internet hype. Then, the combination of low interest rates, a love of real estate born of the prior equity bubble, mortgage securitization, and other factors led to soaring house prices. By 2007, houses were generally highly leveraged and overpriced. The collateral damage of the housing and mortgage crisis spread throughout the economy in ways few had imagined.

Which brings us to today. Allow me ask the obvious, what is overpriced today and which dominoes might prove vulnerable in a correction? Our artificially low interest rates and corresponding bond valuations seem the most likely candidates for disruptive movements.

The factors driving interest rates are complex, and countless financial instruments are tied to interest rates. This is not to predict economic Armageddon, but the dominos are set. There are paths to unwind QE without disruption, but we have not been down this path before. We can hope the path to normal will not be too disruptive. I am acutely aware of what I don’t know, but I have an idea where it might come from. This is fat tail risk.

When liquidity is important, it is important to reserve for it. If managing volatility is important, you might pay a steep price to hedge. Much like the crisis of 2000 and 2009, this one, if it occurs, will likely pass within a few years. I suggest reserving for liquidity needs anticipated within 3 to 5 years, and staying the course with the balance. Manage risk, don’t try to avoid it (you can’t).