Tag Archives: investing

A Letter to Clients Regarding Current Volatility

A few of you have contacted me to ask about the current market downturn, which leaves me wondering what everyone else is thinking. Just in case you find the market unsettling, allow this perspective.

You might recall from my email with the 4th Quarter Reports, sent on January 2, I said, “The market appears fully valued and then some, by about 4%.” In January, the S&P 500 gained 5.62% on little fundamental change. That suggests that the market was overvalued by nearly 10%. On February 6, 2018, the market officially entered correction territory by trading at least 10% off its recent high. That puts it about where I suggested it should be.

I believe the market will trade +/- 10% of fair value about 95% of the time. That means that if a 20% correction occurs when the market is 10% over fair value, nothing extraordinary occurred. Someone who just watched a $2,000,000 portfolio lose $400,000 might not share my perspective, but it’s just math.

According to Deutsche Bank, the stock market averages a correction about every 357 days, or about once a year. The one before this was over 2 years ago. The next question is how long they last? According to John Prestbo at MarketWatch, a Dow Jones Company, the average correction (of 13.3%) lasted about 14 weeks.

For long-term investors, corrections represent an opportunity to purchase quality stocks at bargain prices. The price dip is only a problem if you are leveraged or are a short-term trader.
For now, I expect the market to struggle as the 10-year Treasury rate rises. This pattern is likely to continue until 1st quarter earnings are reported, and corporate write-offs associated with tax reform are behind us.

As the legendary North Carolina basketball Coach Dean Smith was known to say to his teams during timeouts near the end of close games, “Guys, we are exactly where we want to be.” The message was to focus on what you can control and execute.

As always, the first step in building a portfolio is to define the liquidity requirement so we are never forced to sell at a time not of our choosing.

How High is too High?

What difference 3 quarters makes! The S&P 500 is up 14.2% year-to-date, and 4.5% in the 3rd quarter. After the initial Trump rally, nearly everyone, myself included, expected some type of correction. The market continues to brush-off geopolitical concerns. While North Korea might make for scary headlines, the markets are voting that it is unlikely to have a real adverse impact on corporate earnings.

Stocks sell at a multiple of current earnings. The multiple depends on how the market views future earnings. The question of how high the market can go is to ask how much the businesses in the index are worth.

The good news is that there really is not a limit. If a working man puts $5 in a jar every day and does not die, how much is the jar worth? I can calculate how much you should pay for this man’s savings today, but over time, the answer is unlimited.

This is not to suggest the market can’t be overvalued because it can be. Rather, there is no number that represents an absolute limit. I believe the market is moving higher because we have an administration that is pro-business and focused on tax reform. Fiscal spending is also becoming a factor.

There is room for further gains, but corrections will happen. Volatility is the price of equity returns, and that’s been missing for the most part. Stay the course but plan for liquidity.

The Oracle of Charlotte

It’s been eight years since the market hit bottom.  As Morgan Housel of The Motley Fool wrote, “If you went back to 2008 and predicted that over the following eight years the stock market would triple, unemployment would plunge to 1990s levels, oil prices would fall 80%, and inflation would stay tame even while interest rates stayed at all-time lows — I’m telling you, not a single person would have believed you.”

Ok, I didn’t say that exactly, but I got the part right that mattered most.  It was in December 2008.  I was onboarding a new client.  His portfolio was in cash equivalents.  I believed that while we were in the midst of a financial crisis, stocks were oversold compared to intrinsic value.  I told my new client that I believed he had a unique opportunity to triple his money in 5 to 8 years.  Few people are so fortunate as to find themselves with cash at the bottom of a market.

in April of 2009, he fired me.  My mistake was to buy equities in the last days of February, within a week of the absolute bottom.  In retrospect, my timing was nearly perfect, but he couldn’t handle it.  I called him a couple of years ago.  He told me firing me was the biggest mistake he ever made.  I’m guessing it hasn’t gotten any better for him.

Post Election Outlook

The election is finally over.  Markets are beginning to price in the upside potential of a shift to a pro-growth government led infrastructure-led fiscal spending.  This is something I have cited over the past couple of years as the missing piece of policy that could stimulate the economy, given that monetary policy has run its course.

Trump didn’t include a lot of detail in his campaign rhetoric.  Maybe he doesn’t know the details, but we can certainly ascertain his drift.  We do know an administration is a lot more than one person, and collectively, these others will bring the expertise to Trump’s agenda.

We can expect an increase in infrastructure spending.

Trump is known for putting his name on large buildings.  Just imagine if he were President.  According to Capital Group, the spending he has suggested would add up to half a percent per year to GDP over the next four years.

Trump has pledged to lower tax rates for individuals and corporations.  One way to pay for cuts would be to expand the amount subject to tax, which points to a deal for repatriation of the estimated $2 trillion of US corporate earnings held overseas.

Trade is the area most directly controlled by the President.  Trump’s threats to bully concessions from trading partners might work, but also carry the risk of starting trade wars or worse.  However, as occurred with Brexit and Grexit, the votes and threats created leverage, and pressure for concessions.  Perhaps he can negotiate a better deal.

Trump likes to negotiate from a position of strength and has emphasized the need for a strong military.  Increased defense spending to beef up homeland security and offensive capabilities should benefit defense contractors and industrial suppliers.

Health care is another area of focus.  Trump campaigned on repealing the Affordable Care Act.  It is unlikely the 20 million people added to health insurance rolls will be dumped, but the program will be rebranded and modified to reduce the worst imbalances.  Insurance companies will muddle through changes and pharmaceutical companies will still contend with pressure for price regulation.  While more positive than we would have expected a Clinton administration, the outcome is not clear.

He says he wants to repeal Graham-Dodd.  Banking regulation has placed serious regulatory burdens on financial companies.  Some question whether the regulations are adequate, but there is evidence of overreach and unnecessary compliance overhead.  It would be nice to see fewer rules based institutional regulations and more principles-based enforcement of laws to control individuals that compromise the public interest.

It might be best to view the Trump impact as a change in drift, not a full overhaul.

A Vital Sign for the Economy

When the stock market gets stressed by a correction, emotions are magnified. Commentators attribute daily swings to the headline of the day.

One data point worth reviewing is from the American Association of Railroads (AAR). The AAR publishes weekly data on rail traffic.

According to the report for the week ending February 13, 2016, “total U.S. weekly rail traffic was 505,148 carloads and intermodal units, down 3.8 percent compared with the same week last year.” Total freight cars and intermodal units are down 5.8 percent compared to last year for the first 6 weeks this year. But of the 10 carload commodity groups, miscellaneous was up 27.4 percent and motor vehicles and parts were up 12.6 percent.

The sectors posting decreases compared to the same period in 2015 included, “coal, down 32.5 percent to 75,249 carloads; petroleum and petroleum products, down 23.4 percent to 11,303 carloads; and metallic ores and metals, down 15.4 percent to 19,196 carloads.”

The data points to a fairly healthy consumer sector and a supply correction in raw materials commodities. As supply adjusts to demand, prices stabilize and rebound. These are healthy adjustments for an economy on course for the old normal.

For the full AAR press release, click https://www.aar.org/newsandevents/Press-Releases/Pages/2016-02-17-railtraffic.aspx.

Random Thoughts on Investing and Politics

Which way is the market going?  If you listen to the news, you will be a pessimist, since most news is negative.  But if you pay attention to quarterly earnings reports and long-term earnings trends, you will be an optimist.

Businesses are organizations of people who get up every day to create value for customers, with profits flowing to the owners of the company as the reward for their ingenuity and placing capital at risk.  If and when profits decline, the owners and management take corrective action.  In the extreme, they might liquidate the business to avoid further loss of capital, freeing capital and labor resources for redeployment in more productive enterprise.

In 1776, Adam Smith coined the term “Invisible Hand” in a book “An Inquiry into the Nature and Causes of the Wealth of Nations”.  In it he wrote, “Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it … He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Government intervention often impairs the efficient deployment of resources and the creative destruction of inefficient enterprise.  Subsidies and taxes distort economic incentives and reduce the efficient allocation of resources.  The invisible hand is not an outdated classical concept.  It is the natural phenomenon that guides free markets.  Capitalism drives scarce resources to their most productive use.

Socialism short circuits the resource allocation process of capitalism, removing the invisible hand from sectors of the economy.  Without a profit motive, inefficiencies tend to grow unchecked.  While segments of society may be protected, you end up with a smaller pie.

The political pendulum swings between the left and the right.

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more.  That’s a problem for some people.  They do not recognize their disequilibrium.  Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective.fredgraph Fed Funds Rate

The Fed needs to get off the sauce.  Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions.  The longer the distortion persists, the greater the risk.  Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway.  That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money.  It shouldn’t be virtually free.

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.

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.