Tag Archives: Investment Management

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.

3Q 2020 Update

The 3rd quarter of 2020 is in the books. The S&P 500 total return for the 3 months was 8.47%, including the -3.92% decline in September.

With only 5 weeks until the election, at least that source of uncertainty will be resolved. I do not think it makes a great deal of difference to the markets which candidate wins. Of the Democrats’ proposed tax increases, only the corporate rate will affect investors earning under $400,000 per year. Even then, Democrats might not be too keen on raising rates too soon in a shaky economy.

The better news is that the economy is not the same as the stock market. The economy is what is happening now. The stock market is built on earnings expectations. Perhaps the bigger issue that will drive stock market expectations is when and how the COVID issue will be resolved.

The optimism that drove the S&P 500 to 3,500 was not sustainable in the absence of a vaccine. However, earnings, the prospect for additional stimulus, and economic data continue to support the S&P 500 near the recent lows near 3,200. I look for earnings and accommodative Fed policy to support valuations, and COVID resolution to catalyze the continued reopening of the economy into 2021. That should support further earnings and market gains.

Halftime 2020, at Last!

As I suggested last quarter, the market has responded positively to a better understanding of Covid-19 and how to treat it. Political polarization, on the other hand, is likely to only increase into the election this fall. Social unrest is a problem, but rioting has given way to more rational discussions of legitimate issues.

 Despite the upheaval, the S&P 500 is only -4.04% YTD, and that is from a level that might be considered 5% overvalued by the Morningstar indicator.

In terms of the Morningstar market valuation indicator, the market ranged from 78% of fair value on April 1, to 5% overvalued on June 8. We finished the quarter 1% undervalued. Recovery has been driven by Government stimulus, business reopening, progress in controlling the virus, and hope for a vaccine. As we open the 3rd quarter, only the Government stimulus remains as a tailwind.

Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine. The market anticipates a vaccine by early 2021. Although the market may pop on headline vaccine news, a development that could cause a sustainable rally is likely to me months off. Beyond that, we need to reckon with the 600-pound gorilla at the end of the vaccine tunnel: the election. While most administrations take more credit than they deserve regarding market movements, the current polarization could have a major adverse impact if the Democrats win both the Presidency and the Senate, opening the door to a progressive tax, spending, and anti-business policy in general.

So which direction do I think the market will move next? Last quarter I suggested, “we should see better than average returns in the not-too-distant future.” Now, however, I am less inclined to speculate about the short-term given the range of possibilities and the lack of near-term earnings visibility. Longer-term, the trend is still up. Earnings are almost certain to improve as business and employment normalize post-pandemic. The real question surrounds the rate of growth.

COVID-19 Attacks Portfolios

People are emotional. I strive to be a realist, at least in financial matters. I expect the medical crisis to get worse. The market is in panic mode since the near-term is unknown. The main issue for markets is how long before people can go back to work? That will determine which and how many businesses might not survive under current management and ownership. I believe that the Government’s response is appropriate and will prevent an extended financial crisis by helping to bridge the gap. Furthermore, I believe that the medical community is making great progress in addressing the medical aspect. Testing will be available for most workers in a matter of weeks, enabling healthy workers to return to their jobs. The news on the development of treatments and vaccines is encouraging.

What’s the outlook for long-term investors? The S&P 500 closed the first quarter at 2,584.59. If it takes three years to achieve prior closing highs (3,386.15 on 2/19/2020), the annual return would be 10.32%. We’ve seen unprecedented volatility with 10% up and down days. Selling now runs the risk of missing the bottom. Although virus related news flow will likely get worse, the market tends to turn up before the headlines improve.

I concluded my last quarterly update with a prescient observation, “caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes.” “Plague” is my vernacular for highly contagious disease. The COVID-19 pandemic is worse than war financially. Wars don’t shut down small businesses and can even stimulate production.

According to the Morningstar Market Valuation Chart, the market is now about 20% undervalued. Markets tend to overreact in the face of uncertainty. The stock market is a discounting machine, but we don’t know what to discount. We are down 27% from the February high. Since we were about 7% overvalued in February, the 20% discount to fair value is consistent.

The volatility is dizzying. If you’ve ever been on a boat in rough water, you might have experienced seasickness. One of the best remedies is to focus on the distant horizon. Volatile markets are like that. In the short term, all bets are off. The medical news is sure to get worse. The issue is when the markets will be able to see past that. When we get past the virus and go back to work, how long will it take to get back where we were? I don’t think it will take 3 years, and maybe only a fraction of that. If I’m right, we should see better than average returns in the not-too-distant future.

If you are having second thoughts about your portfolio and think you’d prefer something less volatile, now is not the time to make that change. The time to de-risk is when markets are optimistic and setting new highs. Unfortunately, you’ll feel complacent. That’s why I frequently remind clients to plan for liquidity needs, to avoid the need to sell in a down market. Extremely low interest rates make this a risky time to de-risk with bonds. As I suggested in last quarter’s letter, some risks don’t show up in economic leading indicators. A virus that causes the Government to shut down business for more than a month, who would have imagined?

We Had a Good Year, Now What?

We finished a strong year, but perhaps not as strong as the numbers appear. Remember, we started from a low point after the market tanked in the 4th quarter of 2018 when the market decided the Fed was tightening too fast. The Fed reversed course, and after a few zig-zags rallied to finish strong.
I look for the stock market to return around 10% per year ON AVERAGE. Rarely does it go up 10% in any given year. It seems to be either +20% or more or -10% to flat. Furthermore, on average it goes up about 2 out of 3 years. That means it goes DOWN about 1 in every 3 years. We emphasize planning for liquidity to reduce the need to sell when the market is down. Financial planning helps define when, and how much you expect to need from your portfolio, at least for major events you can plan for.
A good year in the market does not change affect the probability that the next year will be up or down. Much like flipping a coin, the market has no memory. The market reflects what is known and expected at any given time. You can’t time the market and go to cash after years the market goes up by more than average and expect to improve the odds. That’s the gambler’s fallacy.
I view the current rally as a high risk, risk-on market. The rally is high risk because it occurred while 3 significant geopolitical events were happening: impeachment, trade war, and Brexit. A negative outcome from the market’s perspective in any one of these events could have precipitated a market correction. The trade war and Brexit appear to be moving toward a positive direction. Although pro-business Trump has been impeached by the House, the market appears to discount the possibility of conviction in the Senate.
Where do we go from here? The key variables include interest rates, valuation, and earnings. Economic indicators point to continued slow expansion rather than recession. Generous valuation is a function of low interest rates. Low interest rates coupled with continuing slow expansion can sustain current valuations. The wild card seems to be inflation. Although there is little indication that it will accelerate, it is notoriously hard to predict. The Fed wants higher inflation, and inflation could erase some Government debt (they pay it off with cheaper dollars). The Government would benefit from higher inflation. Inflation drives long-term interest rates and that would challenge valuations. Fortunately, as the last 10 years indicate, it is hard to generate inflation without stronger growth, but faster growth would help offset the effect of higher interest rates.
This starts to look like a circular argument, and that’s good news. Much like Newton’s Third Law, for every force there is an equal and opposite force, the economic forces driving markets tend to revert to long term averages. However, caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes. Sleep well!

Cross-Currents

The cross-currents of economic data are all over the place. The good news is that there is no clear indication of a recession. More specifically, indications are that the economy will continue in slow-growth mode of around 2%.

Personal consumption is about 70% of GDP and is currently the strongest component. Business investment and labor force growth are the keys to productivity, and this is the more worrisome factor. Political uncertainty discourages capital investment. Workers need better tools if they are to increase output. Labor supply, on the other hand, is constrained by birth rates, demographics, and immigration policy.

Trade war issues are contributing to weakness in manufacturing. While that could spill over into other areas, the weakness appears to be within the bounds of normal volatility. The best news on the trade front is that the pain does not discriminate. There are no winners. Consequently, trade wars are generally short-lived. The bad news is that neither China nor the U.S. has much incentive to compromise before the next Presidential election.

Finally, the Fed has worked itself into a position that raising interest rates appears to cause the stock market to decline. That’s logical since interest rates factor into stock valuation. However, the real issue is whether higher rates would dampen economic activity. I believe higher rates would be healthy and lead to a stronger economy. Any economic activity that would cease due to a 4 or 5% interest rate is probably an inefficient or unwise use of resources anyway. Getting to higher rates will cause market tantrums, but the end is nothing to fear.

Quarterly Update – 1Q19

The market peaked in early October, 2018, and came very close to the official 20% decline that defines an official “bear market.” The real issue is not the depth of the decline, but how long it takes to recover. After the market roared back (+13.06%) in the first quarter, we are nearly there.

Last quarter I shared a chart I use, that indicated the market was valued at 88% of fair value. Today, that reading is about 98%. There is a natural regression to fair value. We’re about where we are supposed to be, not cheap but not too expensive.

There has been a lot of talk in the media about the “yield curve” and what that means about recession risk. I wrote a blog post on the issue the day the curve inverted on March 22. Link here: https://www.daltonfin.com/2019/03/22/what-volatility-looks-like/.  Sure enough, the inversion was transient, with the 3-month T-Bill currently at 2.4% and the 10-year Treasury Note at 2.41%, virtually flat.

(Caution –  the next 2 paragraphs are on the wonky side)

The spread between the 10 and 2-Year Treasury is Worth Watching. When it goes negative, it is inverted.

The main problem with conventional yield curve analysis is that current conditions are a lot different from past circumstances, after 10 years of central bank intervention. The absolute level of interest rates has not been this low in any prior inversion analysis. To illustrate why this is important, consider an economy with no inflation. If the interest rate is the price of money, how much would you need to be paid to lend your money to the U.S. Federal Government? Now, add that rate to the expected inflation rate to get the level that the 3-month T-Bill should yield today in a normalized environment. Anything short of that is like a morphine drip to the economy. The Fed is trying to wean us, but that requires balancing the market’s tantrums (see December) which can become a self-fulfilling prophecy if a stock market decline causes a slow-down.

The Fed only controls the short end of the curve. The market controls the long end. When bond traders bet the Fed will cut rates, they buy the long end because interest rate changes compound and prices move inversely to rates. Increased demand on the long end causes long rates to fall. The greater concern is when the Fed starts cutting short rates. That signals trouble because they have more information than anyone else. What does the Fed do when they see trouble? They cut short rates to juice the economy. The problem is, there’s usually trouble on the horizon when that happens. The good news? That’s not the case today.

Volatility is the price of equity returns. We can manage risk if we understand your liquidity requirements. If we can anticipate distributions, we can reduce or eliminate the possibility of being forced to sell when the market is cheap. That’s what converts a temporary loss of capital a permanent loss.

And Now a Word from Our Sponsor

I was watching CNBC with the sound muted when I noticed an interview. I saw a woman and the graphic, 30 Years of Industry Experience. Wow! That’s all CNBC can say about their distinguished guest? While experience is necessary, it is hardly sufficient. One might expect something more substantive. It’s true that I only have 25 years of industry experience, so what do I know?

I know that the length of time I’ve been a financial advisor says very little about me. In my case, I think the 13 years as a financial analyst, before the last 25 years in financial services, was far more influential in my professional development. The role of a financial analyst is that of a paid devil’s advocate.

A corporate financial analyst is a gatekeeper. Any advocate in a company promoting a project or strategy that requires investment needs to demonstrate the financial effects of the idea to management. That requires a financial analysis of the project to determine the net present value and internal rate of return based on projected investment and the resulting cash flows. The financial analyst must be sold on the assumptions that will drive his models. Garbage-in, garbage-out.

The analyst must drill into the underlying data to verify everything. The marketing, engineering, and new product folks become emotionally invested in their ideas. The analyst must vet the projects as the gatekeeper to funding and balance the interests of zealous advocates against the numbers.

I view investing like project analysis. They both need to pass the expected return on investment hurdles and scrutiny of the underlying assumptions.

Many financial advisors, in fact, the most successful ones in my experience, are successful because they are well-connected and are great relationship managers. They impress, like any good salesman.

Who’s watching your wallet?

An autobiographical perspective from Robert Higgins

Zoom Out

Time brings perspective, and now might be a good time to reflect on that. This month has been exhausting for investors. The damage is relative. If you invested last month and need to sell now, you might have a problem. But if you are a prudent investor with a 3 to 5-year time horizon, I think you’ll be just fine. This is normal volatility. For perspective, consider the following views of the S&P 500.

First, consider how you feel. The chart below shows a 5-day view. Pretty lousy, huh?

Next, we’ll zoom out to a 3-month view. Not much better.

Now let’s see how the index has done over the past 12 months.

As the above chart shows, it has been like a roller coaster, but it is still positive. Now let’s zoom out to the 2-year view. I think most investors would be pleased with the 29% gain they would have received from the SPY, an ETF that tracks the total return of the S&P 500 including dividends. These charts show just the index, excluding dividends.

Finally, here’s the 5-year view that shows the accumulation of retained earnings created by millions of people going to work every day. This is more like it. Now our scary stock market looks more like a not so uncommon speed bump along the way to greater prosperity.

Exhale and have a nice day!

Charts from Yahoo Finance. Past results are not guaranteed. Investing involves risk, including loss of principal.