Tag Archives: Stock Market

Recession Strategy

I am seeing a lot of ink about how to prepare for the next recession. Clients want to know what we’re doing to prepare. Investment companies are asking me which funds I think are best for the next downturn.

The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.

I’ve been investing since the 1970’s. My education and career have focused on economics and finance. What have I learned? In my view, valuation risk is easy to observe, but timing a correction is still difficult. I recognized that the S&P 500 was overvalued in 1998, but it doubled again before getting cut in half in 2000. I observed in 1999 that the market would either go down by 50% or trade sideways for 10 years while earnings caught up. I had no idea I would be right on both counts. Despite that, a diversified portfolio including small cap, international and bonds fared much better.

Systemic risk is harder to recognize. I didn’t see the 2008 crisis coming. But it really wasn’t a stretch to see what asset class was overvalued, i.e. real estate. But then you needed to understand that banks and credit agencies were operating in a corrupt system underwritten by government agencies, that mortgage defaults would create a downward spiral as underwater homeowners defaulted, forcing prices ever lower.

We accept the unpredictable nature of corrections, and that unique circumstances precipitate them. Today, credit seems to be the most mispriced asset class, driven by government intervention. But bonds are math, and the effects of normalization should be more moderate than a speculative equity correction unless there are forces involving leverage that are not on my radar – like the mortgage security market. Still, the recovery of the past 10 years made staying invested worthwhile. We just needed to hedge for liquidity needs over the next 3 to 5 years to emerge unscathed.

What does all this mean? I believe that a heightened level of concern about the next recession or correction is healthy. As investors de-risk portfolios, valuations will be earnings driven, and that’s a good thing for fundamental investors. Certainly war, policy mistakes, and scandal can impact markets, but these events have nothing to do with the duration of a market expansion. They can happen at any time, so why should the risk seem greater now?

My favored strategy continues to be the bucket approach. One of the key benefits of a financial plan is that it identifies anticipated liquidity needs. Given that most market downturns are resolved in less than 3 to 5 years, it is prudent to establish reserves equal to your liquidity needs in something with less risk than the stock market. Accepting risk in the short-term is gambling, and gambling with what you can’t afford to lose is a bad idea. Investors have time on their side as companies continue building wealth even while the market doesn’t always correlate with that. Be prepared, be vigilant, and stay the course until fundamentals indicate otherwise.

“WE’RE BUYING STOCKS THIS MORNING, AND I’D RATHER BUY THEM CHEAPER, BUT I’VE BEEN BUYING STOCKS SINCE MARCH 11th, 1942, AND I REALLY, I BOUGHT THEM UNDER EVERY PRESIDENT, SEVEN REPUBLICANS, SEVEN DEMOCRATS I’VE BOUGHT THEM QUARTER AFTER QUARTER. SOME OF THE BUYS WERE TERRIFIC, SOME OF THEM WEREN’T AT SUCH GOOD TIMES AND I DON’T KNOW WHEN TO BUY STOCKS, BUT I KNOW WHETHER TO BUY STOCKS, AND ASSUMING YOU’RE GOING TO HOLD THEM, WOULDN’T YOU RATHER OWN AN INTEREST IN A VARIETY OF GREAT BUSINESSES THAN HAVE A PIECE OF PAPER THAT’S GOING TO PAY YOU 3% IN 30 YEARS OR SHORT TERM DEPOSIT THAT PAYS YOU 2% OF THE SORT.” WARREN BUFFETT, August 30, 2018

Investing involves risk, including loss of principal. Past results do not guarantee future results.

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.

Tax Reform and Earnings Season

If a company wants to take advantage of a tax cut, what’s the first thing they do? For starters, they should accelerate expenses and write-offs to maximize the value of deductions while higher rates are in effect. If so, one might expect some low earnings numbers in the coming 4th quarter earnings season. While weak earnings might make sense given tax reform-induced accounting, uncertainty is never a good thing for investors. The take is that we might see an increase in volatility if earnings disappoint, leaving investors wondering why.

While tax reform is positive for stocks, the path forward might not be as straight as you think.

The State of the Yield Curve

The yield curve is getting a lot of attention because it has flattened 65 basis points this year. Although the yield curve is a good indicator of where we are in the economic cycle, it does not indicate a recession is likely. Fundamental data are supportive of economic expansion.

(Source: Bloomberg, NBER, GSAM, as of 11/30/2107)

The Risk of Cash

The S&P 500 is up 21.54% (Morningstar, intraday 11/8/2017) since the Trump rally began one year ago. While corporate earnings are up, price multiples have also expanded with growing optimism of policy reforms that could further improve earnings growth. This leaves many investors wondering if they should simply go to cash to lock in the gains.

For a long-term investor, someone who doesn’t plan to use the money for at least 5 years, this might not be a clever idea. To illustrate, let’s assume that we perceive an elevated risk of a 15% correction to get back in line with normal growth from where we were a year ago. From that level, we might expect 8% to 10% average annual growth. If we are correct, and the market goes down 15%, and then grows at 8% per year for 3 years, it would still be worth more than if it were left in cash.

To illustrate, a $100 investment that declines by 15% is worth $85. Then if it grows by 8% per year for 3 years (85 x 1.08^3), it would be worth $107.07. That implies cash would have to earn 2.3% per year to keep up, and that is not available in today’s low-interest rate market without material risk.

As a short-term tactical move, cash can serve as an effective hedge against a falling market, but only if an investor has the fortitude to use it and invest when fear is at its height.
Perhaps the greatest risk for a long-term investor is selling out, not taking advantage of a market correction, and then reinvesting when higher prices signal all clear. It happens all the time.

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.

Beware the Pundits

Not much has changed since my last blog post, and I don’t have any revelations to share. Trump is still talking about the same issues he mentioned in his campaign. Real change happens slowly. But the drift is real, and that has unleashed animal spirits in the markets.

The gains to date are not purely about valuation. Currently, 70% of companies have reported 4Q earnings, and 2/3 have beaten estimates, according to Forbes. Earnings are improving and the real question is how steep and how long the trend will run.

All things being equal, higher valuations increase risk. If price-to-earnings multiples expand faster than earnings growth, the risk of a correction increases. Without calling names, geopolitical risk seems to be an ongoing factor, so it seems a matter of time until a crisis scares the bejeepers out of the market and everyone scurries to cash.

A Buffet saying comes to mind, “Be fearful when others are greedy, and greedy when others are fearful.” I’m sensing an increase in the greed factor as investors hate missing a rally. This might be a good time to think about harvesting positions you wouldn’t buy at today’s prices, and be very picky about your reinvestment options. Dry powder can go a long way in a correction.

Longer-term, the table is set for sustained and perhaps accelerating, earnings growth. In the 90’s, everyone thought the market would average 12% forever. Now the pundits agree 8% seems ambitious. When have the pundits ever gotten it right?

Finally, recognize that volatility is the price we pay for equity returns. Plan accordingly and stay the course.

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons.  You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates.  If you’re counting on bonds for income, you are going to need to own a lot more bonds.  While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels.  Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform.  Some parts of the bond market have less exposure to interest rate risk.  Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay.  My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important.  Let’s take the case of the Brexit induced market decline that began last Friday.  Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode.  If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day.  Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete.  If you wait until the next day, the price could be higher.  It could have gone lower too, but that’s speculation.  If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem.  Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format.  There is no perfect solution.  If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin.  If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class.  To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.

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.