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Kult Wealth Management offers high-quality wealth management services to help you plan and manage a secure retirement. Our risk-conscious investment management philosophy focuses not only on growing your wealth, but also on protecting it.

June 25 2020: Disconnect?

 

The most frequent question we have received in recent weeks is, “Is the stock market overpriced?”  Many believe there is a disconnect between a horribly performing economy and a strong partial recovery in the stock market following a five-week S&P 500 decline of 34% in February-March.

As investor Howard Marks likes to say, things in the real world generally fluctuate between “pretty good” and “not so hot.”  But in the world of investing, our minds perceive things as fluctuating between “flawless” and “hopeless.”

The pendulum of investor psychology continually swings between these extremes; it just seems to be swinging much more quickly these days!

The Haves and Have-Nots

In a continuation of a trend that existed prior to this year’s events, the stocks of large technology companies have left the stocks of many other companies behind.  As The Wall Street Journal reported yesterday, the divergence in the performance this year of the three major U.S. stock market indexes, the Dow, the S&P 500, and the Nasdaq, is the widest it has been in more than a decade.

The surge in the stocks of large technology companies has driven the technology-heavy Nasdaq index to a year-to-date gain of 10% while the S&P 500 and Dow have declined 5% and 10%, respectively (performance figures through June 24).

Through June 24, year-to-date stock gains for large technology companies are 48% for Amazon.com, 26% for Microsoft, 23% for Apple, 14% for Facebook, and 7% for Alphabet (Google).  The strong stock performance of these giant companies has significantly boosted the results of the Nasdaq and S&P 500.  As reported by SentimenTrader, the technology sector now comprises 27% of the S&P 500 index, its highest weighting in the index since the technology stock bubble days of late-1999 and 2000.

Beneath the surface, other parts of the stock market, many of which are more dependent on a healthy economy, are still suffering.  Vanguard’s index fund tracking the stocks of companies based in developed economies outside of the U.S. is down over 11% thus far in 2020, while the S&P 600 index of smaller U.S. company stocks is down over 21%.

Given large technology companies’ enviable profitability and growth, their stocks arguably deserve to trade at a premium to the rest of the market.  We believe, however, that the stock market recovery will be healthier and more sustainable if it is able to broaden to include other companies.  While we felt nearly everything was on sale in March, more recently we have been trimming our stock investments that hold the strongly-performing large technology companies.

Triple Threat

Our biggest concern for savers and retirees is that we are back to an expected prolonged era of extremely low interest rates.  Fed Chairman Jay Powell recently said that “we are not even thinking about thinking about raising interest rates.”  This leads to low yields on savings accounts, CDs, money markets, and safe bonds.

Savers and retirees continue to face the unpalatable choice of accepting low returns on safe investments, perhaps for the foreseeable future, or taking more risk in search of higher returns.  Ben Meng, chief investment officer of Calpers, recently described the challenge facing investors as a “triple threat of low interest rates, high asset valuation and low economic growth.”

We are living through a period of high uncertainty.  Rather than attempt to predict the future course of events, we will stick to our knitting.  We will continue to hold several years’ worth of cash flow needs in more stable investments for our retired clients, and we will await future swings in the pendulum to try to help your results through rebalancing.

 

Langley, Karen. "The Big U.S. Stock Indexes Are Telling Different Stories." The Wall Street Journal, Updated June 23, 2020 5:52 ET. Web. 24 Jun. 2020.

Goepfert, Jason. "Buffett scorn reflects a market heavily weighted toward tech." SentimenTrader Blog, 2020-06-23, SentimenTrader.com

Meng, Ben. "Calpers Prepares for the Long Haul." The Wall Street Journal, June 14, 2020.  Web 24 Jun. 2020.

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

 

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March 12, 2020: Is This Time Different?

  “Neither ‘get in’ nor ‘get out’ are investment strategies…they represent gambling on moments in time; when investing should ALWAYS be a process over time.”

-Liz Ann Sonders, Schwab Chief Investment Strategist

We are experiencing a frightening drop in stock prices.  For the first time in 11 years, the Dow has entered bear market territory, defined as a drop of 20% or more.  The S&P 500 will likely follow the Dow into bear market territory today.

Stunningly, it took only 19 trading days for the Dow to go from a record high, set on February 12, to a bear market.  According to this morning’s Wall Street Journal, this was the Dow’s fastest move from a peak to a bear market on record, compared to an average peak-to-bear market span of 136 days.

Is This Time Different?

Although our reactions to crises may be different now due to social media and 24-hour opinion-based television, the rules of investing have not changed.  It seems quaint to boil down investing to the mantra “buy low, sell high,” but that’s really what it’s all about, isn’t it?

We manage portfolios based upon targeted allocations to stocks and bonds.  When stock allocations rise above our targets, we sell a portion of them and reinvest the proceeds into bonds.  When stock prices drop, causing stock allocations to fall below our targets, we buy more of them.  This approach removes emotion from the process when it can do the most damage; i.e., during times of panic or euphoria.

Our younger clients with no need to draw from their portfolios have more allocated to stocks, while our clients with near-term cash flow needs have less money allocated to stocks and more allocated to stable investments.  Entering a stock market panic with an appropriate asset allocation means we will not be forced to sell stocks at bear market prices to meet cash flow needs.

We wish we could avoid risk and earn an acceptable return on safe investments, but we are investing in a prolonged period of 1-2% interest rates and, in the case of savings accounts, CDs, and money markets, rates appear to be headed even lower.  For this reason, we believe nearly every investor must embrace some level of stock market risk.

Looking Ahead

Given recent precautions taken to prevent the spread of coronavirus, it seems certain that the global economy will endure a significant hit in the near-term.  Whether this leads to a recession remains to be seen.  Importantly, we do NOT believe this is a repeat of the Global Financial Crisis of 2008-2009.

As to the stock market, for most of the past several years we have been net sellers of stocks as they rose in price and drove our stock allocations above our targets.  In recent weeks, we have been buyers of stocks as their prices have dropped sharply.  We do not expect a quick payoff from recent weeks’ purchases but believe they will prove to be profitable within your time horizon.

Unfortunately, we must forewarn you that your first quarter results will almost certainly be ugly.  Importantly, however, we believe this quarter’s losses are temporary in nature and we do not intend to lock them in by selling stocks at these prices.  If you wish to discuss your finances in greater detail with us, please contact us to schedule a meeting or telephone call.  Thank you for your patience during this crisis.

 

Sonders, Liz Ann. "Manic Monday (Tuesday, Wednesday, Thursday, Friday)." Charles Schwab MARKET VOLATILITY, March 9, 2020. Web. 12 Mar. 2020.   

Otani, Akane and Karen Langley. "Dow's 11-Year Bull Market Ends." The Wall Street Journal, March 12, 2020. 

"Dow Jones Industrial Average since the start of the past bull market." The Wall Street Journal. Web. 12 Mar. 2020.

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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March 3, 2020: Coronavirus

 

“[The coronavirus] makes no difference in our investments.  There’s always going to be some news, good or bad, every day.  If somebody came and told me that the global growth rate was going to be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price, and I like the prices better today than I liked them last Friday.”

 

- Warren Buffett, February 24 CNBC interview

After a strong 2019 and impressive start to this year, stock prices have declined sharply over the past couple of weeks.  We just experienced one of the swiftest stock market corrections in history, yesterday’s partial recovery notwithstanding.

We wrote in our December newsletter about the futility of short-term forecasting.  This year’s coronavirus outbreak was a complete surprise, making those who offered forecasts for this year, without any apparent humility, look silly.

We are not in the prediction business, certainly not with regard to the effects of a virus, and we have always stressed the importance of acknowledging what is knowable regarding the short-term direction of economies and investment markets.  As Howard Marks wrote in his book, Mastering the Market Cycle, “All we can know about the future—at best—is what the probabilities are…We generally have no choice but to be content with knowing the probabilities.”

It seems probable to us that precautions currently being taken to reduce the spread of the coronavirus will meaningfully impact global economic growth in a negative fashion over the short-term.  (Importantly, however, we think that predictions regarding the ultimate severity and duration of an economic downturn are, at best, educated guesses.)

It seems equally probable to us that the coronavirus scare has not changed the long-term prospects for corporate performance, so we rebalanced from bonds to stocks last week within the parameters of our targeted asset allocation plans.  High-quality bonds nicely performed their role as portfolio diversifiers last week, rising in price as stocks declined.  This dynamic provided the dry powder for last week’s rebalancing into stocks.  For our retired clients drawing from their portfolios, we continue to earmark high-quality bonds for near-term (e.g., several years or more) cash flow needs, so we do not expect to be forced sellers of stocks at a time or price other than that of our choosing.

Stocks continue to represent the engine for long-term growth in your portfolio, despite their periodic frightening hiccups.  In a world of 1-2% expected returns on safe investments, we believe stock investments are particularly important components of your investment portfolio.  We will continue to add to them when their prices drop and trim them when they perform well.

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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December 18, 2019: Two Kinds of Forecasters

 

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

-          John Kenneth Galbraith

‘Tis the season for economic and stock market forecasts for the upcoming year.  The precision with which some forecasters express their opinions continually amuses us, particularly when examining their low success rates.  Human beings crave answers, even for unknowable aspects of life such as whether the stock market will rise or fall during the next year, so there will always be job security for forecasters.

As we wrote in our last letter, the U.S. economy is enjoying its longest expansion in modern history, and the U.S. consumer appears to be in solid financial shape.  Outside of the U.S., many economies are exhibiting hints of bottoming following slowdowns this year.  Global monetary policy is accommodative.

As to the investment markets, stock prices have risen nicely in 2019 following a sharp fourth quarter correction last year.  We are pleased to see broader participation in stock gains in recent months, with non-U.S. and economically cyclical companies’ stocks joining the fun.

Short-term Versus Long-term Forecasting:

Despite the plethora of short-term forecasts this time of year, please remember that no one knows the near-term direction of economies or investment markets.  We believe there are reasons for optimism regarding global economic growth and rising investment markets in 2020, but we also respect the potential impact from uncertainty over issues we cannot control (e.g., trade issues, U.S. presidential election, Brexit).

As to long-term investment forecasts, current interest rates tend to be good predictors of future bond returns, and stock valuations tend to be good predictors of future stock returns.  Regarding bonds, we believe their role as a risk-reducer is as relevant as ever, but it is difficult to see how bonds can produce high returns in the future given their extremely low yields currently.

In terms of stock valuations, it depends on whether you compare them to their past valuations or to other types of investments.  Examining certain valuation measures such as price-to-earnings ratios, dividend yields, and the total value of the stock market relative to the economy, stocks look expensive relative to their historical valuations.  We believe that the more expensive stocks are, the more vulnerable they are to bad news and the more likely they are to earn below-average returns over the next 5-10 years.

Comparing stocks to bonds, on the other hand, makes stock prices look more reasonable.  After a period of rising interest rates in 2018, whereby investors could earn safe returns of 2.5-3%, rates have come back down this year.  Once again, it is difficult to find a safe return above 2%.  Consequently, stock market valuation models that incorporate the low level of interest rates make stocks look attractive in comparison to safe investments.  If interest rates remain low, it seems reasonable to believe that stock valuations will remain high.

Ultimately, we think the combination of low interest rates and rich prices on stocks and bonds demands humility with respect to future long-term return expectations. In short, we do not think it is a time for boldness or overconfidence. However, we feel just as strongly that it would not be appropriate to abandon your asset allocation plan, which is based upon your time horizon, cash flow needs, and ability to mentally withstand downturns without abandoning your plan. We will continue to manage your investment portfolio according to these principles.

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

 

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August 7, 2019: The One-handed Economist

 

“Give me a one-handed economist!  All my economists say, ‘On the one hand…on the other!’”

-          Harry Truman                                   

 

Record U.S. Economic Expansion

Lost in the recent focus on tariffs and interest rates is the fact that the current economic expansion in the U.S. just became the longest on record.  Although the overall growth rate of this expansion has been anemic relative to previous expansions, inflation-adjusted wages have grown more robustly than previous expansions, a positive for the U.S. consumer (source: The Wall Street Journal).

As to the future, this is where Harry Truman’s two-handed economist comes in.  On the one hand, we have low inflation and interest rates, unemployment is low and real wages have grown, consumer debt service appears reasonable, and the U.S. economy is less susceptible to an oil price shock than in the past.  Additionally, perhaps the memory of the Great Recession of 2008-2009 has subdued animal spirits and is helping to prevent excesses that naturally lead to recessions; for example, The Wall Street Journal observed that household debt has not increased nearly as significantly as it did in the last expansion.

On the other hand, the federal government is running historic peacetime deficits despite a growing economy and has failed to address long-term budget challenges.  Interestingly, the only thing Democrats and Republicans seem to agree on is boosting spending and borrowing.  Other areas of concern include a potential tariff war, a significant rise in corporate debt, and the potential for asset bubbles resulting from continued extraordinarily low interest rates.

Howard Marks of Oaktree Capital recently pointed out that, “In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates and rising financial markets.  It’s important to recognize that these things are essentially incompatible.  They haven’t co-existed historically, and it’s not prudent to assume they will do so in the future.”

At ten years and counting, the U.S. economic expansion has been impressively long.  Although we will surely experience a recession at some point, we continue to believe it is extremely difficult to predict the timing and severity of recessions.  Furthermore, we do not subscribe to an investment strategy that involves “getting out of” or “going all-in” the stock market in response to one’s expectations for the economy.  We will comment further on the investment markets in a future letter.

Interest Rate Reduction

As expected, last week the Federal Reserve reduced its target for short-term interest rates by one-quarter of a percentage point.  This was the first rate cut since the global financial crisis in 2008, the first cut with U.S. unemployment below 4%, and the first time since the dot-com era of the 1990s that the Fed eased policy with U.S. stocks at or near record highs (source: Capital Group).

What we used to call “unconventional monetary policy” has now become the norm in the U.S. and elsewhere.  Previously unthinkable negative interest rates have become commonplace throughout much of the world; perhaps this, as much as anything, forced the Fed to lower rates in the U.S.

As a reminder, the Fed’s target for short-term rates directly affects savers via yields on bank savings accounts, money markets, and shorter-term bonds.  Fed policy also affects borrowers via rates on adjustable rate mortgages and many other types of loans; for example, loans tied to the Prime Rate.

The Fed’s target for short-term interest rates does not, however, control fixed mortgage rates, a common misconception.  Fixed mortgage rates are directly influenced by longer-term rates, which are determined by the bond market.  Longer-term rates should represent the collective judgment of bond investors toward future inflation and economic growth (extraordinary central bank involvement notwithstanding).  As it happens, longer-term rates have been on the decline since last November, which has translated into a significant drop in fixed mortgage rates since then.  If you have a fixed mortgage, we recommend asking your lender whether it makes sense to refinance.

 

Hilsenrath, Jon. "After Record-Long Expansion, Here's What Could Knock the Economy Off Course." Wall Street Journal, 3 Jun. 2019. Web 31 Jul. 2019.  
"US Business Cycle Expansions and Contractions." (www.nber.org/cycles/cyclesmain.html) the NATIONAL BUREAU of ECONOMIC RESEARCH. Web 2 Aug. 2019.
Marks, Howard. "This Time It's Different." 2019 Oaktree Capital Management, L.P. Memo to Oaktree Clients. 12 Jun. 2019.
"Fed rate cut shifts monetary policy into overdrive." The Capital Group Capital Ideas. Web 2 Aug. 2019.

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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May 1, 2019: Social Insecurity?

“Sometimes I wonder whether the world is being run by smart people who
are putting us on, or by imbeciles who really mean it.”

                                                                                                Mark Twain

 

You may have seen headlines referencing Social Security’s financial challenges following the recently-issued annual report from the trustees of the Social Security program.  Social Security is often referred to as the “third rail” of politics given the high risk politicians feel they will take on if they propose ways to shore up its finances.  The solution lies in raising taxes, cutting benefits, or a combination of the two.  For those who love to be loved, these are not very palatable choices!

Brief History of Social Security:

The Social Security program started in 1935 as a response to the widespread poverty and unemployment caused by the Great Depression, as well as a means to address the increasing economic insecurity of older Americans following the Depression-induced depletion of private pension plans.

The initial version of Social Security was more of a funded insurance program than what we have today.  The program initially covered workers only, and stressed the importance of being fully-funded to provide for projected benefits.  Most workers retired at 65, and life expectancy was significantly shorter than it is today.

Various amendments in 1939 added dependent and survivor benefits, and also accelerated benefits so that workers who had contributed to the system for only a few years received full retirement benefits.  This changed the system from a funded insurance program to a pay-as-you-go program whereby current workers finance the benefits of current retirees.

After years of deteriorating Social Security finances during the 1970s, the National Commission on Social Security Reform (also known as the Greenspan Commission) was formed.  The Commission’s recommendations that were adopted by Congress in 1983 included raising the age at which a retiree could receive full benefits, increasing payroll taxes, and subjecting a portion of Social Security benefits to income taxes for certain recipients (based on their level of income).

The changes enacted in 1983 translated to a nearly 30-year period during which inflows from payroll and income tax exceeded benefits paid.  These excess inflows were accumulated in the Social Security trust fund that grew to $2.6 trillion by 2010.

Social Security Today

Since 2010, Social Security benefits paid have exceeded income from payroll and income taxes, meaning that the remainder of benefits had to be paid via the interest income on the trust fund’s assets.  The trustees of Social Security currently expect that, starting next year, interest income on trust fund assets will not be sufficient to cover the gap between benefits paid and the combination of payroll and income taxes.  Consequently, trust fund principal will be tapped in 2020 and beyond in order to cover a portion of Social Security benefits.  Using current assumptions, the trust fund principal will be fully depleted by 2035.

What Happens Next?

Once the Social Security trust fund is depleted in 2035, it is expected that payroll and income taxes will be sufficient to cover only 75% of Social Security benefits.  In other words, if legislators wait until 2035 to address this issue, it will require an immediate 25% across-the-board cut in benefits, a significant tax increase, or a combination of the two.

If legislators were to act now, on the other hand, it is estimated that a 2.7 percentage point increase in payroll taxes (i.e., from the current 12.4% to 15.1%) would be sufficient to make Social Security solvent for the foreseeable future.  Alternatively, an immediate 17% cut in Social Security benefits for all current and future beneficiaries would do the trick.  (Or, a combination of tax increases and benefit cuts would address the issue.)

Our best guess is that we will eventually see a political compromise that calls for higher payroll taxes on workers, increased income taxes on Social Security benefits, and benefit cuts in the form of reduced inflation adjustments and/or means-testing for higher-income recipients.  This would be similar to the 1983 adoption of the Greenspan Commission’s recommendations.  We are not holding our collective breath for a near-term solution, but we will keep you apprised of any significant developments.

 

Sources:

Ellis, Charles, Alicia Munnell and Andrew Eschtruth. "Falling Short: The Coming Retirement Crisis and What to do About It."

"The 2019 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Trust funds."

Munnell, Alicia. "Social Security's Financial Outlook: The  2018 Update in Perspective."Center for Retirement Research at Boston College.

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January 21, 2019: Remembering Jack Bogle

“If a statue is ever erected to honor the person who has done the most for American investors,
the hands-down choice should be Jack Bogle."

-  Warren Buffett, February 25, 2017 letter to Berkshire Hathaway shareholders

Vanguard founder Jack Bogle passed away last week at the age of 89.  After graduating from Princeton University in 1951, Bogle started his investment career with Wellington Management Company.  In 1974 he left Wellington to form Vanguard, now one of the largest investment managers in the world.

Bogle referred to his new venture as “The Vanguard Experiment,” whereby Vanguard mutual funds would be operated at-cost, similar to a mutual insurance company or other non-profit organization.  This was and continues to be a radical departure from the traditional mutual fund structure in which an external management company manages a fund or funds for profit.

Although he was not the inventor of the indexing concept, Bogle forever changed the investment management industry in 1976 when Vanguard introduced the first index mutual fund.  The goal of the First Index Investment Trust (later renamed Vanguard 500 Index) was to simply match the return of the Standard & Poor’s 500 Index, a measure of the U.S. stock market.  Again, this was a radical departure from traditional investment management strategies that sought to beat the returns of the stock market.

First Index Investment Trust was initially poorly-received, gathering only $11 million in assets via its initial offering in 1976 versus a goal of $150 million.  It was often referred to as “Bogle’s folly,” and some said it was downright un-American and represented an acceptance of mediocrity.  Edward Johnson, Chairman of Fidelity Investments at the time, doubted that Fidelity would embrace the index-investing concept and told the press, “I can’t believe that the great mass of investors are [sic] going to be satisfied with just receiving average returns.  The name of the game is to be the best.”

More than forty years later, index-investing is now widely-embraced by investors.  Low-cost mutual and exchange-traded funds tracking tax-efficient, well-constructed indexes have proven to be very difficult to beat over the long-term.  Fidelity Investments has not only joined Vanguard in offering index funds, but they recently became the first company to offer zero-cost index funds, regularly touting this fact via full-page newspaper ads and comparing their index funds to Vanguard’s index funds.  Imitation is indeed the sincerest form of flattery!

We’ll leave the last word on Jack Bogle to Warren Buffett via another excerpt from his February 25, 2017 letter to Berkshire Hathaway shareholders:

“For decades, Jack has urged investors to invest in ultra-low-cost index funds.  In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers…In his early years, Jack was frequently mocked by the investment management industry.  Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned.  He is a hero to them and to me.”

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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December 6, 2018: The Return of Risk

A year ago, one of us had a discussion with the owner of his local auto repair shop about bitcoin.  At the time, the price of bitcoin had skyrocketed and appeared to be a one-way ticket to wealth.  The auto shop owner was extolling the virtues of bitcoin, not only as an investment, but as a medium of exchange.  When asked, “Would you accept bitcoin as payment for your auto repair services?” the auto shop owner unhesitatingly replied, “absolutely.”  Our observer bit his tongue and went on his way, hoping the auto shop owner had not exposed too much of his financial security to bitcoin.  Since that conversation, the price of bitcoin is down 75%.

Return of Risk:

We have expressed concerns in prior letters that the Federal Reserve’s extraordinary efforts since the Global Financial Crisis to suppress interest rates and whet investors’ risk appetites have suppressed risk premiums (i.e., reduced the potential reward for taking risk) and likely artificially reduced the fluctuations of investment markets.  As the Fed now attempts to gradually reverse its generous crisis-driven monetary policies and the investment markets grapple with other issues, risk has returned.  In fact, this may be the first year since 1972 in which none of the major investment classes returns at least 5%!  (source: Ned Davis Research)

We do not wish to sound glib or resort to a cliché, but corrections in the prices of riskier assets can be healthy in a variety of ways.  Prior to this correction, we had been concerned that the strong performance of momentum-driven and other risky investment strategies encouraged aggressive behavior on the part of investors and made investing appear to be less risky than it is.  Prolonged periods of complacency tend to end badly, so perhaps the current correction will, ironically, extend the life of the bull market that began in 2009.

Although it is impossible to know the short-term direction of markets, we think it is prudent to mentally prepare yourself for further fluctuations in the investment markets in the coming months as they adjust to higher interest rates and slowing economic and corporate earnings growth.  As we have described on numerous occasions in the past, we worked extensively earlier this year to upgrade the quality of our bond holdings given the rise in Treasury and money market yields.  These investments have recently provided solid ballast in the midst of a significant correction in global stocks, and will provide the necessary dry powder for future rebalancing opportunities.

 

 

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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November 20, 2018: Sharp Ups and Downs

You have probably noticed the recent sharp ups and downs in the stock market. Prior to October, the well-known U.S. stock market benchmarks (e.g., Dow, S&P 500) had bucked the trend of declining stock markets outside of the U.S. that began earlier this year. Starting in October, however, U.S. stocks have joined in the downtrend.

As one of many leading indicators, the stock market downturn may be foretelling an eventual economic recession in the U.S. Although the U.S. economy has been strong and may continue to grow, albeit at a slower pace, it is quite possible that certain economies outside of the U.S. are already experiencing recessions.

In the past, global economic recessions in which the U.S. economy continued to grow resulted in less severe stock market corrections than global recessions that included the U.S. economy. According to Ned Davis Research, the average stock market correction has been around 20% during a global recession in which the U.S. continued to grow. Although the current correction may turn out to be more or less severe than the average, currently we are about halfway to the average correction. Regardless of the ultimate severity of this correction, we believe it is reasonable to assume that the bumpy ride for stocks will continue in the coming months.

As a reminder, we keep many years’ worth of cash flow needs in more stable bonds and money market for our retired clients, which means we do not expect to be forced sellers of stocks at unattractive prices. For our younger clients adding money to their portfolios, a declining stock market provides lower prices on long-term investments, which translates into higher expected returns in the future.

Past performance does not guarantee future results. Investment strategies discussed may not be suitable for all investors. Diversification does not guarantee against investment loss. The information provided here is for general informational purposes only. The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation. Investors should thoroughly evaluate any security before taking action. International investments involve special risks, including currency fluctuations and political and economic instability. Opinions expressed are subject to change without notice in reaction to shifting market conditions. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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October 19, 2018: Feeling Old

We felt really old reading a newspaper article the other day. The title of the article was, “Professional Videogamers Hit the Gym,” and it described how those who play video games for a living are lifting weights, doing yoga, and eating healthy foods in an effort to prolong their careers.

Our reaction to this was: When the heck did playing video games become a profession?

Update on the Economy and Investment Markets:

In nine months or so the U.S. economic expansion will become the longest on record. Although we are concerned with the levels of corporate and government debt, we think the U.S. consumer is in decent shape, not to mention highly-confident. This bodes well for consumer spending in the coming months, which is a significant contributor to our economy.

As to the investment markets, another thing that makes us feel old is the fact that no one who has invested in the U.S. stock market since the global financial crisis ten years ago has experienced a bear market or a really bad year. It has been a long time since investors have been tested by a severe or prolonged economic or stock market downturn. As “old fogeys” who experienced the severe downturns from 2000-2002 and 2007-2009, we are always mindful of managing your portfolio’s risk.

You have probably noticed the increased volatility in the stock market recently. Although we cannot know the reasons for certain, presumably this has been primarily caused by a sharp rise in longer-term interest rates over the past several weeks.
Prior to the recent volatility, the rise in the well-known Dow and S&P 500 indexes masked a very weak global stock market. Certain stock markets outside of the U.S. are already experiencing bear markets, down more than 20% from their highs.

The well-known U.S. stock market indexes, while setting records during the third quarter, were driven by fewer and fewer rising stocks. Aggressive momentum investing strategies; i.e., buying what has performed best recently, was this year’s ticket to solid performance until recently. As is often the case, those strategies that performed best prior to the recent correction have performed the worst during the correction. As investors, we all must decide whether we want our portfolio to fully participate in aggressive markets or limit losses in weak markets. We simply cannot have it both ways.

Although the economy is strong, we’ve pointed out before that high levels of consumer confidence, low levels of unemployment, and high allocations to stocks by U.S. investors have been reliable predictors of subdued future stock returns.
This seems counterintuitive, but it speaks to human psychology and its effect on risk-taking. Although we all understand the concept of “buying low and selling high,” it is very difficult to do in practice. Most of us are hard-wired to become more optimistic and risk-tolerant when things are going well, and this can lead us to invest more aggressively despite high prices. Conversely, most of us become more worried and risk-averse when things are not going well, and this can cause us to invest more conservatively when prices are low. This is the opposite of buying low and selling high, and we will continue to try to help you resist this temptation.

Past performance does not guarantee future results.  Investment strategies discussed may not be suitable for all investors.  Diversification does not guarantee against investment loss.  The information provided here is for general informational purposes only.  The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation.  Investors should thoroughly evaluate any security before taking action.  International investments involve special risks, including currency fluctuations and political and economic instability.  Opinions expressed are subject to change without notice in reaction to shifting market conditions.  Data contained herein is obtained from what are considered reliable sources.  However, its accuracy, completeness or reliability cannot be guaranteed.

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September 28, 2018: Swimming Naked

“You never know who’s swimming naked until the tide goes out.”
- Warren Buffett

As expected, on Wednesday the Federal Reserve raised its target for short-term interest rates for the third time this year and the eighth time since it began its rate-hike campaign in December of 2015 following seven years of near-0% short-term rates. Wednesday’s move brings the Fed’s target for short-term rates to between 2% and 2.25%. Assuming the U.S. economy’s current strength continues, the Fed expects to raise its interest rate target another percentage point over the next year or so.

As a reminder, increases in the Fed’s short-term interest rate target translate into higher yields on money markets and short-term bonds. Currently, money markets and high-quality short-term bonds are paying 2-3%, and their yields should continue to rise in the coming months assuming the economy remains strong and the Fed continues to raise rates. After nearly a decade of enduring 0-1% yields on money markets and high-quality short-term bonds, this is a very positive development for risk-conscious investors.

Swimming Naked

We acknowledge recycling many of Warren Buffett’s quotes in our newsletters, but his quote regarding swimming naked seems apt to us at this point in the economic and investment cycle. Buffett was analogizing swimming naked to investors taking risks that will be revealed in an unpleasant way when economic conditions change.

By keeping interest rates artificially low for so long in this economic expansion, the Fed forced investors to choose between accepting low returns on safe investments versus reaching for higher returns by taking more risk. Many investors adopted the latter strategy, feeling they had to abandon their risk aversion and move out on the risk spectrum in order to earn acceptable returns. Given that the prices of riskier investments such as stocks and lower quality bonds have not fluctuated much during this expansion, more aggressive investors have effectively earned something (higher returns) for nothing (not much additional risk).

We are not in the prognostication business, so we will not attempt to predict the timing of the end of this economic expansion. Despite it being the second-longest expansion in history, it certainly feels like it could continue for a while.
Taking the temperature of consumers and investors, however, leads us to conclude that it is not a time for complacency. Consumer confidence tends to increase as economic cycles mature, and current measures of consumer confidence are the highest they have been in 18 years. Growing confidence tends to lead to weaker vigilance on the part of investors, and many investors currently have more risk in their portfolios than they may realize. Importantly, high levels of consumer confidence and investors’ allocations to riskier investments have proven to be contrary indicators in the past, preceding economic recessions and investment declines.

We concede that it takes fortitude to embrace a risk-conscious approach when markets are rewarding aggressive behavior, but we think it is unwise to become more aggressive at this time. Our biggest investment concern at this point is the growing level and declining credit quality of corporate and government debt. We have welcomed the rise in money market and Treasury yields and have spent much of this year improving the credit quality of our bond holdings. We feel owning these will provide you with a suitable pair of swim trunks when economic conditions change and the tide goes out.

Past performance does not guarantee future results. Investment strategies discussed may not be suitable for all investors. Diversification does not guarantee against investment loss. The information provided here is for general informational purposes only. The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation. Investors should thoroughly evaluate any security before taking action. International investments involve special risks, including currency fluctuations and political and economic instability. Opinions expressed are subject to change without notice in reaction to shifting market conditions. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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August 1, 2018: Recession Signal?

“Most things I worry about…never happen anyway.”
- Tom Petty, from Crawling Back to You

The financial press has recently been consumed with the near-term potential for an “inverted yield curve.” This describes a situation in which shorter-term interest rates exceed longer-term interest rates. As of this writing, the yields available on 6-month and 2-year Treasurys, which are commonly used as measures of short-term interest rates, are 2.27% and 2.67%, respectively. The yield on the 10-year Treasury, which is commonly used as a measure of longer-term interest rates, is 2.98%.

Many people are confused by the relationship between the Federal Reserve’s interest rate policies and the level of interest rates on various types of bond investments (and loans). Shorter-term interest rates are overwhelmingly determined by the Federal Reserve’s actions; this is why yields on 6-month and 2-year Treasurys have risen by approximately 2% since the Fed began raising its target for interest rates in late-2015 and are the highest they have been in ten years.

Longer-term rates, on the other hand, are generally driven by investors’ expectations for longer-term economic growth and inflation, and may or may not follow changes in shorter-term rates. The 10-year Treasury yield of 2.98% is higher than it was when the Fed began raising its interest rate target in late-2015, but it has not risen nearly as much as yields on shorter-term bonds. Thus, the spread between short-term and long-term interest rates has narrowed; this is referred to as a “flattening yield curve.” If long-term rates remain where they are and the Fed continues to drive short-term rates higher, we will experience an “inverted yield curve” whereby short-term rates are higher than long-term rates.

Who Cares?

Historically, an inverted yield curve has been an excellent predictor of economic recessions. According to The Wall Street Journal, “Over the last 50 years, a recession has followed every time the yield on two-year Treasurys has exceeded that of 10-year Treasurys.” Although the 2-year Treasury yield is still lower than the 10-year Treasury yield, one or two more interest rate increases by the Fed may do the trick. Given how close we are to an inverted yield curve, you are likely to hear more about this subject in the coming months.

As you might imagine, it is difficult to use the yield curve as a means to predict the specific timing of a recession and/or to adjust your investment portfolio’s targeted stock allocation to reduce your risk. The yield curve last inverted in December of 2005, but the Great Recession did not start until December of 2007. In earlier instances of an inverted yield curve, the timing and severity of recessions and stock market corrections varied considerably.

Another problem with analyzing today’s yield curve is attempting to quantify how much the current low level of long-term interest rates reflects global central banks’ generous monetary policies (e.g., purchase of longer-term bonds) versus investors’ concerns over future economic growth. As The Economist recently observed, “just how much distortion [to the yield curve] is occurring is unclear concerning the effect of asset-purchase programs by the European Central Bank and the Bank of Japan.”

The 10-year Treasury yield of 2.98% looks downright juicy compared to the barely-visible yields on many European and Japanese government bonds. This condition may continue to keep a lid on longer-term U.S. Treasury yields for the time being and may or may not reflect an impending economic slowdown.

What to Do?

We are respectful of the yield curve’s signals and mindful that the current economic expansion in the U.S. is the second-longest in modern history and cannot continue forever. We do not believe this is a time for you to take on more risk. Having said that, we do not necessarily believe an economic recession is imminent in the U.S.

Perhaps most importantly, we are pleased that we can finally earn a return on safe investments such as money markets and Treasury bonds and, as a result, we have made changes to the bond portion of many of our clients’ portfolios in recent months. Specifically, we have been gradually replacing a portion of non-Treasury bonds with Treasurys and money markets and expect to continue to do so in the coming months. These have tended to provide the greatest protection from recessions and stock market corrections in the past and we expect they will continue to do so in the future.

Past performance does not guarantee future results. Investment strategies discussed may not be suitable for all investors. Diversification does not guarantee against investment loss. The information provided here is for general informational purposes only. The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation. Investors should thoroughly evaluate any security before taking action. International investments involve special risks, including currency fluctuations and political and economic instability. Opinions expressed are subject to change without notice in reaction to shifting market conditions. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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