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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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