Financial planners often work with averages. But the reality is that each bear market will be different from the norm. At the time that I write this, the depth of this particular drawdown does not even rank with the worst in history. Sure, it may still get worse, but that’s where we are today.
We may not want to hear about how things will get better, because the situation with the Covid-19 pandemic and its resulting prescription of social isolation and market downdrafts is scary. But, eventually, things will get better.
Keep in mind that things may get worse before they get better. The count of people with the virus will almost certainly increase. If you don’t have a source yet, you can keep up with it over here. But eventually, the Coronavirus epidemic will run out of steam. We will get back to our places of work. Kids will go back to school. Financial markets will right themselves out. We will revert to standard toilet paper buying habits. We will start going out to eat again. Life will become normal again.
Financially, the question is not just how bad will things get, but how long it will take for our nest eggs to rebuild, so we can put our lives back on tr
Hence, it could take us a while before we make it back to the previous market peak. However, we may want to look at the data differently. This graph shows that, historically, we have needed to achieve a return of 46.9% to recover from a bear market . According to Franklin Templeton calculations, these numbers can look daunting. However, they have been achieved and exceeded after every past downturn. While there is no guarantee, these numbers suggest that there will be strong returns once we have reached the bottom of the market. I like to think of this as an opportunity.
With the time that it takes for investments to grow and get your money back, there is time to take advantage of higher expected returns. For those who have resources available, this means that there is time to deploy your money at lower prices than has been possible in recent months.
Those of us who have diversified portfolios and are not in a position to make new investments, the opportunity is to rebalance to benefit from a faster upswing.
We know from history that every US stock market downturn was followed by new peaks at some point following.
Could this time be different?
Of course, that too is possible.
I like to think that the future will be better. We will still wake up in the morning looking to improve ourselves, make our lives better, and achieve our goals. We are still going to invent new technologies, fight global warming, and struggle for a more equitable society.
We are living through difficult times right now. Losses in our brokerage and retirement accounts are not helping. But we will get through this. Please reach out to me if you have specific questions or concerns.
Do-It-Yourself (DIY) Investors have been cropping up everywhere since the end of the 2008 Financial Crisis.
DIY investors tend to be well-educated professionals of reasonable means that prefer to build their own portfolios without the help of an investment professional.
They educate themselves about investing by reading a number of investment books (here is a popular one for Bogleheads) and subscription-based services espousing the benefits of the DIY approach.
A lot of DIY investors identify strongly with Jack Bogle, the founder of Vanguard for his dedicated approach to index investing.
One thing that distinguishes today’s crop of DIY investors from the original crop back in the 90’s is that today’s investors are much more focused on exchange-traded funds (ETF) as compared to individual stocks. A large number of inexpensive and liquid ETF’s have made this possible.
The primary appeal of DIY investing revolves around gaining control over your portfolio.
You are in charge and make all decisions. From selecting a specific ETF to all buy and sell decisions. A secondary appeal of DIY investing is cost – if you are the manager of your own portfolio you save yourself the fee that would have gone to your investment advisor. Typically this fee amounts to about 1% of the value of your portfolio.
DIY investors tend to do well when capital markets exhibit low volatility and the trend in price is well established. Everybody loves up-trending markets that don’t fluctuate much. But as Humphrey Neill, a famous contrarian investor used to say “Don’t confuse brains with a bull market”.
The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake will increase significantly.
DIY investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in such a benign environment.
But when the capital markets get dicey, the implications of one’s actions increase dramatically. A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.
Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before.
I have lived through the 1987, 2000-2002 and 2008 stock market meltdowns. None of these were fun but I learned valuable lessons in each of these crises. Mainly I learned not to panic but also ways to course correct once it became clear that action was required. A key insight is that changing fundamentals require changing portfolio compositions.
A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior afford you is a game plan honed by the school of hard knocks.
Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, DIY investors are at a significant disadvantage.
The potential for errors during a crisis goes up exponentially. Three common reactions or mistakes that we have seen from DIY investors involve:
1. Selling Everything in a Panic
No questions asked, just get rid of everything that is taking a hit before it gets even worse. Taking action by selling everything may give the DIY investor a sense of relief. But making decisions in a highly charged emotional state is asking for trouble.
If the decision to sell is based on solid research and is well thought out, fine. But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place. Investing comes with volatility, there is no way around this!
DIY investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change. And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.
Fortunately, most DIY investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But don’t kid yourself – in a market meltdown you will want to sell everything and more!
You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence.
Photo by Goh Rhy Yan on Unsplash
2. Becoming extremely risk-averse and freezing up even if action is clearly needed
Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2018 we have already had a couple of equity market corrections but in each case, the market recovered its losses fairly quickly.
No harm, no foul! Doing nothing or standing pat works just fine when markets recover.
The bigger problem for investors is when corrections take on a bigger life and become outright market crashes. For example, the S&P 500 was down three straight years from 2000 to 2002. What do you do when the roof seems to be caving in?
Many DIY investors close their eyes and pretend that this is not happening to them. They get frozen and choose to ignore reality. This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue.
Wishing the problem away does not work. From the field of behavioral finance, we know that investors tend to hang on to their losing investments way too long. The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.
The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.
You observe falling prices and you get more and more uncomfortable. But is there any real economic information in investor sentiment?
Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks much predictive ability.
Has something changed recently to warrant this drop in market values? Are growth rates and profitability permanently impaired, or is the market overreacting? Are investors reacting to the perception of market over-valuation? These are all questions that require some real expertise and most importantly an understanding of context.
There is no cookie cutter way to analyze market action making the experience in similar conditions coupled with knowledge of historical market behavior all that much more valuable.
3. Failing to assess the changing risk levels of their portfolios
A frequent mistake made by DIY investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.
Much of the thought behind DIY investing hinges on ideas derived from Modern Portfolio Theory (MPT) but somehow you hardly ever hear DIY investors justify changing allocations based on the volatility structure and composition of their portfolios.
A related mistake is to often assume diversification benefits that often are not there when you need them most. A good read on “fake diversification” can be found here.
Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors. In fact, one could say that by ignoring the volatility structure of portfolios DIY investors are ignoring some of the lowest hanging fruit available.
As Nobel Prize Winner Harry Markowitz once said: “diversification is the only free lunch provided by capital markets”.
In a study done a couple of years ago on portfolio rebalancing, I showed just how much stock and bond volatility and correlations can change over time.
Source: Global Focus Capital LLC
Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability. And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.
Say, a DIY investor has a portfolio composed of 60% US stocks and 40% US Bonds. The DIY investor diligently rebalances this portfolio every month so that the weights stay in sync. What would this 60/40 portfolio look like in terms of volatility?
Using the above study over the 2000 to 2016 period, the average volatility of this 60/40 portfolio would average 8%. Assuming that the average volatility would not change much would be a mistake. The range of volatility goes from 4% to 15% as shown in Figure 2.
Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk. A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 15%. Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.
Source: Global Focus Capital LLC
DIY investors do not often construct portfolios targeting an explicit range of risk. Instead, the often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their “normal” levels. These assumptions are not supported by the empirical evidence.
Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification. What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions.
DIY investing is here to stay. Many non-investment professionals have educated themselves as to the virtues of retaining control over their portfolios. After all, DIY investors are saving themselves the fee that they would normally pay their advisor for managing their portfolio.
When markets trend up and volatility is low, DIY investors will typically fully participate in the gains.
But there is another “cost” that DIY may be incurring on their own that often rears its ugly head especially during periods of capital market turbulence.
We are all human and we suffer from the same biases and fears. The difference is that experienced professional investors have the advantage of having seen similar periods of capital market stress before and possess a more nuanced perspective of normal capital market behavior.
Professional investors while prone to the same fears as the DIY crowd are better positioned to focus their attention on the fundamentals of investment performance -growth, profitability & valuation – that ultimately drive portfolio values.
Experience and knowledge gained over many market cycles are at a premium when your portfolio most needs it. At Insight Financial Strategists we are experts in integrating your financial planning needs with your investments.
You do not have to go at it alone and compete against the pros. Our investment approach is rooted in the latest academic research and implemented using low-cost investment vehicles.
Interested in talking? Please schedule a complimentary consultation here.
Investors throw out lots of platitudes about their portfolios being diversified. Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?
Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.
But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection. Whatever the price was, it was well worth it!
The portfolio diversification concept is, however, different from typical insurance in some important ways. When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.
The devil is always in the details, right? You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?
When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?
Probably not. Remember the old saying – assume makes an a** out of you and me! Better be safe than sorry when it comes to your financial health.
Let’s start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns. One investment will neither kill nor make your whole portfolio.
A diversified portfolio contains investments that behave differently. While some investments zig, others zag. When one investment is up big, you might have another one that is down. Your portfolio ends up in the middle somewhere. Never as high as your best performing investment and never as low as your worst nightmare investment.
Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.
Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?
I know these questions may seem a bit sophomoric but knowing the “why” for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.
The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.
Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive. Anybody up to buying some snake oil?
Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.
Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket – whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!
With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?
Accumulating investments over time is a very common practice. People sometimes get enamored with a certain investment type such as tech in the late 90’s and when things don’t pan out they are reluctant to sell the investment.
Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic. Many individual investors are hoarders without admitting it.
Sometimes it is as simple as when people change jobs leaving behind a 401(K).
Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.
But let me warn you – looking only at past returns will tell you much about the past but virtually nothing about the future. Ruthlessly eliminate funds that you don’t understand, have high fees or simply do not fit the style that you’re looking for. Don’t eliminate funds based solely on past performance.
Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix. There is no rhyme or reason for any of this, but many people use this approach, right?
This is a very common mistake of investors. A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.
Solution: Less is often better when it comes to your investments. Too many funds means extra confusion. Simplify to a small number of funds that will serve as your core portfolio holdings. Think of these funds as the pillars holding up your financial house.
Choose low cost funds that you will be comfortable holding for decades. Hint – focus on a small number of broad based index funds covering stocks and bonds.
Photo by Natalie Rhea Riggs on Unsplash
Symptom 3: Your portfolio contains lots of investments with the same “theme”
Sounds like you have a fun portfolio when things go well but a nightmare when they don’t. People fall in love with investment themes all the time. They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.
In the late 90’s it was all about the internet. Many people loaded up on the sector and lost their shirt soon after.
Starting in mid-2017 the buzz was all about cryptocurrencies. Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.
Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the “new, new” thing. You should too!
If you really understand a theme think about how long it will take for the mainstream to adopt it in mass. Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!
Symptom 4: All your investments are in the same asset class
This is a variation of the previous issue. Sometimes you hear people say, “I am just a bond guy”. Or, maybe they say “I am a stock jockey”. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health. As my mother would say, “do things in moderation”. I still think that this is great advice whether it is about eating or investing.
The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.
Let’s take the case of stocks. In any given day, most stocks tend to move up or down together. When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day. Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.
Same applies to bonds but the herding effect is even stronger. Take the case of US bonds of a similar maturity, say 10 years. This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury. If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep. Same on the downside. Just like sheep.
Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together. Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.
Solution: For most people it makes sense to hold investments in all the key asset classes. The three main asset classes that you should own are stocks, bonds and real estate.
Don’t get too cute. If you own a home you probably already have enough real estate exposure.
Why should you own stocks? For growing your nest egg over the long-term. Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.
Why own bonds? Historically, people held bonds for the yield and stability. In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment. In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.
But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.
Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts. The value of your holdings will still be heavily influenced by movements in your stock holdings. Your account values will, however, not fluctuate as much. Is this worth it to you?
For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections. A good night’s sleep is a prerequisite for a happy life.
Symptom 5: Your portfolio has never gone through a tough market environment
Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification. After all if you just pick your investments wisely why should you worry?
Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.
Go back to the late 90’s. Investors were riding AOL, Cisco, Dell, and Microsoft. Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.
For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56. By July 1, 2002 the price had dropped to $14.32 – a horrific 76% decline from the peak. It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!
You don’t need diversification when things are going well. You only need it when the bottom is falling out from one of your investments. Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.
Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.
Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?
Many times the tension is between your rational side and your emotions. Behavioral research shows that most times the emotional side wins out. Most investors panic during corrections because they are not properly diversified.
Investing is fun when capital markets are going up and everybody is making money. Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.
Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.
Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.
Making decisions under stress is never optimal. Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.
Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch. Most people agree with his statement and attempt to build diversification into their investment strategies.
But the devil is in the details. Many people remain confused by the term and its impact on their financial health.
But understanding portfolio diversification is not an academic nicety – it materially affects your financial health
For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.
If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.
Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.
Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.
For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.
For a more in-depth analysis of your portfolio’s true diversification consult a professional consultant experienced in portfolio construction issues. You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.
Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night. Only a comprehensive wealth management assessment can give you the level of detail required.
We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio. Don’t assume that you are diversified. Contact the team at Insight Financial Strategists for a free initial consultation.
At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.
The last couple of months have tested investors. In a sense, we all got lulled by the wonderful returns of last year and any hiccup was bound to create some stress.
The talk at the end of 2017 was all about tax cuts and the short-term boost that lower tax rates would provide to consumer spending and the bottom-line of US corporations.
For the first month of the year, things couldn’t have been going better for equity investors. Bond investors while not exactly sitting in the catbird’s seat were slowly adapting to the inevitable rise in yields.
Emerging market equities, in particular, jumped ahead and the mood among global investors was one of optimism. Market commentators were even talking about a stock market melt-up!
Two months later the mood has changed drastically. Investors are nervous and we have already witnessed two small corrections in the equity markets.
Source: FRED (Federal Reserve Economic Data), Insight Financial Strategists, April 2018
The first mini-correction attributed to rising inflationary expectations took the S&P 500 from a peak of 2873 on January 26 to a low of 2581 on February 8. The 11% drop while not unprecedented was keenly felt by investors accustomed to the record low levels of volatility seen in the last year. It felt like going from a newly paved highway to a dirt road without any warning signs!
Were rising inflationary expectations to blame for the early February stock market fall? Our research did not support this story. We had been seeing a slow rise in inflationary expectations for about a year but US Inflation Protected Note prices containing the market’s consensus forecast of inflation over the next 5 and 10 years did not exhibit any significant upward pressure.
Inflation in the US seems to be fairly range bound with the latest year over year reading of 2.3% (February). Inflationary expectations as of April 6 for the next 5 years stand at 2.0% and for 10 years out at 2.1%.
The market implied forecast may turn out to be too benign, but for now, our own view of economic conditions in the US is closely aligned with these market-based expectations.
A number of events could have caused the early February correction, but in the context of long-term capital market history, we think that this episode will appear as a mere blip on price charts. Rising inflationary expectations do not seem a likely culprit for this episode of equity market stress.
Source: Quandl, FRED, Insight Financial Strategists, April 2018
What about the most recent late March equity market drawdown? US equity market markets staged a strong recovery from the February lows with the S&P 500 having recovered all but 3% of the losses from the January 26 peak. Since early March the global markets have, however, been on a roller coaster ride. Up one day, down big the next. As of April 6, the S&P 500 has lost over 6% since March 9.
The second mini-correction of the year has re-tested the resolve of equity investors. Volatility levels have jumped up and have risen significantly from the lows of 2017. The intraday movement of markets (the difference between the high and low of the day) has been about 2X that of normal periods and 4X that experienced last year.
Source: Quandl, FRED, Insight Financial Strategists, April 2018
Market volatility has been historically low over the last few years but the large intraday swings we have been seeing this year are distressing to even seasoned investors. John Bogle in a recent interview for Marketwatch commented that he had not seen such a volatile market in his lifetime. He was referring specifically to the huge intra-day moves seen over the last two weeks.
What has caused this recent bout of stock market volatility? As always there are many possible reasons, but this time around we see a more direct link to the uncertainty surrounding a possible global trade war.
Markets do not react well to uncertainty especially to events that are both hard to quantify in terms of the probability of occurrence and the magnitude of consequences.
Trade wars are not everyday events. The last time wholesale tariffs were imposed in the US happened in 1930 when the Smoot-Hawley Tariff Act was passed. While economists will debate whether the Act exacerbated the Great Depression, in general, it is acknowledged that tariffs limit economic growth.
Free-trade has been a goal of most nations for the last 50 years. Gains from free trade provide a win-win outcome enabling producers to focus on goods and services where they enjoy a comparative advantage and consumers to reap the benefits through lower costs is one of the strongest held beliefs of modern economics.
Global trade of goods and services currently accounts for 27% of worldwide output (according to the OECD). Disrupting global trade by imposing tariffs on a large number of items seems reckless. It is especially reckless when considering that we picked a fight with the world’s largest economy – China. China also owns 19% of the outstanding supply of US Treasuries.
No doubt Chinese trade practices are unfair to US companies. Forcing US companies to transfer technical know-how to Chinese firms seems especially egregious given the state of China’s economic development. China is the largest global economy and many of its technology companies are already global powerhouses.
Another bone of contention for some is the under-valuation of the yuan. An undervalued currency is a huge weapon for increasing the attractiveness of a country’s exports. However, it is not clear that the yuan is under-valued. According to an IMF report in July of 2017, the fair value of the yuan was roughly in line with market prices and fundamentals.
At first, the tariffs proposed by the Trump administration seemed fairly innocuous – washing machines and solar panels. Then on March 1, the US proposed tariffs on steel and aluminum. Not good especially since many traditional allies of the US (mainly Canada and South Korea) would be the primary targets. Gary Cohn, the administration’s top economic advisor, resigned in protest sending shockwaves through the financial community. The S&P 500 reacted with a 1.34% loss for the day
However what really got the capital markets in a tissy was the announcement on March 22 of tariffs on $50 billion worth of Chinese imports. The fight was on and it did not take very long for Chinese authorities to retaliate with in-kind tariffs on US goods.
The S&P 500 dropped 2.55% on March 22 and 2.12% on the next day. Likewise, Chinese equity markets reacted quite negatively to the possibility of an all-out trade war with the US with the iShares China Large-Cap ETF (FXI) dropping 3.8% and 2.4% respectively on those days.
Where is this all going to end up? In an all-out trade war like after the passage of the Smoot-Hawley Act? Or, in serious bilateral negotiations between the US and China?
Our guess is that there are enough rational agents in both the US and Chinese administrations to avert an all-out trade war, but getting the negotiations going will not be easy and will take time. China has already requested negotiations through the WTO Dispute Settlement Mechanism. Luckily there is at least a 60 day comment period separating talk and action.
The US is not likely to be a winner in a global trade war. Nobody is really. The most likely outcome is lower overall global growth and increased uncertainty – not a good recipe for capital markets especially in light of current above-average valuation levels.
The main problem for the US is that as a nation we are not saving enough. The current net savings rate as a function of GDP currently stands at 1.3%. This number has been steadily trending down – the average since 1947 when numbers were first compiled is 6.6%.
The US balance of payments and trade deficits are a function of the imbalance between domestic savings and our thirst to grow and consume. In 2017, the US had merchandise trade deficits with 102 countries. China is not our only problem!
Let’s hope that cooler heads prevail and that the disruption to global trade proves minimal. Some of the damage has already been done as uncertainty has engulfed global capital markets.
The real economic damage of a global trade war is likely to be substantial. Both equity and bond markets would come under significant stress. Equities would likely take the most immediate hit as earnings growth, especially for multi-nationals, would drop significantly.
Bonds are also likely to take a hit as a likely reaction by the Chinese authorities would be to decrease their investments in the US Treasury market. Interest rates in the US would likely jump up causing pain to fixed income investors as well as worsening the federal budget deficit.
What do we expect in the intermediate-term from capital markets? While all this talk about trade wars and inflation scares may fill our daily news capture, it is worthwhile to remember that fundamentals drive long-term asset class performance.
In the short-term, capital markets can be heavily influenced by changing investor sentiment, but over the horizons that truly matter to most investors most periods of capital market stress tend to wash out.
Our current capital market perspectives assume that a trade war will not materialize. Our views are informed by a number of proprietary asset class models updated as of the end of March.
Our current intermediate-term views reflect:
A preference for stocks over bonds despite their higher levels of risk
A desire for international over US equity based on valuation differentials and a depreciating US dollar – we especially like emerging market stocks
Within the fixed income market, wefavor corporate bonds as we believe that economic conditions will remain robust and default risk will be contained
Small allocations to commodities as this asset class gradually recovers from the bear market it’s been in since the 2008 Financial Crisis
A reduction in our exposure to real estate as the asset class is being heavily penalized in the markets for its interest rate sensitivity
Minimal allocations to cash – the opportunity cost of holding large sums of low yielding cash is high especially for investors with a multi-year horizon
A return of risk on/off equity market volatility– this will surely stress investors without a solid plan for navigating market turbulence
What should individual investors do while politicians flex their muscles? For starters evaluate your goals, risk attitude, spending patterns and investment strategy. Make sure that the shoe still fits. Capital markets are not static and neither are personal situations.
A long-term orientation and tactical flexibility will be a necessity for investors as they navigate what we think will be difficult market conditions over the next decade.
Such an approach will be especially important for individuals near or already in retirement. The sequence-of-returns-risk is especially important to manage in the years surrounding retirement when the individual will start drawing down savings.
Our approach at Insight Financial Strategists explicitly deals with this type of sequence-of-returns-risk by building the individual’s portfolio around the concept of goal-oriented buckets. Each bucket has a distinct goal and risk profile.
The short-term bucket, for example, while customized for each individual, has the overriding goal of providing a steady stream of cash flow to the individual. This is the safe money designed to exhibit minimal volatility.
The goal of the intermediate-term bucket is different – this part of the portfolio is designed to grow the purchasing power of the individual in a risk-controlled manner. A sometimes bumpier ride is the price of growth for this bucket but the rewards should be more than commensurate with the additional risk taken.
Finally, the long-term bucket is designed to maximize the long-term appreciation of this portion of the portfolio. This bucket will be the most volatile over the short term and is suitable for individuals with time horizons exceeding ten years and able and willing to withstand the inevitable periods of capital market stress.
The mental picture I use is that of flying. The six hour trip from Boston to LA is great when it is all smooth sailing. The plane seems to be flying itself and you pay more attention to the movie you are watching than thinking about the age of the aircraft or training of the pilot and crew.
But the first time there is a little air bump and maybe lighting strikes your plane you immediately tense up and fix your gaze on the crew. Are they calm? Do they seem competent? Is this their first rodeo?
You form a mental image of what you want your pilot to look like. Calm and collected for starters. But mainly experienced. We all want to see Captain Sully at the helm.
Clearly, we all would love smooth capital markets forever. But the close friend of return is always uncertainty. The two are inseparable even though they may not always be in direct contact. In times of turbulence you want experience at the helm and a solid understanding of how the two are intertwined.
How do we think of uncertainty in the capital markets? There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right) but without hopefully appearing too cavalier we think that it is useful to think of uncertainty as a normal distribution of potential outcomes.
We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking) has led us to the right tail of the distribution.
In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more. The year turned out much better than expected. What do we expect for this coming year?
Our baseline assessment is fairly benign as we discussed last month in our Capital Market Overview. A quick review is in order.
We expect equities to again do better than bonds. We also expect international assets to outperform domestic strategies. We expect robust global growth. Our most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdown. In our judgement there is about an 80% probability that such a scenario plays out in 2018.
On the downside we expect the low volatility that has accompanied capital markets recently to once again revert back to risk on/off.
Our baseline assessment is fairly benign
We expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution. The press calls these events Black Swans. Our best assessment is that there is about a 15% probability of seeing a Black Swan event in 2018.
On the other end of the uncertainty distribution you have what we call Green Swans – events, low in probability that when they happen are wildly positive for investors. We attach a 5% chance of experiencing such extreme positive events over the current calendar year
1. An inflation spike caused by a sustained rally in commodity prices
Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).
In our view, forecast complacency has set in and the risks are to the upside. Traders would describe the low inflation trade as over-crowded. Maybe it is time to re-think what happens if the consensus turns out to be wrong.
The immediate effect of an upward spike in inflation would be a rise in bond yields. Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.
What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Another could be related to the resurgence of global growth and continued demand for commodities such as iron ore and copper. Third, a depreciating US dollar leading to commodity price inflation.
2. A spike in capital market turmoil caused by a geo-political blowup
The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.
Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.
All of these events have blowup potential. While the probability of any of these events happening in 2018 is low, the magnitude of the capital market response is likely to be large and negative especially for equity markets. Global economic growth would also, no doubt, loose some of its momentum.
3. An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China
It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping. It is widely acknowledged that the US retail market is over-built.
According to the Institute of International Finance global debt hit a record last year at $233 trillion. Debt levels as a percentage of global GDP are higher today compared to 2007. Figuring prominently in the debt discussion is China.
Global Debt Reaches a Record in Q3 2017 Source: IIF, IMF, BIS
The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis. The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.
Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies. The robust GDP growth in China and the tacit understanding of the monetary authorities of the extent of the problem will hopefully keep the wolves at bay.
The implications of a debt scare for investors would be quite dire. Investors have had plenty of experience with debt crisis in recent years – Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets. A Chinese debt scare would no doubt be of greater impact to global investors. Emerging market debt spreads would certainly blow up.
What about the right hand tail of the uncertainty distribution – the Green Swans?
These are wildly positive events for investors that carry a low probability of happening. What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?
1. Positive global growth surprise possibly brought on by the recently enacted US tax reform
The US is the largest economy in the world and still remains a significant engine of global growth. Could we be surprised by a spurt in US economic growth this year?
According to the Conference Board US real GDP is expected to growth 2.8% in 2018. Could we see 4% growth? The President certainly hopes so. Not that likely. The last time that US GDP growth was above 4% was in 2000.
What could give us the upside scenario for growth? Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.
Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.
We view both scenarios as likely but providing only a marginal boost to growth. As they say we remain cautiously optimistic, but would not bet the farm on this.
2. A spurt in exuberant expectations driven by the cryptocurrency craze
Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way. We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.
In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher. Lots of investors succumbed to FOMO in the final stages of the bubble.
Photo by Ilya Pavlov on Unsplash
The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble. It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.
No doubt fortunes have been and will continue to be made in cryptocurrencies. Blockchain technology which underlies the crypto offerings is here to stay, but we worry about the lack of investor education and the speed of the price action in late 2017. Whatever happened to Peter Lynch’s “buy what you know” approach?
What would be our best estimate for capital markets should the cryptocurrency craze gain further momentum in 2018? First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.
Companies adopting blockchain technologies would see their valuations increase disproportionally. In general, animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day. The primary beneficiary would be equity investors.
History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018. What shape and form it will take (or Swan color) we don’t know.
Preparing for tail risk events is very expensive and under most scenarios not worth bothering with.
Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.
The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion. Again playing it too safe can result in many lost opportunities for capturing significant market up moves.
Investing in capital markets is all about weighting these probabilities and focusing on a small number of key research-driven fundamental drivers of risk and return.
How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health. Putting a financial plan in place and having an experienced Captain Sully-type as your captain during times of turbulence should reassure investors in meeting their long-term goals.
Note:The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions. We make no representation as to the accuracy or completeness of the information presented. This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.
Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances. All investments are subject to risk, including the loss of principal.
Insight Financial Strategists LLC is a Registered Investment Adviser.