Should You Buy An Annuity?

By Chris Chen CFP | Capital Markets

Should You Buy An Annuity?

Annuities are a popular retirement planning device. According to Investment News, sales broke a record in 2018. Yet, they continue to be misunderstood. There are several types of annuities, with fixed, fixed indexed, and variable being some of the most common. Unfortunately, annuities are so complex, that salespeople often have difficulty communicating their values and shortcomings to clients. It is sometimes said, humorously, that the greatest value of an annuity is the steak dinner that it comes with.

 

Joking aside, the point is that annuities are complex and most of their benefits are intangible, except for the steak. As a client, you will eventually have to decide that if you are not going to become an expert with annuities, you will have to trust a salesperson.

Annuities have value. However, their value must be balanced with costs and lost opportunity considerations. In addition to the direct costs of the annuity, like “mortality and expense”, the expense ratio of the investments or the costs of the “riders”, and indirect opportunity costs what are the value of the benefits you might be giving up to get an annuity?.

First, what does an annuity get you?

Fixed Income

The most commonly advertised benefit of an annuity is fixed income. The insurance company that sells and manages the annuity will be paying you periodically, usually monthly, for the rest of your life (usually).  That payment is presented as fixed: it will never decrease. Obviously, that is appealing to a lot of people: finally a financial instrument with some safety built in.

Rarely does the salesperson point out the obvious: the periodic payment amount will never increase either.

Why does it matter yo have your payment increase? In an age where people ought to be planning for retirement for 20 or 30 years or more, a periodic payment that does not increase is basically a payment that continuously loses value to inflation. While you may not notice it from one year to the next,  inflation is pernicious: it will slowly eat away your purchasing power.

For instance, the table below shows that with inflation of 3%, the value in today’s dollars of a $5,000 annuity payment that you might receive today goes down to $2,803 in 20 years. In other words, you would be losing almost $2,200 of purchasing power automatically. Needless to say, this is something that you would want to know before buying the annuity.

Source: Insight Financial Strategists LLC

Tax Advantage

Also, annuities are Tax-advantaged. Americans love tax-advantaged investments, almost as much as they like tax-free investments. That is a key point to note: the money that you contribute to an annuity is not taxable when it distributes in retirement because, presumably, you have already paid taxes on it. Therefore, when the annuities distribute in retirement, part of the distribution is your own money that comes back to you tax-free. The gains, however, come back to you taxable as ordinary income.  

Now, how does the tax treatment of annuities compare to other methods of investing, like for example investing in equities and fixed income outside of an annuity?  As with annuities, contributions to your investment are not taxed again when they are distributed. However, your gains will usually be taxable as capital gains. This is important because for many people capital gains tax rates are lower than ordinary income tax rates. In other words, you may very well be paying more taxes by putting your money in an annuity than if you had invested outside of it if the right circumstances are met.

Guarantee

Another attractive benefit of annuities is that the payment amounts are Guaranteed.  Financial Planners are not usually able to say that anything is guaranteed, because we do not know the future.  However, financial salespeople can say that about annuities, because the benefits are guaranteed by the insurance company. Obviously, that is a very powerful statement, especially in the absence of comparable guarantees for traditional investment products.

The bottom line is that traditional investments are not guaranteed. We know from watching the market or hearing about it on TV that anything can happen. In particular, the stock market can drop.

Hence if we could protect ourselves from the risk of the stock market going down, it would obviously be a good thing. We know that in any given year the market could go down. In fact, according to Logan Kane, on any random day, we have a 47 percent chance of stocks falling and a 53% chance of stocks rising. In any given year, we have a 75% chance of stocks rising.

We also know that on average the stock market goes up. In fact, even when it goes down, we know that in any rolling five year period it will also go up as demonstrated with the S&P500 on the following graph.

Source: bespokepremium.com

Therefore, when we protect ourselves against the downsides of the stock market with annuities we give up a lot of upside opportunity cost in return.  

Investments

Annuity companies tend to be shy about disclosing how your contributions are invested, except for variable annuities where the regulatory disclosure requirements are well developed. Variable annuities are invested in a mix of stock and bond funds. You can get a thorough description in their disclosure document.

Otherwise, insurance companies will rather have a root canal than tell you how their fixed annuities are invested. Perhaps it does not matter since the insurance company guarantees the payments. Maybe we don’t need to know.

Fixed index annuities are another matter.  These instruments allow for the potential for growth.  Mind you, in the typical words of a self-described “industry-leading financial organization”, ” your money is not actually invested in or exposed to the market”.

They can get away with this statement because it is, most likely, technically true. However, in order to make the returns that they claim that their annuities can make, the insurance companies have to invest in something more than cash. Fixed index annuities put their money, your money, in derivatives: stock options and futures. Technically, it saves you stock market volatility by being outside of it. Instead, you get derivatives market volatility which is even greater.

This has to be one of the most misleading sales pitches that financial salespeople make about fixed index annuities. Still, if the insurance company guarantees the returns, maybe it’s okay anyway?

Costs

Lastly, what about the costs??

Insurance companies tend to be less than forthcoming about the costs of their annuities, except when regulations force them to disclose them. For instance, variable annuities typically disclose a lot of information. When you read the prospectus you will find that it discloses various kinds of fees: administration, mortality and expense, mutual fund subaccount, turnover ratio, and death benefit being some of the most common. According to the Motley Fool, you might find that the total ongoing cost of your variable annuity can be anywhere from 2.46% to 5.94% a year.  

Disclosure requirements for fixed and fixed index annuities are much less developed, which may be why insurance companies don’t typically disclose them.  However, disclosure notwithstanding, there is definitely a cost that goes to paying your salesperson’s commission or the complicated options and futures strategies on your fixed index.

Value

The primary value of annuity products is not in the income or guarantee or tax benefit that they provide. The primary value of annuities is that they absorb risks that you as an investor are not willing to take in the market. Annuities give you a guaranteed fixed income. In exchange, they limit the possibility of growth in your capital or your income.

They do that by balancing your risks with other people like you. As we suspect, most of us will not have an average life expectancy. We are either above average or below average. As Bill Sharpe, a Nobel prize winner in economics reminds us, buying an annuity allows us to share those risks, and for those of us who are above average, an annuity may well be a great bargain.

As the organizer of the annuity party, the insurance company absorbs some of the risks as well. When we buy an annuity, we are transferring the risk of investing on our own to the insurance company. If the insurance fails in its investments, it commits to paying us anyway. That is valuable, but does the benefit need to cost that much? Could it be overpriced?

Annuities can provide incredible value. However, the simplicity of providing guaranteed monthly income is well overtaken by the complexity, direct costs and the opportunity cost. It is important to understand what you are getting and what you are giving up with an annuity, You can make sure that it meets your needs first by getting advice that is in your best interest by a fee-only financial planner.  You can find one at NAPFA or XYPN. Both are organizations of Certified Financial Planners that are committed to giving you advice that is in your best interest.

Market Perspectives – October 2018

By Chris Chen CFP | Capital Markets

Should we panic yet?

September 2018 marked the 10 year anniversary of the Lehman Brothers bankruptcy in 2008, that ushered several months of extreme activity in the financial markets. The market slide from December 2007 to March 2009 was one of the steepest and scariest that we remember.

Yet, ten years later, the S&P 500 has enjoyed the longest bull market in US history, having lasted 3,453 days from March 9, 2009, until the end of September 2018. (footnote: Dow Jones Indices and Washington Post) As has been the case throughout its history US markets have recovered and more than made up the losses of the last downturn. According to Morningstar, the S&P 500 returned an annual 12% from October 1, 2008, to September 30, 2018. On a cumulative basis, the S&P 500 has returned by 210%.

This rally has been largely fueled by the easy monetary policy of the Federal Reserve, which moved short-term interest rates effectively to zero in the wake of the 2008-2009 bear market, promoting risky behaviors, especially with corporate borrowing, which have helped drive the U.S. stock market upwards since then.

We all want to know when the next market downturn will occur. Some may think that it has started already with the October 2018 volatility. Since we cannot predict the future with any accuracy, we’ll stipulate that it may well have. However, we believe that the October market reflects a reversal to the greater volatility that the financial markets have historically displayed instead of the placid pace that we have been accustomed to since the Great Recession. We should get used to more of the same in the future.

We are likely to be in the late innings of the current economic expansion. However, there are reasons for a cautiously positive outlook for the short term. Either for the short or long run, it continues to be important to match the risks of your investments with the need you will have for the funds.  (If you are not sure what I am talking about here, drop me a line). If your needs for your money is in the short term, invest appropriately.

With proper matching of asset risk and liability timing, you can be well prepared for the downturns that will inevitably come.

A New Round of Tariffs

In late September, the U.S. placed an additional round of tariffs on $200B of Chinese goods. They are expected to affect a wide range of products, from computer electronics to forestry and fishing.

In response, China accused the Trump administration of bullying and applied their own tariffs on $60B worth of goods. If the Chinese response looks weak, it is only because China imports a lot less from the US than we do from them!  That should not be reassuring as China has many other tools to retaliate with besides imposing tariffs on American goods.

According to Fitch, the rating agency, these trade escalations will have a negative impact on global growth. As a result, they lowered their economic growth forecasts slightly from 3.2% to 3.1%.

In its simplest form, a tariff is a tax imposed on imported goods. Eventually, it gets paid by consumers. There are already anecdotes of the effects of the tariffs on the price and availability of some products. Coupled with the tariffs imposed by China, we expect that they will work themselves in the numbers in quarters to come.

Consumer Confidence Near All-time High

American consumers continue to be oblivious to the effects of trade and tariff risks. The Conference Board’s Consumer Confidence Index hit an 18-year high and sits very close to an all-time high, due in part to a strong outlook on economic growth and low unemployment.

Speaking of unemployment: it fell to 3.7% in September 2018, well below the 50- year average of 6.2%. Normally, we expect low unemployment to be associated with wage inflation. Fortunately for employers, although not for workers, wage growth has remained stagnant well below historical averages.

The Era of Easy Money is Coming to an End

In each of the last four quarters, the Federal Reserve increased the Fed Funds rate 25 basis points (bps). It now stands at a level of 2.00% – 2.25%. We have had three increases already in 2018 and 8 since 2015. It is possible that the volatility that we experienced in October 2o18 may delay the projected December 2018 increases. However, at this time, owing to the otherwise strong economy, we expect that the increase will come through, and will be followed by two more increases in 2019.

Inflation Is Stable

The Core PCE (Personal Consumption Expenditures), a measure of inflation, is running right around the Fed target of 2%. From the Federal Reserve perspective, that is good news, as inflation has persisted below this mark for the last several years. Inflation is one of the key economic measures that the Fed watches very closely. When interest rates climb faster than anticipated, it may signal an overheating economy and inflation. The Fed may then increase interest rates more quickly.  

U.S. Equity

Reversing last quarter when small-cap stocks outperformed large-cap stocks, this quarter saw large-cap stocks outperform their small-cap counterparts as trade and tariff talk dissipated. In addition, large-cap stocks are still benefiting from the effects of the tax cut. Even so, on a year-to-date basis, small-cap stocks have still outpaced large-cap stocks 11.5% to 10.5% as of the end of September.

From a style perspective, the last quarter continued to increase the gap between growth and value stocks. On a year-to-date basis, large-cap growth stocks, as represented by the Russell 1000 Growth, have outperformed large value stocks, as represented by the Russell 1000 Value by 13.2% (17.1% vs. 3.9%).

Non-U.S. Equity

International equities have continued to lag their U.S. counterparts in 3Q2018. In fact, the MSCI EAFE was the only major international equity index we follow that earned a positive return during the quarter (1.4%). Additionally, each of the four major international equity indexes we follow have fallen on a YTD basis.

During 3Q, much of the conversation in emerging markets surrounded Turkey and Argentina. Turkey’s direct impact on the overall return of the MSCI Emerging Markets index was minimal as it comprises only 0.6% of the MSCI Emerging Markets Index. However, because Argentina comprises almost 16% of the MSCI Frontier Markets Index, its troubles certainly had a greater impact on returns. We expect that MSCI will reclassify Argentina into the MSCI Emerging Markets Index in mid-2019.

Emerging markets continue to have strong growth and attractive fundamentals. Specifically, they are considerably less expensive from a P/E ratio perspective and pay higher dividends.

However, the Fed rate increases have hurt, as US rate hikes have a tendency to increase the value of the dollar, and decrease the attractiveness of emerging market investments. Also, while the U.S. comprises 55% of global market capitalization, 45% continues to come from outside our borders.

Therefore, despite occasional challenges, we believe that it is important for investors to be diversified in markets outside the U.S. Investors should keep in mind that investing domestically vs. internationally should not be an all-or-nothing endeavor. We continue to believe that global diversification is important.

Fixed Income

Fixed income investments continue to be challenged in a rising rate environment. Specifically, Treasury investments have yielded negative returns over the last 12 months. The picture worsens with longer maturities and most other fixed-income categories.

We continue to keep an eye on the shape of the yield curve. When the 2 year and 10 year Treasuries (the yield curve) come to close together, it is often a precursor of recession. That happens when investors no longer believe that they are being adequately compensated for holding longer maturities. This year the gap between the two has continued to narrow and therefore has fueled speculation. As of now, the curve has not inverted (ie short-term rates are still lower than long-term rates). Therefore, the best we can say is that this indicator is inconclusive at this time.

In anticipation of continued fixed income market turmoil due to rising rates and other factors, our fixed income portfolio is weighted toward shorter maturities and floating rate instruments. We believe that this provides an adequate return at an acceptable risk.

 

Check our blog post on the Seven Year End Wealth Management Strategies

 

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. Index performance information, financial conditions, inflationary and future risk and return information is provided for illustrative purposes only. One cannot invest directly in an index. Past performance is no guarantee of future results. Individual investor performance may vary depending on asset allocation, the 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 Massachusetts Registered Investment Adviser.

Divorce is Getting Even More Expensive

By Chris Chen CFP | Capital Markets

Ten months later we are still finding out what the Tax Cuts and Jobs Act (TCJA) passed with great fanfare in December 2017 really does for us. If you think that you might join the ranks of divorced people this year or in the future, there are provisions of the TCJA that you may want to pay attention to.  

Some of these provisions include eliminating exemptions and most deductions, lowering federal tax rates,  and raising the limit for the Alternative Minimum Tax (AMT).

However, there are two main areas where the TCJA affects divorcing couples specifically: child support and alimony.

Exemptions and Child Support

The TCJA eliminates the value of the personal and dependent exemptions that were so familiar in years past. It also increases standard deductions from their 2017 values of $6,350 to $12,000 for single filers, $9,350 to $18,000 for Head of Household filers and, $12,700 to $24,000 for Married Filing Jointly filers.

As a result, claiming a Head of Household (HOH) status can make a measurable difference for a newly single parent. To claim it, the taxpayer needs to be unmarried, pay for more than 50% of the household expenses and have a dependent who has lived in the household for more than 50% of the time. If there is one child, only one parent can claim to be HOH for this family.

One child For divorcing couples, the incremental savings for being Head of Household instead of Single mean that this is likely to be a significant point of discussion in divorce negotiations.

The parent who is Head of Household can also claim the expanded $2,000 Child Tax Credit for each qualifying child, including $1,400 that are reimbursable (i.e., you need to earn income to get it). Tax credits are much more valuable than exemptions. Whereas exemptions reduce taxable income, tax credits directly reduce the amount of tax itself.

In the past, parents could alternate taking children as exemptions using IRS form 8332. Of course, children exemptions helped reduce taxable income. As a result, exemptions have been an important clause in separation agreements. However, under the new tax law, exemptions no longer result in a reduction in taxable income.

With TCJA, it is not clear that the Child Tax Credit will be tradeable. Effectively, it would require the IRS to publish a regulation that allows trading of the Child Tax Credit between parents and a form that makes it possible. So far, the IRS has not released that regulation. This is sure to frustrate some parents, as they try to arrange their finances for their post-divorce reality.  Their best bet is to negotiate as if the Child Tax Credit will not be tradeable, but write in the agreement that it may be traded if allowed by laws and regulations. Parents could then work on dividing the economic benefits of the credit instead.

The Child Tax Credit and the HOH status provide a measurable boost to the after-tax income of the beneficiary. Thus, they will become an essential consideration of any divorce negotiation involving children.

Alimony

Starting with agreements that will be signed on January 1, 2019, or later, alimony will no longer be deductible from taxable income by the payor or taxable as income to the recipient.  The TCJA ends a longstanding practice that allowed divorcing couples to liberate tax money from the federal government to enhance their post-divorce joint income. Because typically the payor of alimony has a higher income and is usually in a higher tax bracket than the recipient, taxpayers were able to arbitrage the two tax rates and enjoy additional cash flow that would not have been available otherwise. For many, deducting alimony from taxable income was a welcome sweetener to the bitterness of having to pay it.

Abolishing the deductibility of alimony ripples through its other provisions: no longer do divorcing couples have to worry about structuring their alimony to make it comply with tax law. From 2019 on alimony will be considered a simple property transfer pursuant to divorce with no income tax consequences.

The change in the law effectively makes alimony more burdensome to payors.  With deductibility, alimony reduced a payor’s income taxes. Thus the net impact to the payor’s cash flow was the alimony paid minus the taxes saved. Now that deductibility is eliminated, the impact on cash flow is just alimony.

Conversely, recipients will no longer have to pay income taxes on their alimony, theoretically resulting in higher cash flow. However, it is the view of this writer that as a result of this change, alimony awards will trend down to take into consideration the cash flow impact on the payor. In all likelihood, recipients will end up paying the price.

This clawback of tax revenue was projected to raise $8B over ten years, a trifle compared to the $1.5 trillion cost of TCJA.

While this change in alimony treatment comes in 2019, separation agreements concluded in 2018 and before will abide by the old rules unless the divorce agreement specifies otherwise. Speak with your mediator or your lawyer: there may still be time to complete a separation agreement before the end of the year.

A Last Word

Much of the TCJA sunsets in 2025, reverting in 2026 to the rules that were in force until 2017, with one notable exception: alimony which, under the current law, will continue to be non-deductible in 2026 and later. As a result, separation agreements should take into account that they may be subject to one set of tax rules until 2025, and then may have to revert to another one in 2026.

Can we count on Congress to extend the TCJA beyond 2025, as it did with the Bush tax cuts in 2013? Perhaps. Lawmakers are loath to vote for anything that could appear as a tax increase. However, it would not be prudent to count on Congress’ good heart! Thus, separation agreements should maintain sufficient flexibility to take future changes in the tax environment into account.

Overall the TCJA will likely be a net cost to divorcing couples, especially those with child support or alimony obligations. However, knowing the rules can still improve a divorcing situation. Checking with a Divorce Financial Planner is likely to pay dividends.

A previous version of this post was published in Kiplinger on October 5, 2018

 

Check out other interesting articles:

In Divorce, Can We Share a CDFA?

Pension Division in Divorce

Post-Divorce Investments 

 

Note: A previous version of this post was published in Kiplinger on October 5, 2018

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented.  To determine a course of action that may be appropriate for you, consult with your attorney, financial planner or tax advisor before implementing any plan.. Tax laws and regulations are complex and subject to change, which can materially impact investment results.

 

Don’t Ignore the Chatter – a Trade War represents a Major Risk

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

Quarterly Capital Market Perspectives

There’s been a lot of sideways action in this year’s capital markets. We have had a couple of mini-corrections already but equity markets have done a remarkable job of ignoring some clouds on the horizon.

The big elephant in the room that investors have chosen for the most part to ignore is the possibility of an all-out global trade war.

What started back in February as aluminum and steel tariffs has delved into a war of words and escalation of tariffs between the world’s three largest economies of the US, China and Europe.

There is almost a sense of disbelief that this could be happening after decades of globalization.  We are so used to the free flow of goods and services across borders that we hardly ever stop and think about where things are made.

Is a Toyota Camry Japanese or a “Made in the USA” car from a company that so happens to be domiciled in Japan? Is your iPhone an American product or a product made in Asia for a US-based company?

Global companies such as Apple or Toyota operate in highly inter-linked global supply chain and sales channels. A trade war will be highly disruptive to global trade and manufacturing.

Ultimately, an all-out trade war creates massive uncertainty and significantly lowers global economic growth going forward. According to Oxford Economics a trade war could cost the global economy $800 Billion.

To read more about our views on key risk factors facing investors for the rest of 2018 and our intermediate-term outlook for major asset classes please read our Quarterly Capital Market Perspectives.

Capital Market Perspectives – April 2018

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

 

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.

Figure 1

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.

Figure 2

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.

Figure 3

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, we favor 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.

Understanding Asset Class Risk and Return – Your Pocketbook and Psyche Will Thank You

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

 

Markets do not just go up as much as we wish for that to be always the case.

Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.

How investors react to periods of capital market stress is incredibly important.

Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.

On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.

 

So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.

In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook.  Even though you believe in your investments, your emotions will be tugging at you and second-guessing you.  This is the curse of being too early.

In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains.  This is the curse of being too late.

 Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.

Getting punched in the nose is not an uncommon experience for stock market investors.  For bond market investors the experience is not as common but it still happens.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.

Investors are frequently confused by capital market behavior.  Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns.  Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.

Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat.  Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic.  Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.

Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary.  Profits, valuations, profitability, growth potential become the drivers of prices.  Periods of stress are frequently forgotten and appear as mere blips on historical price charts.

One of the key tenets of long-term investing is that risk and return are inextricably tied together.   Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes – short or long-term – cannot be predicted with total certainty.

Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk.  Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.

Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.

To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs.  We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns.  Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill.  US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.

The first thing that jumps out from the chart is the much higher level of return variability of stocks.

The second thing that jumps out is the incredible year over year smoothness of T-bill returns.  Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.

The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008.  Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.

 Figure 1

What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.

Table 1

Key highlights:

• Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
• In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
• If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 – a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds don’t come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
• From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
• If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.

 

What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?

Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.

Figure 2

 

The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods.  There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.

We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills – the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982.  In the first two instances, equity holders lost money.  In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.

Table 2

Some observations are in order:

• As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out – not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
• Over a ten year holding period stocks do not look as scary – only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
• Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
• Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data

 

What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:

• The 60/0/40 portfolio composed of 60% stocks and 40% bonds – a traditional industry benchmark
• The 40/0/60 portfolio composed of 40% stocks and 60% bonds – a moderately conservative mix
• The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds – a conservative mix for a very risk-averse investor

Mixing asset classes is usually referred to as multi-asset class investing.  The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.

It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills.  The correlation between bonds and bills was 0.3.  Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.

Table 3

 

What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?

• When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
• The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
• The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
• The lowest risk multi-asset class strategy that we looked at – the 25/50/25 portfolio – had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
• A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
• Comparing two traditionally low-risk portfolios – 100% bonds and the 25/50/25 portfolio – demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.

 

Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health.  The first relates to the holding period.  Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.

Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.

The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth.  In terms of the multi-asset class portfolios – the 60/0/40 versus the 40/0/60 – yields only a 1% average return difference but a 2X difference over the 1928-2017 period.

Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.

The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns.   Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.

 

Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills.  Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.

Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They don’t worry much about the daily vicissitudes of the stock market.  They accept risk in return for higher expected returns.

Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.

Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks.  Or they may mix in varying proportions of risky and less risky asset classes and strategies.

Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.

 

Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?

Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth.  If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan.  In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.

 

 

Key Insights Into Understanding Equity Market Corrections

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

Corrections, Recoveries and All That Jazz

Stock Market Corrections are tough on equity investors.  Over the last couple of weeks, there has been nowhere to hide – normally defensive strategies provided little relief.

After a long period of minimal equity market hiccups investors were reminded that the opposite side of the return coin involves risk.

Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.

If risk and return are tied together why do investors get so nervous when suddenly equity markets go haywire?  Memories of 2008 come flooding back and investors get hyper fixated on relatively small market movements.

As of Friday, February 9, the S&P 500 had dropped 8.8% from its high of January 26.  Granted the drop has been swift and intraday market action (the difference between the high and low of the day ) has been off the charts, but you would have thought that we were on the verge of another Financial Crisis.

Figure 1 depicts the rolling 12 month returns on the S&P 500 as of the end of 2017. There are more periods of positive rather than negative returns as expected. We can also see that the downdrafts in recent years have been painful for investors – the implosion of the Technology Bubble (2000-2002) and the 2008 Financial Crisis still very much linger in investor minds today.

Figure 1

The key insight that investors need to come away with from looking at the history of stock market returns is that to get the good (those returns averaging 10% a year) you must be prepared financially and most importantly emotionally to endure the bad (those nasty corrections).

Investors need to remember that risk and return are the opposite side of the same coin.  They also need to understand the context in which market corrections take place.  While history always rhymes every equity market correction possesses unique elements that shape its ultimate effect on investors.

Understanding the market and economic context is incredibly important for everyday investing.  It is, however, absolutely critical for understanding the implications of equity market corrections and most appropriate course of action.

The point is that not all equity market corrections are made of the same cloth.  Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.

Given the events of the last couple of weeks we understand the skittishness of equity investors. Last year was fantastic for investors.  We hardly had a hiccup in the last year. Investors started adapting to the environment – high returns and low volatility.

All the fireworks have come from Washington rather than Wall Street.  Yet, the lingering suspicion is that this party like all others before it must end at some time. Maybe it is just time, right?

We are professional wealth managers, not magicians or fortune readers. Nobody knows when the next big stock market crash will happen and least of all nobody knows the severity of the downturn.

At best, we can analyze the current equity market downturn and attempt to better understand the context in which current equity market prices started heading south.

While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections – technical, economic and structural.  Each type of correction has its own distinct patterns and associated implications for investors. Not every moving animal in the woods is a Russian Bear!

Technical Correction:

This type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis.

Maybe a bit surprising to some, pundits use perfectly logical arguments to justify their bearishness – inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.

All perfectly valid reasons for an equity market correction but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.

Technical Corrections tend to occur on a regular basis especially for higher risk asset classes such as equities.  Long-term equity investors have seen these before and do not seem fazed by the market action.

Newer generations of investors, however, experience great fear and regret.  The immediate response is to sell down usually their most liquid holdings and wait for the market to calm down.  Maybe they will get in again after the panic is over.

Technical Corrections tend to last only about a week or two.  In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.  Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.

Economic Corrections:

These types of capital market corrections are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery.  Typically, the clues as to whether the economy is heading into a recession are present ahead of time.

Usually a large number of economic indicators will point in the same direction.  For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment and layoffs start accelerating in cyclically sensitive sectors.

In the last half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are, no doubt, painful but the implications to investors are fairly straightforward.

In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside.  As the economy starts recovering, equity investments outperform marginally but with significant volatility.

Being early is never comfortable but it beats being late.  Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake bitten to put any money at risk.

And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds.  As the uncertainty regarding the economic recovery fades in the rear view, capital markets tend to become less volatile as well.

Structural Corrections:

These are the most severe type and involve periods of real economic and financial stress.  Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.

Structural Corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake.  Without decisive fiscal and monetary policies there is a risk of total economic collapse.  Under these circumstances, equity investors are often completely wiped out and bond holders don’t fare much better.

Structural Corrections happen during periods of total economic unravelling.  The most usual signs of eminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost.  The financial system is usually at the root cause of the crisis and liquidity in the system suddenly disappears.  Faith in the system dries up overnight – the first stop are banks, next are capital markets.

The Great Depression of 1929-39 and the Financial Crisis of 2007-09 are prime examples of Structural Corrections that were felt across the globe.  History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.

What should investors do during a correction?

The answer depends on the context surrounding the capital markets at that moment.  For example, the implications of a Technical Correction are very different from those of a Structural Correction.

Misdiagnosing what type of correction you are in can have severe consequences for your financial health.  Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.

Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything.  In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.

Our preferred approach is based on a solid understanding of capital market behavior coupled with hands-on experience under a variety of capital market situations.  Understanding capital market history is the prerequisite but experience is the key extra ingredient to gain confidence in properly evaluating the context in which markets are experiencing distress.

Table 1 provides a checklist as to the type of issues that we consider when evaluating the type of correction we might be in.

Table 1

Where are we today?

As of February 12 we have already seen signs of recovery, but the S&P 500 is still down 7.5% from its January 26 peak. Investors remain nervous. The CBOE Volatility Index stands at close to 27% which is significantly higher than where it was before the equity market started convulsing.

A 7.5% drawdown on the S&P 500 is not that uncommon. Investors should be wary but also keep their eye on their long game of growing risk-adjusted portfolio returns.

We believe that the current equity market downdraft falls under the category of a Technical Correction. Why? The numbers back up our assertion.  Our view is that equity markets remain healthy and will out-perform lower risk alternatives such as bonds.

Let’s start with a rundown of the negatives about equity markets.  The biggest knock on equity markets is that they are over-valued relative to historical norms such as price-to-earnings ratios. Agreed, the current Shiller P/E stands at 33.6 relative to a historical average of 17.  For access to the latest Shiller data click here.

On an absolute basis the S&P 500 is over-valued.  When considered relative to interest rates the picture changes.  Estimates by Professor Domadoran at NYU, for example, yield fair valuations on the S&P 500.

What else? Interest rates are too low. Agreed again, but low yields are the problem of the bond investor. A low cost of money is actually good for equity investors.

What about rising interest rates? The 10 Year US Treasury Note hit a low of 2.05% in early September and has been rising since. It currently stands at 2.84%.  Higher, for sure.  A real danger to equity markets? Not quite, especially in light of low rates of inflation.

Inflation-adjusted yields (sometimes called real yields) are still significantly below historical norms.

Higher real rates imply lower equity values.  We agree, but we see the current upward progression of interest rates in the US as fairly well telegraphed by the Federal Reserve.

We also still believe that US monetary policy is accommodative.  For example, Federal Reserve Bank of Atlanta estimates generated by the well-known Taylor rule show current Fed Funds rates about 2% too low (read here for a review).

What about the positives regarding equity markets? For one, we have a strong global economy.  Every major economy in the world is in growth mode.  The IMF recently raised their estimate of global GDP growth to 3.9% for both 2018 and 2019.

Inflation seems under control as well. The IMF estimates that global inflation will run 3.2% in 2018, unchanged from last year. Inflation in the US ran at 2.1% in 2017.

Monetary policy remains accommodative.  In the US the Fed reserve is slowly weening investors off artificially low interest rates, while in most other parts of the world (Europe and Japan in particular) central banks have yet to embark on the process of normalization.

The recently enacted lowering of the US corporate tax rate is also a positive for US domiciled companies.  Lower corporate tax rates translate immediately into higher cash flows.  Higher cash flows translate into higher corporate valuations. The main beneficiaries of lower corporate taxes are ultimately shareholders. 

What should investors do today?

Our analysis of the data leads us to the conclusion that the current equity market correction is driven by technical considerations and not fundamental issues.

We do not know how long the equity downdraft may last, but we expect this blip to barely register in the long-run.

Our advice may be rather boring but plain-vanilla seems the best response to the current state of investor panic.

• If you were comfortable with your financial plan at year-end, do nothing. Don’t obsess over every single market gyration. There is not enough evidence to merit an increase in fear or a significant re-positioning of your portfolio towards safer asset classes such as bonds
• If you did not have a plan in place, don’t go out and sell your equity holding before figuring out the status of your financial health in relation to your goals. Consult a certified financial planner if you need help.
• If you have some cash on the sidelines, deploy some of it in the equity markets. Given that all major equity markets have taken a beating spread your money around a bit. We still rate International Developed Markets and Emerging Markets as attractive.  Consider whether it makes sense for you to put some money in the US and some abroad.

Whatever you do don’t panic. Focus on your asset allocation in relation to your needs, goals and appetite for risk. Don’t let that Russian Bear get to you!

Taking risk and suffering the inevitable equity market drawdowns is part of investing. Be cautious but be smart. Talk to your Advisor if you need help. Make your money work for you!

Market Correction? Hold on to your socks!

By Chris Chen CFP | Capital Markets , Financial Planning , Investment Planning , Risk Management

As of the close of the market yesterday February 5, the S&P 500 has suffered a loss of 6.2% from its high on Jan 26, 2018 .  All other major indices have followed this downward trend. After we have been telling you for months that the market was going to be due for a major correction, has the time come?

One of the ways that we gauge market risk is by observing our proprietary Risk Aversion Index . It has started to show “normal” behavior compared to the last few years when  it was indicating a lot more complacency to risk than average.  Clearly market participants are feeling antsy.  However, according to the risk measure, it is too early to draw conclusions.

We have not experienced meaningful corrections in the recent past. However it is worth remembering that according to American Capital historically 5% corrections happen 3 times a year on average, and 10% corrections happen once a year on average .  The current correction may just be a long overdue reminder that we are not entitled to volatility free financial markets.

Just two weeks ago the consensus was that we were going to experience a continuation of the bull market at least into the early part of this year. This is still our view. Although the stock market is a leading indicator, at this time this correction does not appear to be a recession driven correction.

A Last Word

When it comes to your investments, verify that your investment profile matches your financial planning profile . That would not insulate you from market corrections. However, matching investment and financial planning profiles would help ensure that you are taking the appropriate amount of risk given your goals and time horizon . If you haven’t measured your risk profile in a while, you may do so at this link.  Unlike the stock market, it is risk free!

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Risk Management

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

2017 came and went without nary a whimper. None of the big concerns at the end of the previous year happened or at least global capital markets did not seem to be disturbed by much of anything.

Stocks went up in a straight line, bonds did ok, volatility was super low and at the end of the year exuberant expectations were in full bloom as everybody and their aunt became fixated on Bitcoin.

The global economy keeps doing well and memories of the 2008 Financial Crisis are receding.  Consumer sentiment remains upbeat.

Being an investor is wonderful when markets are calm and statements show gains month after month.  Everybody is an investment genius. We forget how painful  it is when capital markets experience stress and things get a bit crazy.

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

What could cause a Black Swan in 2018?

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.

The number of apparel and retail companies expected to disappear is higher today than in 2008 during the Financial Crisis. Read here for a list of apparel and retailers at risk.

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.

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.

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.

Conclusion:

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.