Month: December 2018

Another Rough Week

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This was a rough week for the stock market, coming after an already ugly start to the quarter. Since my last update on 12/6, global stock markets have continued to decline, with the US finally starting to catch down to the malaise that the rest of the world has been experiencing for most of 2018. Surveying the damage, here are the % changes since 12/6, since start of Q4, and since the 52-week high for various ETFs (ignoring dividends):

The most aggressive portfolios are down 15-20% for the quarter. The most conservative are approximately flat. Most of your portfolios lie in between with retirement portfolios for those of you with a long way till retirement being quite aggressive, but likely still down 10-18%, balanced portfolios down 7-14%, and more conservative portfolios down a few percentage points. Almost all portfolios are now down from where they were a year ago. As I said in the 12/6 update, this may seem like an extreme drawdown after years of low volatility, but from a historical context it’s not. It has happened faster than most declines in the recent past, but that could very well be a good thing if it means a shorter interval of declines. I don’t really worry about the short-term movements of stocks, but I do worry about the damage to consumer and business confidence that deep, drawn out declines can cause. Losses never feel good, but as long as we can stand the loss without needing to liquidate or liquidating in panic, they actually are good in two ways. They reset stocks and asset classes to lower valuations while shaking out the weak-handed or leveraged market participants, providing a future opportunity to grow. They also provide an opportunity to invest more money at lower prices. If you invest $1,000 per month for 20 years in a market that gains 8% per year every year vs. a market that ends in the same place but experiences 20% losses every 5 years along the way, you wind up with almost $45,000 more in the latter case. This is what we experienced from the 2007 top to the recent 2018 top. Without the financial crisis and its opportunity to invest at MUCH lower prices, portfolios wouldn’t be nearly as big as they are today. Try to keep this in mind when dealing with the pain of quarters like this one.

As far as why this is happening, I outlined the major market concerns in Part 2 of my last post. I won’t rehash those. But in the last couple of weeks, the following distinct events occurred that added to market uneasiness around those points:

· Trade talks resumed with China, but the administration said (after many mixed messages) there is no flexibility on the 3/1/19 deadline for a deal. They also are on record saying a deal would be difficult in such a short period, and the president is on record saying that if it doesn’t happen, he’s ok proceeding with increased tariffs, “I’m a tariff man”. Without getting political, this does not inspire confidence in a resolution to the trade war. In fact, it tells international markets to prepare for intensification.

· Oil continued to plunge, down 12% from 12/6 and a whopping 38% just in Q4 2018. While this is good for the average consumer (gas prices, heating oil, airline tickets, shipping costs), it is not good for that portion of the US economy, which has had massive growth and has taken on a lot of debt over the past 10 years. High debt and low oil prices will pressure the balance sheets of oil companies and ultimately lead to defaults, bankruptcies, and business closings. None of those are good for markets and the weakness in the energy sector is causing tightening in credit markets with potential for spillover outside of energy.

· Federal Express released earnings that were mostly in-line with estimates, but substantially decreased guidance for the remainder of their fiscal year (two more quarters) on a slowdown in global shipments. One might think this is the classic attempt at UPOD (under promise over deliver) and that FedEx was using recent market weakness as an opportunity to set expectations low for the next few quarters. However, they’re actually acting on their reduced forecasts by reducing their global shipment processing capacity. You don’t do that unless you know the economy is slowing, at least internationally. They’re just one company, but as a global shipping juggernaut, their actions are concerning.

· The Federal Reserve held its last meeting of 2018 and raised interest rates by another 25 basis points. The move was widely expected, though there was hope that they would instead pause given recent market performance. They did not pause and while they walked back their estimates for the neutral interest rate as well as expectations of 2019 hikes (from 3 to 2), that was not enough for markets. Fed Chairman Jay Powell tried to ease markets during his press conference by repeatedly stating that there was no pre-determined course for interest rates and that the Fed would adjust their policy and their forecasts as economic data came in. Then he made a huge (in my opinion) communication error by stating that the Fed would not alter their plan to reduce their balance sheet (reverse the Quantitative Easing purchases of treasuries using printed money), commonly known as Quantitative Tightening. While I’m sure he meant that it wouldn’t be altered except in extreme conditions, he said flat out, that it wouldn’t be altered. Stocks tanked as a result. There have since been attempts to walk those comments back by the other Fed governors, but the damage to confidence has already been done. This is not as bad as an actual Fed policy mistake, but a communication mistake that causes volatility and a loss of confidence in the Fed as a backstop when the proverbial “stuff” hits the fan, really shakes the markets.

· From a technical standpoint, for the traders, computer algorithms, and funds that follow chart trends and more numerical data points on the market, the damage done by the above created multiple “sell” signals. I won’t get into “Dow Theory”, broken trend lines, violated moving averages, “death crosses”, and broken long-term support. Suffice it to say that a segment of the market has decided it’s safer to sell than to buy or hold at this point and they are doing so quickly and at any price. This cycle of losses triggering more selling probably triggers margin calls, hedge fund liquidations, and more forced selling which takes a while to clear through the market. It often takes prices well below fair value for sidelined buyers to step in, break the cycle, reverse the trend, and flip all those technical indicators back to “buy” signals.

The potential good news is that we’ve hit some extremes on sentiment that can be viewed as exhaustion points for selling. This is based on the idea that when everyone in the world has become bearish and has sold, there is no one left to sell and markets bottom. Think March, 2009. Over the last few days we experienced the following:

· The CBOE put/call ratio hit an all-time high. That means that substantially more bearish bets were being made through the options market than bullish ones. So much so that the level of downside bets to upside bets exceeds recorded history.

· The CNN Fear & Greed Index hit 3 (on a 0-100 scale with 0 being the most fear and 100 being the most greed). The index hasn’t been around for that long, but I don’t remember ever seeing it that low.

· The AAII Investor Sentiment Survey results show that only 25% of people are bullish with over 47% bearing (almost the exact opposite of the start of Q4). They note that “Optimism and pessimism remain outside their typical ranges: bullish sentiment is unusually low and bearish is unusually high. Historically, both have been followed by higher-than-median six- and 12-month returns for the S&P 500 index, particularly unusually low optimism.“

· The VIX, Wall Street’s fear gauge that is based on the annualized expected change in the S&P 500 based on short-term options pricing hit 30. That implies an annualized 30% move, up or down, in the S&P 500. While it can certainly go higher, market average is in the 15-20 range and last year at this time it was below 10. It tends to spike when fear is high and short-term traders are buying options and willing to pay a hefty price to hedge their portfolio positions.

· The SKEW index, which shows the relative price of out-of-the-money puts (bets that the market will drop big) to out-of-the-money calls (bets the market will rise big) has finally started to move up from a multi-year low. The complacency that had crept into the market, even through the October declines, is finally waning.

I’m not saying the drop is over and prices will snap back. It remains to be seen what the economy actually does in 2019 and how monetary policy and fiscal policy evolve as a result. We’re nowhere near what happened in 2002-2003 or 2008-2009 and I’ve told all of you many times to prepare to lose 50% of the money that you have in stocks at some point during your lifetime. This could be it. Or it could not be. The market is always correct and I think it has correctly priced in the known risks and more importantly, the risk of the unknown heading into the next couple of years. Selling has been extreme, but that doesn’t mean it has been “overdone” simply because of extreme indicators, nor does it mean that this is just the beginning of the decline, simply because uptrends have been broken and Dow Theory says it is. We have continued to harvest losses for tax purposes where appropriate and to rebalance portfolios back to their target stock/bond weightings. If stocks continue to fall, there will be more of this. If they don’t, then our rebalancing actions of selling bonds and buying stocks (the reverse of what we’ve been doing during the bull market) create the perfect buy low / sell high rhythm, while keeping portfolio risk levels and return targets in sync with client goals.

There is no doubt that losses cause pain. We all work hard for our money and hate to see it evaporate in a market decline. There is no way to earn equity returns over the long term though without being willing to live through the declines. If there were no risks in stocks, they would pay 2% as FDIC-insured bank accounts do. We investors signed up for this risk and if nothing else, we should take solace in the fact that lower prices are a good thing when you’re a buyer. We should also remember that there have been thousands of crises, recessions, political upheavals, natural disasters, wars, and plagues. It’s not a coincidence that even after all of that, we were recently at all-time highs with all-time high global population and all-time high measures of productivity. Humans will continue to worry and humans will continue to create better lives for themselves and their children. This (the current downturn) too shall pass.

If you’re reading this as a PWA client and have questions or want to discuss your individual portfolio, goals, etc., as always, please don’t hesitate to contact me. I hope you all have a wonderful holiday season filled with friends, family, and fun.

Market Update – Part Two, “The Why” – What’s Causing Market Angst

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This is part two of a two-part post on recent market declines. Part one contained what I call “The What”, defining the declines and trying to give some historical perspective. Part two contains “The Why” by trying to summarize, in layman’s terms, what is causing the market angst at the moment and what to do about it.

Trying to understand the stock market is like trying to understand a baby. Everything tends to be perfectly fine until suddenly, it’s not. Even when you can pinpoint the immediate cause of a meltdown, it’s often underlying issues that have been building (tired, hungry, getting sick… in the case of the baby) that are the root cause of the meltdown. There is little to no communication about the why… you just know it’s not good. I’m going to give you my opinion on what has caused the stock market to act like a baby over the past couple of months. Like the baby, the stock market hasn’t told me precisely what’s wrong… I just pay close attention to things that could be root causes so I know what’s going on when a triggering event occurs and causes a meltdown. While we can’t do anything about the meltdown, and we know it’s not abnormal (see Part one of this post), it’s reassuring to know the potential causes. I see six of these, with the last two being the most important:

1) Rising interest rates – the Federal Reserve has been raising the overnight lending rate by 25 basis points per quarter for about two years. It now targets 2-2.25% with markets expecting another quarter-point hike later this month. 2.5% is historically low and the Fed still considers it to be stimulative to growth. However, after nearly a decade of ZIRP (zero interest-rate policy) there is an anchoring effect that must be considered. Suddenly, investors can earn 2% (which is still just barely the rate of inflation) in a savings account or 3-4% in a fairly safe bond fund and it feels like a huge win vs. a decade of zero. On the margin, more may be choosing conservative investments over stocks. Mortgage rates climbing back to near 5% (historically very low) suddenly makes home purchases a lot more expensive when everyone was used to paying 3.5%. We’re seeing home sales decline and price increases halt as a result. Corporations borrowed massive amounts of money at low rates over the past decade and used it to invest in growth, pay dividends, and buy back stock. As those loans become due, where will the money come from to pay it all back? New loans at higher rates? That’s going to hurt the income statement. Secondary equity offerings? Not good for the stock. Then there’s the massive debt that governments, including ours, have taken on. At low rates, that debt is affordable. But as rates rise, the interest payments start to swamp the tax collections (especially after “mandatory spending”). This is how debt spirals to a point where it can’t be paid back. If the Fed stays on its current course to return rates to historically normal levels before the economy can anchor to non-zero levels, it will act as an economic shock and stop growth in its tracks. Last week, Fed chief Jay Powell indicated that the Fed isn’t on a pre-determined course, is close to “neutral”, and will be data dependent. This eased some market concerns, but a Fed policy mistake is still a big market risk.

2) Global trade issues – I think this one is pretty easy to understand. If the US and China are entering a long, drawn-out trade war with tariffs and other impediments to global trade issued on both sides, then there will ultimately be less global trade. Less trade means less growth and less growth means corporations make less money (or grow more slowly) while debt issues are exacerbated. Tariffs as negotiating weapons are ok to the market, especially for long-term gains like protection of intellectual property across borders. Tariffs as the end game will not be ok with the stock market. Every time it looks like there’s a path to easing of tensions, markets rally. Every time tensions increase, markets fall. Lack of communication as to the plan and inconsistent messages cast doubt on ultimate resolution. The stock market is only going to put up with that for so long before pricing in a higher probability of an extended trade war.

3) Strengthening US Dollar – the dollar has been on the rise vs. most other currencies as the US has been doing better economically than most other countries. As the dollar strengthens, US exports seem more expensive to foreign consumers, hurting US demand. US multi-national corporations lose on currency exchange when repatriating foreign profits (weak currency) into US dollars at home (strong currency), thereby hurting profits. Foreign debt issued in US Dollars becomes bigger to the foreign country that owes the money. This weakens the foreign currency further and can spiral into a currency crisis. All of these things are bad for US stocks.

4) European Union Issues – I’ll lump Brexit and the overall fiscal fiasco of the EU into one major issue. If a Brexit deal can’t be reached with the EU and there is a “hard Brexit”, Great Brittan and the European Union essentially stop doing business with each other, resulting in massive job losses and other economic dislocations. The possibility of that happening has ramped up recently as deadlines approach. In the rest of the EU, budget issues continue to challenge the southern countries who need ongoing support from Germany and the wealthier, less debt-riddled countries. The threat of Italy losing its borrowing lifeline, potentially ditching the Euro, and maybe setting off a chain reaction with other countries doing the same is like the Greek issues of a few years ago times 100. It’s becoming more and more apparent that the European Union experiment, in its current form, has failed and it’s now just a matter of stretching out the unraveling for a long enough period so that it can be creatively redesigned or unwound in the least shocking way possible. If Europe can fix itself over the next decade, even if it involves some up-front pain, that would be a massive lift for the global economy. If it can’t and there is a financial shock as a result of unraveling, it certainly won’t be good for stocks.

5) Too much government debt – the world simply has taken on too much debt over time. Governments have promised too much to their people in return for votes (low taxes, high spending). Either defaults are going to happen or inflation is going to spike, thereby making those fixed rate debts seem smaller in future dollars. Either one is going to hurt. The more time that passes with already bloated debts growing faster than the economies they rely on, while interest rates rise, the closer the world gets to a point of no return. We don’t know where that point is, when the debt markets will turn on borrowers that can’t repay, or if / when governments would start the inflationary printing presses to avoid default. This risk moves in slow motion but is probably the biggest one for the long-term.

6) The self-fulfilling prophesy – we’re pretty far from this happening in my opinion, but this is the biggest short-term risk. If the stock market volatility goes on for too long or if the market falls too far, then consumer and business confidence will wane. Our economy is built on confidence. If companies stop hiring, expanding, and investing, and/or consumers stop spending, recession is right around the corner. Similarly, you may have heard about the inverting yield curve lately. Generally, long-term interest rates are higher than short-term rates (positive, upward sloping yield curve if you plot rates on the y-axis and term on the x-axis of a graph). This positive yield curve is an indicator of expected future growth. Lately, short-term rates (specifically the two-year treasury) have been approaching long-term rates (specifically the 10-year treasury). That 2-10 spread is closely watched as an indicator of future growth and it’s dangerously close to inverting. The last several times that happened after a period of normal rates, a recession has been on the horizon. Higher short-term rates than long-term rates are deadly for banks who borrow short (pay on deposits) and lend long (loans and mortgages). If banks can’t make money on that spread (“net interest margin”, their profits dry up and they may wind up with less money to lend or be unwilling to lend. Less lending can impact the ability for businesses and consumers to borrow, potentially leading to recession. This means that an inverted yield curve that predicts recession could actually lead to it… another self-fulfilling prophecy. Keep in mind though that even if recession happens, the typical one is a pause that refreshes, that brings valuations back in line, that scares off the weak hands, that kills the companies that took on too much leverage, that leads to the birth of the next growth cycle. A recession in a world with too much debt though could intensify and accelerate the debt issues described in #5.

Here’s the good news… when there are reasons for concern in the stock market, the eventual elimination of those concerns often leads to new growth. This is frequently called “climbing the wall of worry”. When the worries are all gone and everything is perfect, then perfection is priced into the market and there’s often no more room for prices to increase. No more wall of worry means nothing to climb. So, it’s highly possible that these worries will provide the legs for the next bull market to stand on. I have to admit, when the tax cuts went through, unemployment dropped near 4%, corporate profit margins hit all-time highs, inflation remained low despite low interest rates, I started to worry that there wasn’t much to worry about. Now there’s a real wall of worry to potentially climb.

If you’ve read this far, I know what you’re probably thinking… This is all well and good and thanks for explaining all that but… is this an opportunity to buy cheap, or a last chance opportunity to get out before a big fall? No one ever knows that answer in advance. What we do know for certain is that there are going to be big falls at some points in the future. I tell clients to expect a 50% decline in stocks at some point in life (we had two of them in one decade in the 2000’s). This of course doesn’t mean your portfolio will fall 50% because not all of your money is in stocks. Young clients with decades until retirement and only a small percentage of what they’ll ultimately need to retire have retirement money primarily invested in stocks. But, they actually benefit from a decline in prices because they have much more to contribute to their retirement portfolios (at lower prices if prices fall) than would be lost from a temporary decline in the value of existing assets. On the other extreme, clients who are well into retirement, or those with shorter-term goals where money is needed over the next few years, are not primarily invested in stocks. A portfolio that is 30% stocks / 70% bonds will experience about a 15% loss if the stock market falls 50% (generally less than 15% because bonds tend to do well when stocks fall dramatically). It’s essential to get the mix right, but once you do, it doesn’t matter what happens with stocks over the short-term. You’re either in stocks for the long-term or you’re not primarily in stocks.

We know declines will happen. We just don’t know when they’re going to happen. When you invest, you accept that stocks are going to fall, and create a plan that works despite the stock market’s short-term swings. If a stock market decline scares you off your plan, you’re doing yourself an injustice by allowing that to happen. As I pointed out in Part one of this update, stocks are down at least 5% from recent highs almost half the time. So, should you buy, or should you sell? If your plan calls for adding money to your portfolio to target a future goal and you have free cash flow to do that, then add money (buy). If your plan calls for liquidation to support retirement expenses or to buy that next house, then withdraw money (sell). React to life events, not stock market events. Avoid the temptation to put your emergency fund in stocks during the good times or to pull your retirement money out of stocks in the bad times. In the meantime, we will be using the volatility, where appropriate, to rebalance portfolios back to target (sell what’s up, buy what’s down) and tax-loss harvest (sell securities with unrealized losses and repurchase similar securities to unlock the loss for tax purposes). Volatility fees bad, but without it, stocks would be risk-free. If they were risk-free, they’d be paying 2% like savings accounts. The risk has to be there in order to justify the long-term returns. I will continue to remind you that when the market is smiling, a tantrum is around the corner. When the market is throwing a tantrum, happier times and then more tantrums are ahead. It is the nature of being a parent… er umm… an investor 🙂

Market Update – Part One, “The What” – Some Perspective On Recent Declines

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This is part one of a two-part post on recent market declines. It contains what I call “The What”, defining the declines and trying to give some historical perspective. Part two will contain “The Why” by trying to summarize, in layman’s terms, what is causing the market angst at the moment and what to do about it (hint: stick to the plan).

There is an old investment adage which states that “risk happens fast”. From all-time highs in late September, the S&P 500 (US Large Cap Stocks) has declined about 7.5% over the past 2 ½ months. While the percentage declines aren’t anything out of the norm, the daily swings feel massive given the higher levels for each index than we’re all used to and the relative calm we’ve experienced over the past few years. Here are some stats to help get your head around what’s happening and why it’s not out of the ordinary:

  • Per Factset, over the last 40 years, the maximum yearly drawdown from peak on the S&P 500 has been:
    • 0-5%: 3 times
    • 5-10%: 15 times
    • 10-20%: 17 times
    • 20-30%: 2 times
    • 30-50%: 3 times

At 7.5%, we’re not even up to the typical downturn at this point.

  • Research by Robert Frey, expanded on recently by Ben Carlson, shows that while markets generally move up over the long-term, they’re in a drawn down state (down significantly from peak) nearly half the time. Specifically, looking at all the monthly closing index values, dating all the way back to 1927, the S&P 500 has been:
    • 5-10% below its most recent peak 12.8% of the time
    • 10-20% below its most recent peak 13.1% of the time
    • 20% or more below its most recent peak 23.1% of the time.

That means that in total, we’re living in a period where stocks are down at least 5%, 49% of the time!

  • Charlie Bilello of Pension Partners looked at daily moves in the S&P 500 (which seem extreme over the past few months… 3%+ down yesterday, 12/4 for example). Since 1928, the average number of days per year with 1%, 2%, and 3% moves are:
    • 1% Moves: 60 per year
    • 2% Moves: 17 per year
    • 3% Moves: 7 per year

In 2018, we’ve had (56) 1% days, (15) 2% days, and (5) 3% days… right in line with average. Why does it feel so much more volatile than average? Because, in general, we tend to weight recent history more strongly than extended history and in 2017, we only had (8) 1% days, and no 2% or 3% days. That kind of stability is what’s rare, not the moves we’ve seen recently.

While all of the above considers the S&P 500, it is important to note that foreign stocks are off quite a bit more than the S&P 500. Foreign developed countries are down 16.5% in US Dollar terms from their most recent high early in 2018 and foreign emerging countries are down 19%. Of course we also have to expect more volatility in foreign markets (especially emerging markets), to go along with their higher expectation for future growth and future returns. In that light, even those drawdowns are far from extreme levels.

I hope that helps to put the extent of the recent market decline in perspective. As I type this message, futures are pointing to another down day tomorrow (currently a bit more than 1%, but as much as 2% earlier) as Canada has apparently arrested the CFO of one of China’s telecom equipment companies that is wanted in the US for alleged violations of US sanctions on Iran. Futures sold off on fears that this would drive a wedge between US/China trade talks that just recently gave the first glimmer of potential progress. More here from CNBC for those who are interested in the full story. Whatever the reason, just remember that an average year contains 17 days with 2% moves in the stock market. These are normal occurrences in response to short-term news that will barely be remembered a few years from now. Remember all the angst over Cypress a few years ago? I’d bet just barely, if at all, and that is exactly my point.

[tags  Perspective, Stocks, S&P 500, Historical Returns, Drawdowns]