Another Rough Week

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.

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

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 10/15/2014

I don’t have a crystal ball and can’t tell you where the market is going, but I can tell you why I think it has fallen recently. Here are my top pain points in reverse order of concern/impact over the short-term (#6 having the biggest impact in my opinion):

1) Geopolitical Tensions / Civil Unrest – press on these has eased recently just because there seems to be worse news in other areas to take the headlines, but they’re still very present. Middle East, Russia / Ukraine, Hong Kong… all these sorts of issues threaten global economic growth through lower productivity and inefficient use of resources. Protests, sanctions, wars, fear, and loss of life around the world that seems like it will be ongoing indefinitely.

2) Central Banks – the US Federal Reserve is ending Quantitative Easing (QE), their bond buying program that essentially amounted to printing money to purchase treasury bonds (finance government debt spending) and mortgage backed securities (finance home purchases). Many worry that the end of QE and the ultimate beginning of an interest-rate hike cycle will put the brakes on a recovering US economy. So far, long-term treasury rates and mortgage rates have stayed low despite the Fed pulling back on QE as a potential economic slowdown tends to lower rates on its own. Other major economies of the world are also moving in the opposite direction, embarking on further monetary stimulus programs as the US pulls back. This forces their rates lower and acts as competition for US rates, dragging them lower as well. 10-year government bonds in Germany are paying less than 0.7% right now. US ending monetary stimulus while Europe and Japan extend stimulus tends to push the US Dollar up vs. the Euro and the Yen, making our exports less competitive which can also act to slow down the US economy. As one of very few sources of global economic recovery for the last few years, a lot is riding on continued US growth and the end of QE combined with a stronger dollar jeopardize that.

3) Europe – the majority of the continent’s economy is still a disaster and there aren’t any signs of improvements. Many suspect a QE-like program launching in Europe soon, but the legalities of such a program in a common currency with so many different jurisdictions involved make it difficult to pull off. There’s also no way of knowing how it effective it would even be given how low interest rates in the Euro zone already are. Additionally, some concerns from a few years ago are roaring back. Greece wants to end its participation in its bailout program, but doing so means it won’t be able to borrow at the low euro-zone rates, and potentially means it will need to exit the Euro completely which threatens the stability of the currency as a whole. If Greece reverts to its issues of a few years back, Portugal, Spain, and Italy (maybe even France) can’t be far behind.

4) Oil – the price of oil has been plunging in the past few weeks. While this is good for global economic growth in general (lower prices at the pump, lower heating oil this winter, lower costs for airlines, etc.), a portion of the US recovery has been led by the energy sector and our progression toward oil independence from the Middle East though domestic production and Canadian imports. It appears that OPEC is putting on a sort-of price war now with the US, keeping their production high despite falling prices because their drilling costs are lower than our more complex ways of extracting oil (oil sands, fracking, etc.). If they can push the price down for long enough, they may be able to force a reduction in US / Canadian production and maybe even put some US / Canadian companies out of business which will ultimately push prices back up with a larger share of oil production coming from the Middle East again. As energy prices dramatically fall, hedge funds that are dedicated toward energy investments, sometimes in a leveraged way, are forced to liquidate which causes further drops in energy prices and ultimately in other assets as well. Forced selling begets forced selling and the price of everything tends to fall in a whoosh until leverage is managed, markets clear, and price stability resumes. If oil continues to fall, it’s likely the rest of the market will fall with it until oil stabilizes. The good news is that once the forced selling is done, we’ll be left with lower energy prices overall and as long as the US / Canadian producers survive, that will be a stimulus to the economy in additional discretionary money in the pockets of consumers.

5) Ebola – this is one of those very low probability of extreme catastrophe events that makes it very hard for financial markets to price risk. When markets can’t price risk, then tend to avoid it, and that means short-term traders selling just about everything other than the safest assets (treasuries). Ebola has been around for a long time and there have been other outbreaks. There will be other outbreaks after this as well, since it is carried by animals that can transmit the virus to humans, without illness by the animals. If contained, as it has been in the past, it will come and go again as any other flare up of disease (remember SARS?). If not controlled, given a 70% mortality rate with the latest outbreak, it threatens large sections of the population. The concept of confident long-term market growth is based on population growth and productivity increases over time. If a disease eliminates substantial portions of the population, that premise fails and even over the long-term, economies will shrink and equity markets will shrink with them. Even if the most likely scenario happens (a minor breakout with no epidemic-like results), fear of the disease can temporarily cause fear of being out in public, traveling, shopping, etc. Each time more negative ebola news comes out, stock markets take another leg down. With a 10-14 day incubation period, It could take several weeks to see that the breakout is controlled before some confidence is restored. As I write this, details have emerged about a 2nd healthcare worker in Dallas having ebola and having flown on a commercial jet the night before her symptoms began. Sure enough the market fell to new lows shortly after the news. The US CDC needs to instill confidence soon or ebola will take the economy down in the short-term (best case) and could take it down in the long-term if it truly does become an epidemic. Again, very low probability of extreme catastrophe, but until it’s a zero probability, it will have an impact in financial markets.

6) Fear / Self-Fulfillment – Fear of all of the above having a negative impact on the economy causes markets to fall which causes confidence to fall which causes spending to drop and layoffs to begin, which causes the economy to contract. It can be self-fulfilling and can happen very quickly. The more the stock market falls and the longer the fall drags on due to fear of a recession, the higher the potential that the recession occurs as a result. This is the biggest concern for the stock market short-term. This correction, so far, has happened quickly and hasn’t taken market levels to a point that the fall will impact the economy. That doesn’t stop the market from starting to worry about though.

Remember, markets tend to climb the wall of worry. As long as there are reasons to worry, there’s room for the market to go up. New worries will push it down temporarily (no one was talking about ebola a year ago), but the lower prices go, the better the price you get if you’re using a consistent plan of buying over time. This is why people are so successful with 401ks. Volatility creates wealth for those who don’t fear it (see https://blog.perpetualwealthadvisors.com/2013/06/20/the-value-of-volatility/). While we can’t control the aggregate market going through a fear-cycle, I hope that understanding the reasons that cause the fear helps you avoid it.

Market Update – End of Q2 2014

There’s an old saying on Wall Street that markets tend to climb a wall of worry. That couldn’t be more true over the last few years. Whether it’s our own political and fiscal dysfunction, high unemployment, geopolitical tensions in the middle east, a debt crisis in Europe, slowing growth in emerging markets like China, the old “too much too fast” theory on stock market gains, the Federal Reserve and other central banks printing money, the potential end of that money printing, etc., there has been no shortage of reasons to worry the next correction cometh soon. Yet the stock market, as it usually does, makes a fool of those who try to predict it’s short-term behavior, and continues to climb that wall of worry. There is also no shortage of stock market prognosticators. Despite natural instincts to attempt to join them, I avoid it wherever possible and help clients design a plan that will be successful regardless of what the stock market does over the short-term. We don’t have to predict the short-term movements of the stock market in order to invest money toward particular financial goals. We simply have to keep money that’s necessary for short-term goals, predominantly out of the stock market!

As strongly as I feel that trying to predict market movements is a fools game, I do think it’s possible and necessary to present a rational explanation for what the stock market has done in the recent past. This is to help clients past the natural fears that prevent them from sticking to their plan at times like 2009 (and for some, even now because of a feeling that the market is “too high”). It’s also to help clients past the natural greed that can develop when you see cash earning nothing for years while the stock market gains 200%. I believe that those gains came as part of a recovery cycle from very depressed levels, spurred on by the actions of the Federal Reserve and other central banks around the world. Those actions (low short-term interest rates, quantitative easing or “QE”, and forward guidance in the form of promised low rates for an extended amount of time) allowed the recovery cycle to take place in an environment that could otherwise have taken decades. I think of the recovery in four phases of realization that impart increasing and self-reinforcing confidence in the economy and financial markets. I describe them in more detail below, but for those without the time/desire to read that detail, they run from 1) “the world is not ending”, 2) “we’re growing again, but only because of the Fed”, 3) “interest rates are absurdly low and won’t stay that way for long” to 4) “we’re growing and interest rates are staying low even as the Fed pulls back”. With each realization, the stock market has made a move higher. The phases, in more detail:

· Pre-Recovery: Markets plunging, unemployment soaring, Lehman default, credit markets seizing up… I described the aggregate psychology of the markets during this period as beginning to price in the potential for the end of the financial world.

· Recovery Phase 1: Fed starts ZIRP (zero interest rate policy) and QE (quantitative easing). Unemployment peaks. Stock market bottoms. On 3/24/09, I wrote about QE as a “game changer”, just after that bottom. I’d describe the psychology of this period as pricing out the potential for the end of the financial world. The stock market in March of 2009 had essentially fallen 60% from peak in October 2007. Earnings estimates for S&P 500 companies for the next 12 months had fallen from over $100 per share at peak to ~$60 per share. At the same time, fear in the markets led to PE contraction and the S&P 500 PE fell to just over 10 (for more on PE and market valuation, please see this recent blog post). I remember discussing this with a colleague and stating that “applying a trough multiple to trough earnings is a trough in intelligence.” When earnings fall and have a massive path of recovery in sight (growth back to peak earnings over the next several years), PEs should expand to reflect that, not contract. This is exactly what happened. Over just a few months, PEs expanded back to their market average around 15-16 as the S&P 500 gained 50% from bottom with little change in future earnings estimates.

· Recovery Phase 2: Over the next few years, the Fed continues QE and adds its guidance that rates will stay low for an extended period. The economy begins to grow again, slowly. Job creation picks up to slightly above the level of population growth. Unemployment slowly begins to fall. The stock market continues to climb, but now due to increases in earnings due to a growing economy. At the same time, the unsatisfyingly slow growth weighs on confidence and though earnings are expanding, PEs begin to fall again on concerns for future growth.

· Recovery Phase 3: The Fed launches its new open-ended QE program, called “QE Infinity” by some (see Monetary Bazooka Fired). The Fed promises to keep rates low even longer (first through 2015, then till unemployment falls to a threshold, then beyond that). Interest rates plunge to historical lows as a result of QE and the Fed’s promise. The economy still grows slowly, job creation is still slow, and unemployment continues to fall slowly. Confidence seems a bit higher in the economy and in the Fed’s ability to create a no-lose situation. PEs expand again along with growing earnings and the stock market makes another strong move higher. This time though, I think the reason for the PE expansion is the promise of lower long-term rates for a very long time. We see dividend-paying stocks like utilities and REITs due extremely well in this environment because low interest rates makes their high dividends seem even more valuable. The economic recovery still doesn’t seem to have reached self-sufficiency though with the Fed still pushing it. What happens when the training wheels come off the bike and it has to pedal on its own? In phase 3, that was the market’s biggest worry.

· Recovery Phase 4: The Fed announces the tapering of its QE program, slowing bond purchases with hope of ending the program by late 2014. Markets hiccup on fear that this marks the beginning of the end for low rates. Rates begin to increase, PEs contract, and the stock market dips into the summer of 2013. The Fed reacts by strengthening its resolve to keep rates low well beyond the end of QE. Into early 2014 as the Fed continues to cut back on QE, Europe and Japan embark on monetary easing programs (Japan is in a massive QE program already and Europe begins to hint at one to come). European interest rates, even those for fiscally troubled countries like Italy and Spain plunge to levels that approach US interest rates because of growing confidence that the European Central Bank (ECB) will do anything and everything to make sure those countries don’t default. If Italy’s 10-year treasury yields 3% and the US 10-year treasury (thought to be much much safer than Italy’s bonds) yields 3%, that puts a cap on how much US interest rates can rise. Now, in mid-2014, even though the Fed is almost done with QE, the fear of rapidly rising rates remains in check due to central bank actions overseas. If rates are going to continue to remain low long-term because of those actions, then PEs should expand again to reflect that. Additionally, confidence that the economy won’t falter as rates rise takes hold. Housing can continue to recover. Employers can hire and plan for growth. Consumers can spend without worry of erosion in the jobs market. This is precisely what has happened over the past few months as unemployment has taken another dip down and job creation has picked up sharply. PEs have expanded back out to 15-16 on the S&P 500 (based on next 12 month’s earnings), right at their historical average. The recovery now appears closer to being self-sustaining, or at least is no longer dependent on the Fed’s QE (might still be dependent on Europe and Japan though).

That brings us to present day. Can self-sustaining (or ECB induced) economic growth increase earnings enough to push the stock market higher? Can the expectation of low interest rates for the foreseeable future push PEs above historic averages thereby pushing the stock market higher? Could both happen and really put upward pressure on the market without a spike in inflation? I believe this latest run up in stocks has come from more and more belief that the answer to all of those questions can be “yes”. This, in my opinion, is where the danger lies. If the market starts to price in “yes” answers, but the economy falters and earnings estimates turn out to be too high, or the ECB doesn’t go as far as everyone is expecting, or inflation starts to rear its ugly head and interest rates start to rise, putting pressure on PEs, we could be in for that correction everyone has been expecting for the last 5 years and 200% of gains. Remember, when the wall of worry disappears, stocks may no longer have anything to climb. So, there are lots of reasons to be positive and lots of reasons to worry about being positive. Again, I can’t predict the future, but I do hope my interpretation of why stocks have climbed 200% in 5 years helps you see that we’re not living in a world of irrational exuberance. I also hope my warnings of what could go wrong in the future can keep the greed-monster in check. Stocks are not massively over-valued, nor are they under-valued (S&P 500 PE is 15.55 at the time of this writing, which right about the historical average). There are pockets of stocks that seem very expensive (small cap growth companies, especially in the social media and cloud space), but not the market overall. Stocks have merely recovered from insanely low valuations, have reflected the growth in earnings in recent years, and have adjusted to a new level of long-term interest rates. While corporate margins are at the typical cycle highs, there is still room for revenue expansion if the economy as a whole picks up. We just need to be careful not to count on sharply rising earnings before they occur and not to price in very low long-term rates forever (forever is a very long-time).

This brings me to a related and important point. A few of you have asked in recent months for my stance on what I would do in an insanely and clearly overvalued stock market situation. If such a situation was to present itself (and seeing it might be like trying to drive around a corner while looking in the rear view mirror), I’m prepared to move models to a more conservative allocation and wait for the economy to catch up to the stock market. I’m not saying that evidence will always present itself before the market falls (it would be atypical if it did). I’m not saying we’ll ever move to “all cash” or “all in” at any point regardless of the evidence. I am saying that in an extremely overvalued situation, expectations of future returns will be lower, but risk will be higher. If that’s overwhelmingly clear, it would make sense to reduce risk temporarily, as a matter of prudence, not as a prediction of an impending market disaster. I have been close to doing this a few times in the past, but have a high tolerance when it comes to “overwhelmingly clear”, and so I didn’t act. Doing so would have missed at least a period of one of the biggest bull markets in history. Making such a move, even a small one, is not something I’d take lightly (especially with tax complications in mind that can offset any benefit to being right). If I ever do decide to take this step, I will communicate further on how it will be implemented and of course give all clients the opportunity to ask any questions and express any concerns. What I think is far more important than worrying about this sort of situation is making sure that your asset allocation is reasonable for your financial goals, that you can handle the downside risk without being scared when that risk becomes a reality, and that the upside returns target the returns you need to achieve your goals. Along those lines, after bashing stock market predictions earlier in this message, I’ll end it with two of my own. First, sometime in the next 50 years, the stock market is going to lose at least half of its value over a very short period of time. It might have started yesterday. It might start two decades from now. But, it’s inevitably going to happen. Don’t let the good times lure you into risking money you can’t afford to risk in the stock market. We use bonds and other asset classes for short-term goals because of their safety. We use cash for emergency funds because of the liquidity it provides. We can target an overall asset allocation that gives the best chance of hitting your goals regardless of what the stock market does, but we can’t be greedy and gamble for high returns over the short-term. Second, unless the world comes to a brutal end in some cataclysmic event that would make money useless anyway, the stock market will be much higher 50 years from now than it is today. A dollar invested in the S&P 500 in 1963 would be worth $116 today. That’s despite losing 10% in 1966, more than 42% in 1973-74, almost 50% from late 2000 to early 2003, and almost 60% from late 2007 to early 2009. Amazingly, even a dollar invested at the peak in Oct 2007 would be worth $1.47 today, almost a 50% return. Don’t let fear of the market falling tomorrow stop you from investing for the long-term today. There is no upside to hoarding cash, especially when it earns less than the rate of inflation like it does today. Stick to your plan in the good times and the bad, and always remember that there will be more of both in the future.