Market Update & More (3/15/2020)

Q. How about that stock market rally on Friday? It has to mean Thursday was the bottom right and this was that quick turn you’ve talked about before?

A. Honestly, I doubt it. And I don’t mean that stocks are going to immediately just give that all back, though they certainly could. What I mean is that the stock market is constantly adjusting to price in all known current information and all opinions of those who are invested in it. If the average investor thinks that prices for a company, sector, asset class, country, index, or the market as a whole are too high, then that average investor will be buying less at the current price than selling. That makes prices fall, sometimes rapidly, to a lower point where equilibrium is established again. The reverse of course is true as well. If the average investor, known all they know, thinks prices are too low, then there will be more buying than selling at the current price, thereby pushing prices up. Right now, markets are getting lots of new information daily, sometimes minute-ly (don’t think that’s a word, but let’s go with it anyway). Opinions form, sometimes overreacting, sometimes underreacting, though we never know when that’s the case. Friday’s snap back from Thursday’s ~10% move down is more shifting opinions, more new information, and more projecting the future beyond covid-19 and an oil price war. The odds are good that the market is still fairly priced and if it’s not, we don’t know whether it’s overpriced (near term shock will be worse than expected, recovery longer, long-term impacts) or underpriced (near term shock will be better than expected, recovery shorter, few/no long-term impacts). The key part of that last sentence is “than expected”. We can’t simply read the news, say that covid-19 cases and deaths increased, and think that would cause stocks to lose value. What causes stocks to lose value is when things are worse “than expected”, in aggregate, and that worse than expected result is validly projected into the long-term future. No one can tell you when the stock market is going to bottom or has bottomed, just like they can’t tell you when it is going to top-out or has topped-out. It would be much wiser to say that the best guess is that the market is fairly priced, is most likely to produce average returns from here, but that the likelihood of a wild swing in one direction or the other remains.

Q. Well, that’s disappointing. Everything’s so depressing right now… can you give me a few positives as a result of what’s happening?

A. Absolutely.

  1. Long-term interest rates are extremely low. That’s not just great for refinancing personal debt (e.g. mortgages), but it also means something important about asset prices. A company’s value today is determined by a projection of its future profits, but typically the short-term profits are weighted much higher than long-term profits because of the interest rate you can earn on those profits each year as they’re collected. If interest rates are high, say 10%, you’d rather have a dividend right now and reinvest it at 10% than get it five years from now. That makes the short-term much important relative to the long-term in determining current value. When interest rates are as low as they are now, the value of the next year’s profits is a much smaller portion of a company’s total value. This is extremely important in the sort of scenario we’re living in now where the disruption to profits seems temporary. Losing year one of profits with minimal/no impact on years 2 thru infinity should not change current value by that much, at least not in aggregate (individual company’s might have debt which forces them out of business if they can’t make payments, but then another company that survives takes their revenue going forward). Warren Buffett invested in an airline yesterday. I suspect, he’s using this kind logic in buying the worst possible investment for news flow (ex-cruise lines), at exactly the worst possible time looking at near term profits.
  2. Gas prices will likely be in the ~$1.50 range nationwide in the next couple of weeks. Most people aren’t doing a lot of commuting / traveling right now, but when they do, those cheaper prices at the pump add up to more money in consumer pockets.
  3. More on interest rates… I don’t know if we’ll do this, but the country has an opportunity to extend the maturity of short-term debt to the very long-term without paying much higher (and sometimes even lower) interest rates. Some countries have 50-year and 100-year bonds. For some reason, we don’t go beyond 30. If we could refinance our national debt at low, fixed, long-term rates, it will give some leeway to fixing our fiscal issues.
  4. We’re going to be able to refill the strategic petroleum reserve for the US at prices that seemed unimaginable 10 years ago. The next time there is an oil supply shock, we’ll be much better positioned as a result. (Aside: shouldn’t we also have a strategic medical supply reserve? *sigh*).
  5. For those who are still adding to their portfolios, which are generally the ones that will take the biggest hit from stocks falling in value since retirees don’t have all their money in stocks, the opportunity is substantial. I don’t mean that stocks are a fantastic opportunity now and they should pour money in at current prices. But, investing steadily through the rollercoaster will get you to a higher ending portfolio value than investing the same way in a market that just moves steadily upward. See https://blog.perpetualwealthadvisors.com/2013/06/20/the-value-of-volatility/ for examples.
  6. The worldwide fiscal and monetary response to our current challenges is going to be enormous. This has some long-long-term consequences, but for the medium term, it can’t be anything but a positive. The last decade has also made it much more commonplace and acceptable for the Federal Reserve to pump money into the economy to replace a lower velocity of money due to forced deleveraging. Quantitative Easing (QE) takes a lot of credit for keeping us out of Great Depression II following the financial crisis. There’s a fair chance an even stronger response could come this time if things get dire. Did you know that Japan’s equivalent of the Federal Reserve purchases equity ETFs (i.e. stocks)? Our Fed doesn’t have that mandate from Congress, but I wonder what happens when a national emergency is declared and the president has broader executive order powers? Hmmm…

Q. I feel a little better. Still though, from a financial standpoint, there are tons of people on CNBC and other stations saying they don’t want to be in stocks right now and haven’t been in stocks while this was happening. What do they know that we don’t know?

A. There are lot of doomsayers out in the press right now, taking victory laps because the market is down, even though many haven’t been bullish since before the great financial crisis. Maybe some of you reading this fall into that camp internally as well, feeling like you knew this was going to happen, but thinking back, you’ve felt that for so long that if you had acted at that point, you would have missed out on much more growth than you have lost in the last month. Still others may have nailed their “top” call at exactly the right moment. Surely you will be hearing from them at times like this. There are a lot of people in the world making predictions though and if you frequently make bold ones, you’re bound to be correct and may even find yourself on TV celebrating it. CNBC presents cheerleaders when markets are doing well, calling on people to buy hand-over-fist and perma-bears proclaiming the end of the financial world during a crisis. It’s what gets ratings. It’s also the people who are willing to come on their shows since they’ve been recently correct. It’s not hard to find people who are correct, even several times in a row… If you flip 10,000 coins 10 times, odds are that about 10 of them will come up heads every time. It doesn’t mean the coin has an advantage over the other coins. It means you’re not hearing from the other 9,990.

Q. How do you stay calm about all this? Aren’t you worried at all?

A. In all honesty I have my moments of personal freaking out at times like these, just like many of you that are reading this. Like the old Hair Club For Men commercials for those of you who remember them, I’m not only an advisor, I’m also a client. It’s ok to let yourself feel emotion. It’s just not ok to act on that emotion and do something that you planned specifically not to do exactly in a case like this. I know I signed up for riding a long, upward-sloping roller-coaster the first time I invested. I know with almost certainty that there will be dips of 50% on this ride, with the possibility of more from time to time. I know that it won’t look upward sloping during those dips. I also know that investing in aggregate in the ingenuity of humans and the ever-rising productivity and technological growth of our society is the best way to build long-term wealth. It is the reason why the roller-coaster slopes upward over the long-term. I also know that money I may need in the short-term isn’t invested all in stocks and in matching that return/risk profile with my family’s goals, there’s really nothing to worry about over the short-term. I still worry because I’m human, but my plan gives me comfort. I also sometimes feel like I know what the stock market is going to do (especially in hindsight!!!). During the financial crisis, I convinced myself I knew it was going to happen (in truth, I knew real estate couldn’t rise 15% forever, but I had no idea the depths that we’d be going to in early ’09). I knew after the sharp rise in stocks in spring of ’09, that we were going to revisit those lows again (we didn’t). I knew that the Fiscal Cliff disaster was going to crash the market (it didn’t). I knew that the financial system was going to crack when Europe ex-Germany was inching closer and closer to defaulting on their government debt (it didn’t, and not only didn’t it, but that government debt turned out to be one of the best investments ever for those who bought at the brink of disaster). Now, I’ve had good internal calls as well over the years, but I remind myself frequently about that coin flipping that I mentioned above. In short, I give myself time to freak out, I moan and groan, I remind myself of the futility of market-timing, I pull myself together, and I get back to regularly scheduled life. If any of you, my clients, find yourself stuck between freaking out and getting back to regularly scheduled life, please call me. I’m also a client and I know what it feels like. It’s the reason I write these posts when times are tough. I’m talking to me as much as I am to you. And, I’m listening.

Market Update (3/11/2020)

Continuing the new Q&A format…

Q. I heard the stock market is now down 20%+, so we’re officially in a bear market. That means stocks are going down, right?

A. No. It means stocks have gone down. There is no magic switch that flips when stocks go from down 19.99% to 20.00% that tells everyone that stocks will now fall for some time period. Rather a “bear market” is a description of the past, telling us that the value for a particular asset or index has fallen 20% from it’s high. It is like describing a losing streak when a sports team has lost several games in a row. It doesn’t tell you about the next game. By the way, while the most well-known indices just marked 20% down, other asset classes have been down more than 20% for much longer. The Russell 2000 (US small caps) is down more than 25% from its all-time high and the Russell 2000 Value (US value small caps) is down more than 30%. You’re just hearing about the “bear market” now because the Dow and S&P500 have joined in.

Q. Is this all due to the coronavirus (covid-19)?

A. No. Last weekend, disagreements among OPEC members and between OPEC and Russia led to the kickoff an oil price war. Oil prices, which were already down sharply from levels of a year ago, crashed on Monday to below $30 per barrel. While low oil prices means lower prices at the pump, lower energy costs for consumers, businesses, and energy importing countries in general, falling oil prices now hurt the US due to the abundance of oil we produce. Much of that oil is costlier to obtain than middle eastern oil and while we can do quite well (we’ve actually become a net exporter of oil in recent years) with prices in the $50+ range, down near $30 essentially puts our shale oil companies out of business. There are over 6M jobs in the US directly related to energy and due to the capital investment required to get new oil extraction started, most oil companies have a large amount of debt. Debt with little or no revenue spells bankruptcy. The surviving companies will gobble of the assets of those that fail, and will be well-positioned if there’s ever an oil boom again, but many jobs will be lost in aggregate and the holders of all the bad debt will take losses.

Q. Will the price war go on long-term?

A. No one knows. Saudi Arabia started the war with massive price cuts to try to increase demand for their oil after other OPEC countries and Russia would not agree to supply cuts to try to keep oil prices stable in the midst of falling demand as covid-19 slows down world economies. All sides remain open to talks and there is pain for Saudi Arabia with oil at these prices as well. So it is plausible they will reach an agreement that will return prices to previous levels and potentially cut supply. But the damage to US shale may already be done. As I noted above, it takes major capital investment to start the extraction process and knowing that Saudi Arabia can drop the price of oil at their whim may prevent that capital investments and/or the financing needed for it in the future, even if prices do rise from here. The energy sector of the stock market and the high-yield debt markets both immediately reflected the new reality on Monday will many stocks down near 50% that day alone. An agreement to cut global supply and thereby boost prices worldwide will obviously help on the margin, but job losses and defaults are likely no matter what and that will hurt the US economy somewhat.

Q. Speaking of hurting the US economy, things seem to be getting pretty bad with the coronavirus impact. How bad is this going to get?

A. Like I said in my last message, the fear of the fear of the unknown is the biggest issue. We still don’t have mass testing available in the US, so it’s hard to track places trending toward an outbreak level and take action to curb the spread. Until today, not much action was being taken nationwide. Now we’re seeing large cancellations and postponements including the suspension of the NBA season, travel restrictions from Europe, etc. Work must continue and critical services have to be maintained, but luxuries, hobbies, sports, and leisure travel really have to be restricted. This makes total sense.  With an incubation period of 5-14 days, we’re looking at the past right now, so taking immediate action to stop mass gatherings and travel is necessary, but will take a while to slow the spread. Meanwhile, the economy will suffer from the loss of all that activity. This is what the stock market sees and why it has fallen. Remember though that as the infection count rises (based on per capita cases from other countries, we’re likely in the 10-20k range already… just not counting them yet) , the death toll rises, the economic activity slows, and the news flow worsens, those are all items that the stock market already knows is coming. No one believes the US has 1100 cases of covid-19 infection right now. No one believes this is just going to miraculously go away tomorrow. The stock market is a realist and reflects the best guess at the future news from everyone who buys and sells. That’s why it’s impossible to know when stocks have bottomed. We’ll all see terrible news flow and suddenly the market’s participants in aggregate will begin to see past the pandemic and into the future. Stocks will turn well in advance of the worst times, just as they have in past crises. Because fear & despair usually cause the market to overshoot to the downside (as it did in 2009), when the market turns, it often turns quickly right as the news is hitting its worst.

Q. So you’re saying that selling into the downturn due to the news flow won’t work?

A. I’m saying that selling at any time guessing that the market is going down short-term vs. going up short-term is about a 50/50 bet. Even if you get it right though and sell at the right time, you then have to win another 50/50 bet in the right time to reinvest. Many learned that lesson the hard way selling toward the bottom of the financial crisis in early 2009 and then waited for the news flow to turn to want to buy back in, but by then the market had already moved up past where they sold. We want to avoid that whipsaw and instead do the reverse. Use your target asset allocation (the one that reflects your goals and risk tolerance) as a literal target for your portfolio. As I’ve said previously, that means that if stocks fall, we sell bonds and buy stocks to rebalance back to the target percentages. When stocks rise, as they did strongly in 2019, we did the reverse, selling stocks and buying bonds. There is no guessing or betting or predicting involved. It’s systematic and emotionless.

Q. Ok, so long-term, odds favor a return to recent highs?

A. Of course, though we never know how long that will take. It’s already a distant memory for most, but in Q4 2018, the S&P 500 fell nearly 20% with small caps and international stocks down even more. Over the course of the last 7 days of 2018 and Q1 of 2019, the S&P had recovered almost all of its Q4 losses. By the end of 2019, the S&P 500 was up 30%+ for the year. Other times, 20% losses have been just the beginning of a much bigger, longer slide. We never know the depth of a pullback or the length of time to return to recent highs in advance. But, unless there is a major decline in world population (and even the worst estimates of covid-19 come nowhere near projecting such a thing), then when this is behind us, the world will return to normal, as it always has after a traumatic event. There will be bankruptcies, there will be defaults, and there will be financial dislocations for a while. But ultimately, if there is the same number of people and the same aggregate demand for goods and services, the same technology, the same capacity, the same real assets (even if financial assets are worth less temporarily), how would we not get back to business as usual? That’s what the stock market will eventually see ahead of the turn in the news flow.

Q. Should I then be investing some of my cash emergency fund to take advantage of the temporary lower prices?

A. Absolutely not. An emergency fund is there for emergencies and especially in uncertain times, emergencies like a job loss, medical need, family need, etc. could come up at any time. We never advocate investing the cash that you’ve set aside for emergencies due to the recent movement of financial markets.

Q. What about taking on leverage (loans) via a home equity line of credit and investing that to try to catch the rebound?

A. We don’t recommend investing on leverage whether via a margin loan, a HELOC, or leveraged investment products. Again, we don’t know how long this will last or how deep the downturn will go. If you have $100k and borrow $100k to invest $200k in total into stocks and stocks fall 50%, you have lost all of your $100k. There is no coming back from a 100% loss. Even 1000% returns don’t increase a zero-balance portfolio.

Q. Any other general words of advice for times like this?

A. First off, do what you need to do to keep yourself and your family safe especially if any of you are in poor health or are elderly. You have to stay tuned to the news in some way to know what’s developing and what’s required of you as policies change. Try to tune out the financial part of it as much as possible. Think of all the times your financial advisor has told you that at some point, stocks will again lose 50% of their value. I’m not saying that will happen now, but you, your portfolio, and your plan were then, and are now, prepared for it to happen.  Put the energy you’d spend worrying about it toward better uses in your health, your job, and your family, as much as possible.

Coronavirus

Switching to a new Q&A format for most blog posts as I think it makes them easier to read and allows me to include questions that clients have asked. If you have more questions on a related (or really any topic), please let me know and I will try to include them in future posts.

Q. What is this post about?

A. The economic, financial market, and personal finance impact of the “coronavirus” (covid-19).

Q. Aren’t there more important impacts from a viral outbreak than those related to finance?

A. Yes. It’s not lost on me that there are much greater concerns in public health than in finance when a viral outbreak hits. I am sensitive to the tens of thousands of people who are sick and the thousands who have or will die. My job is in finance though, so I will leave the health and social issues to the experts in those fields and focus here on my scope of knowledge and understanding.

Q. How has covid-19 impacted financial markets?

A. The impact of the Coronavirus (covid-19) on financial markets over the past week has been sharp and swift. Long-term interest rates have fallen sharply (US 10-year treasury hit an all-time low today of 1.243%) causing bond values to increase, while stocks around the globe have fallen. On average, stocks are down about 10% over the last week around the world, with some areas, sectors, and asset classes down much more than that.

Q. We were just at all-time highs though, right? So 10% from all-time high isn’t so bad is it?

A: The well-publicized S&P 500 was recently at an all-time high, after a year with very high returns in 2019, so 10% down only puts the index back to where it was last fall. But in other areas of the market the impact is worse, even in the US. Small cap stocks still hadn’t exceeded their highs from August 2018, even with the great 2019 year, because of how sharply they were down in Q4 2018. They are now down 14% from their all-time high. Small-cap value stocks are down 21% from their high in Aug 2018. Outside the US, stocks peaked in Jan 2018. Developed markets are down 16%, while emerging markets are down 20% from their all-time highs. Perhaps this correction will finally end the perception that all stocks have been moving straight up since 2009, which was simply not true, even before the covid-19 impact.

Q. Why is this virus having such an impact on stocks?

A. It’s mostly fear of the fear of what’s to come. That is, fear of a sharp economic downturn led by public fear of the virus. If people stop traveling, eating out, shopping, etc., due to worries about catching the virus then those part of the economy grind to a halt. If people can’t work in jobs that require physical presence, then those businesses will be impacted as well. If aggregate demand for products falls, then manufacturing is also impacted. Slowly, a population that is afraid to leave their houses, causes widespread economic distress. That leads to layoffs, less spending, and the usual downward spiral that comes with economic recession. Again, it’s the fear of fear that is causing the stock market to panic and price in lower earnings and an economic downturn. For the most part, it is not that those things are actually happening (at least not to a large degree inside the US). There are also overseas manufacturing issues, predominantly in China where the virus seems to have originated back in December and where 78k of the 82k currently confirmed cases exist. Those manufacturing issues cause inventory dislocations (shortages of some things, too much of other things) which also hurt businesses and can cause product shortages and other supply chain disruptions.

Q. Wouldn’t all of that be temporary though?

A. Likely yes. Though we don’t know how long “temporary” is. Unless the virus is so bad that it kills a significant portion of the world’s population, it’s hard to believe there will be long-term economic impact. But, there is a lot that is unknown about the virus at this point. Even if its death rate isn’t high (currently running at 1.65% outside the China with 55 deaths out of 3,332 confirmed cases), it could become a constant part of society like the flu, which could cause some drop in overall productivity. What makes temporary economic downturns dangerous are the massive debt levels that exist in both the public and private sector around the world. Debt payments continue to be due even if revenue (tax collections for government, sales for businesses, wages for individuals) declines or stops. That risks default or bankruptcy, layoffs, reduction in government services, lower consumer spending, etc. Still, over the long-term aggregate demand would return. While individual businesses may fail, when aggregate demand returns, businesses that survive + new businesses pick up that slack, hire those people who were laid off, and return to growth. Take the airlines for example. Their stocks are getting pummeled by fear of virus impacts. If those impacts are bad enough, it’s possible that debt-ridden companies could have a liquidity or solvency crisis and be forced into bankruptcy or out of business. But the airlines in aggregate, likely have to fly the same number of people from point A to point B once aggregate demand returns. So you’ll have winners and losers, but in total, no long-term impact. That makes massive, industry-wide stock declines seem irrational. Better said, if the long-term outlook for earnings remains unchanged, then even if earnings temporarily fall and a few companies fail, true value of the industry as a whole remains unchanged. On a larger scale, this is why PWA uses extremely diversified portfolios rather than picking individual stocks. We don’t know the future winners or losers (covid-19 didn’t even exist 3 months ago) so we don’t bet on individual companies. Instead we invest in the global economy as a whole, which has a very high probability of growth over the long-term.

Q. Aren’t stock prices already high? Couldn’t this drop just be because prices were overvalued before the virus hit and were just looking for a reason to correct?

A. While some sectors and individual company valuations seem high, the stock market, even at its peak, was not excessively valued in my opinion. To value a stock, you have to look at future earnings and interest rates. With interest rates near historic lows even before the virus impact, stock valuations were fair. The S&P 500 for example was priced at about 18x 2020 projected earnings (which were high given the virus, but again, virus impacts are highly likely to be temporary). That’s a 5.55% earnings yield. In other words, if you put $100 into the S&P 500, its companies in aggregate give back $5.55 of earnings per year. Some of that gets paid out to you in dividends and some of it gets reinvested in the company to produce growth for the future. In contrast, the US 10-yr treasury was yielding ~1.5%, and cash was yielding even less than that. Would you rather have 5.5% per year in something with growth over the long-term (even if comes via a rollercoaster ride of ups and downs) or 1-2% of year steady?

Q. What about the Federal Reserve? What are they likely to do if there is a temporary economic shock due to the virus?

A. The Fed says they’re monitoring and stand ready to act. The market has gone from forecasting a moderate chance of one 0.25% rate cut in 2020, to a likely chance of two and maybe even three. Lower rates help to support the economy, ease debt burdens, provide more borrowing opportunities, and push more people toward investment rather than savings, all of which stimulate the economy. I’ve heard people say that rate cuts can’t cure the virus so they won’t help, but that’s not logical. Rate cuts stimulate economic activity. If the economy is depressed, regardless of the cause, then rates cuts will help offset that depression somewhat.

Q. How bad is this virus?

A. No one knows for sure, and certainly not me. I’m not a doctor or virologist (didn’t even sleep in a Holiday Inn last night), so I’ll stay away from the health impact. We also don’t know the real number of infections, though the reported number is about 82.5k worldwide, mostly in China, but with a rapidly growing number of cases outside China (453 two weeks ago, 1200 cases a week ago, 3332 today). We’re told that the virus has a 10-14 day incubation period, though some people may present sooner after exposure, and that it’s possible people might be contagious even during the incubation period (before symptoms present). If that incubation period is 14 days and the number of cases outside China has increased almost 10x in the last two weeks, it feels like a safe bet that 14 days from now there will be a lot more cases worldwide. In the US, there are currently 60 confirmed cases, with the majority coming from those who have been repatriated from overseas. Your guess on whether the other cases have been contained or not is as good as mine, but in a deeply interconnected world and cases multiplying in places like Europe and Japan, the probability of seeing more cases in the US seems high, whether they come from domestic or foreign exposure. Symptoms reportedly range from virtually nothing, to flu-like symptoms, to much more severe breathing issues and complications due to immune response. I haven’t seen any reporting on what those infections in the US have looked like. We do know that the time to recover varies widely, ranging from a couple of days to several weeks. Maybe the only upside to more cases in the US will be more understanding of the virus actual does, how it works, how it spreads, and how long it takes to get better if you catch it.

Q. Ok, so it’s likely to spread, we don’t know how bad it is, it has killed people, the mere fear of it might cause a recession, and company earnings are likely to take a hit… Are you selling everything?

A. Definitely not. The right answer in this case is to stick to your financial plan. I’ve said numerous times on this blog and in conversations with clients that stocks will almost certainly fall 50% from their highs at some point in our lifetimes (it happed twice from 2000-2009). I’ve also said that we will not know what the cause is or that it’s going to happen, until after it begins. And, we’ll never know when the market is down 10% or 20% whether the correction is over and we’ll get a sharp bounce back up (like in Q4 2018), or if it is just beginning of a 50% downturn (like in early 2008). The ideal strategy is not to try to predict the impact of the unpredictable. It’s to invest in a way that you don’t need to make predictions to be successful in achieving your goals. If you are in a place in your life where you need most of your available money soon (retirement funds if retired, education funds as your children near college age, or liquid funds for whatever reason), then that money shouldn’t be invested all in the stock market. On the flipside, if what happens over the short-term doesn’t matter, then you are far better off ignoring short-term impacts and invest aggressively, in stocks, for the long-term. Both of these are emotionally difficult, but it is how PWA manages portfolios for our clients. If a 10% market correction concerns you, then you’re either invested too aggressively for your goals or you’re letting emotion get in the way of rational thought. PWA is not selling any stocks in client portfolios due to covid-19. On the contrary, we will be selling bonds and buying stocks as the value of stocks fall. We did the opposite as stocks rose and this rebalancing provides a natural buy-low-sell-high rhythm over time.

Q. You always say that unless the world ends, everything will be ok over the long-term. What if this virus is, in some sense, the end of the world?

A. At the risk of waxing too philosophical, we can’t live life preparing for the end of the world. If the world ends and you’re the most prepared for it, do you get anything out of that? Similarly, we can’t invest for the end of the world. He who dies with the most money does not win. Given the infinitesimally small chance that this becomes a cataclysmic event and the fact that your assets won’t have value in a post-cataclysm world anyway, it seems to make a lot more sense to plan for life to continue in its current state for many more generations. Remember also that the intersection of your sphere of concern and your sphere of control is where you should spend your time. Epidemics and doomsday predictions (as well as stock market performance) may be something that worry you, but they are most certainly not things you can influence. If you disagree with this answer, let’s discuss. There are definitely ways to plan for the end of the world, irrational as it may seem. It’s just far from my baseline strategy.

Q. So what should I be doing at the intersection of concern and control?

A.

· Interest rates have fallen pretty sharply. Mortgage rates are at all-time lows. If you own a home and haven’t refinanced recently, check with your lender, another bank, and/or a mortgage broker to see what you can do. Often, taking a slightly above market rate (but still below your current rate) lets your lender give a credit that covers most/all closing costs. That makes the benefit of refinancing happen almost instantly, rather than having to wait for the lower interest payments to offset a high amount of closing costs. Optimizing this is dependent on your individual situation.

· If you’ve been sitting on cash waiting for the market to fall to deploy it to more useful investments than a savings account, here’s a 10% pullback. It doesn’t mean it won’t go to 20% or even 50%. It just means it’s 10% cheaper than a week ago. If you’re not ready to pull the trigger, put a plan in place to pull the trigger based on something certain so you keep emotion out of it (e.g. I will add 20% of my excess cash to my portfolio every 5% down in the market). Don’t get me wrong… having your money always invested is a better mathematical answer, even if it means investing a large lump sum. But if you just cannot get yourself to do that, investing something slowly is better than nothing at all.

· On the flipside, make sure you have an emergency fund of 3-6 months of expenses in cash plus any short-term spending that is needed and won’t be covered by income. People tend to let this slip in the good times because they’re always getting bonuses, commissions, etc. and there’s not need to pay attention to cash levels. Be wary of the not-so-good-times.

· Some temporary economic damage is highly likely. There will almost certainly be job losses. We haven’t lived through that in a decade. Unless you can afford the job loss, make yourself indispensable at work.

· I know I said I’d stay out of the health-related advice, but I can’t resist this one. Stay informed, but from factual sources. Listen to the CDC. (You can also find infection statistics, updated daily, from John Hopkins CSSE). Wash your hands. Try not to touch your face. Be wary of misinformation or fear mongering from those who profit by keeping your attention (i.e. anyone who sells ads). And, I hate to say this, but It’s an election year and while we hope our leaders put politics aside, their careers depend on your feelings. Incumbents have a bias toward making the situation seem better than it is. Challengers have an bias toward making the situation seem worse than it is. Keep that in mind and try to listen to more than one source of information before reacting to anything.

Market Update (2/5/2018)

I had hesitated to send one of these out after the two-day pullback in the market because while it looks bad on a point basis (Dow, S&P, etc.), it’s far from exceptional on a % basis, which is what counts. After today’s fall, the S&P is down a little over 1% for the year. Some other assets classes are down a bit more, others are still up on the year. This is far from “Markets in Turmoil”, but that business news headline attracts attention, raises fears, and up go ratings. Because of that, I thought a quick note was warranted to both show there is not turmoil at this point and to give you my perspective on what’s going on. Here’s a quick look at year-to-date performance (including any dividends paid) by asset class (representative ETF) AFTER today’s “plunge”:

US Large Cap (SPY): -1.1%

US Small Cap (VB): -2.7%

Foreign Developed (VEA): -1.5%

Foreign Emerging (VWO): +1.7%

Real Estate Investment Trusts (VNQ): -9.9%

High-Yield Bonds (HYG): -1.3%

Aggregate Bonds (BND): -1.4%

Short-Term Investment Grade Credit Bonds: CSJ: -0.1%

Local Currency Emerging Market Bonds: +2.5%

Aggregate Commodities: +0.5%.

As you can see, with the exception of REITs, which are getting beaten up as interest rates rise, this is far from turmoil.

What happened today is concerning though. Stock markets behaved erratically. Futures liquidity dried up as this started to happen and liquidity in the S&P 500 futures contracts after-hours tonight are as low as they have been in a long time. That means it’s fairly easy to push the market around with relatively small orders, causing big moves in either direction. As a result, S&P futures have been moving 10+ points repeatedly over only a few minutes throughout the evening (this is the equivalent of the Dow moving in about 100 points per few minutes). The markets are down sharply overnight, with recent lows having Dow futures down another 1100 points from today’s close and S&P futures down a little over 100 points. This isn’t being caused by economic issues, bank liquidity issues, terrorism, recession, or anything that caused the last two major (-50%+) market falls. In my opinion, it’s being caused by large, leveraged bets on continuing low volatility which are unraveling in what should have been some mild profit-taking and re-pricing as interest rates moved a bit higher in January. Volatility has been running well below normal as I’ve pointed out in recent quarterly updates. Futures markets generally price in a return to normal volatility over time. Therefore, if one shorts future volatility in futures markets (or via multiple exotic ETFs and other financial products) and volatility remains low, money can be made over and over again very quickly. Hedge funds have been started that engage in this tactic and it has paid off massively over the past year as there has been virtually no volatility in the stock market. The longer the strategy pays off, the more money moves into it, chasing its success. People / funds begin to borrow money to invest in the strategy (leverage) because they can pay a few % of interest per year for their borrowing costs and make 10%+ per month if the strategy continues to do well. For all of history this has been a recipe for disaster and sure enough, it is beginning to unravel. An otherwise ordinary increase in volatility surrounding a few days of rising interest rates / declining stocks causes these bets on low future volatility to lose massive amounts of money very quickly. Fear that they won’t be able to pay back their loans causes margin calls which forces more selling of this strategy. Selling of short volatility funds is essentially buying volatility into a spike in volatility, which causes (of course) more volatility. Other hedge funds know this is happening and try to take advantage of the forced volatility buying (stock selling) causing even more. From there, it’s the same old vicious cycle that has fueled market drops like this in the past. Want proof that this is what’s going on? Today was the single biggest % increase in the VIX (the volatility index) in the history of the market on what wasn’t even in the top 100 down days on a % basis in the history of stocks. Want more proof? Here’s the after-hours chart of an exchanged traded note that tracks the inverse of the volatility index (I know that’s a mouth-full… it’s basically one of these short-future-volatility funds that is blowing up):

You’re reading that right… -86.04%, just since 4pm today! This is going to cause some hedge fund meltdowns. It’s going to cause some margin calls. It’s going to strain markets for a while. But I find it hard to believe an obscure greed-based strategy is going to bring down earnings growth, which is really starting to pick up around the world. That’s not to say there aren’t other factors playing a role here, but I think this short-volatility blow up is a big part of it. Another cue that this is probably a shorter-term event is that it’s not flowing through to currency markets at all (at least not yet). Despite futures being down 4% overnight, the dollar index, a normal flight to quality when there is a lot of fear in the market, is up only 0.1%.

Anything is possible, and as I’ve said many times, I’m certain that the stock market will eventually fall more than 50% again. We probably won’t see it coming in advance of that happening. But, if someone forced me to place a bet, I would bet that this will be a fairly short-term event that will allow the market to build again from whatever bottom that forms. To be clear, I’m not advising anyone to invest money they wouldn’t otherwise invest as a result of this. I’m not advising anyone to be more aggressive or conservative in their portfolio or to reposition assets in any way (other than usual rebalancing) as a result of this. Financial plans are designed to weather market moves, not predict them, and not time them. I know seeing your portfolio value fall hurts. For some of you, it makes you want to sell stocks. For others, it makes you want to aggressively buy stocks. But it is going to happen over and over again and is the price you pay for the kind of growth you’ve experienced over the past several years. Markets can’t only go up, despite what they’ve done in the past year. We’ll be rebalancing client portfolios on the way down (sell bonds, buy stocks), just as we rebalanced in the other direction (sell stocks, buy bonds) on the way up. And, it never hurts to have your planned contributions and 401k deposits go in at a lower level than they otherwise would have.

In short, expect that wild swings in either direction are possible over the next several days. I hope that with the explanation above, you’ll find what happens more interesting than traumatic. As always, if you’re reading this as a PWA client, feel free to contact me with any questions.

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 6/20/13

The Federal Reserve is eventually going to stop firing their Monetary Bazooka (“QE”, as its commonly known). We’ve always known that. Over the last month, culminating in yesterday’s post-FOMC announcement press conference, “eventually” became “soon”. Despite reiterating their promise to keep short-term interest rates near-zero into 2015, their plan to continue to QE program through mid-2014, and their resolve to support the economy through aggressive monetary policy for as long as it needs their support, the Fed has spooked the market by signaling the beginning of the end of monetary stimulus. First, let’s quantify the damage:

There are other factors at work as well including Japan’s unprecedented attempt to stimulate its economy through QE (makes ours look like child’s play) and the currency fluctuations that has caused, China attempting to pop its real estate bubble by extracting stimulus and causing domestic bank liquidity issues, recent protests in Turkey and Brazil, ongoing political instability in Syria, Egypt, and much of the rest of the middle east, inflation in India, Brazil, and some of the other emerging markets, massive unemployment and fiscal issues in southern Europe (Portugal, Italy, Greece, Spain, Cypress) while debating between austerity and trying to stimulate growth. I don’t want to minimize them, but here I want to focus on the Fed, which is really the only change in the past two days. Clearly, from the table above, there hasn’t been anywhere to hide but emerging markets have really taken the biggest beating as expected since they are typically the most volatile asset class.

In addition, mortgage rates have started to rise, following treasury rates. 30-year fixed rates have moved from 3.3% in May to an average of 3.93% last week according to Freddie Mac’s weekly survey, and likely well over 4% this week. Continued increases in mortgage rates will hurt the housing market which has been in full recovery mode for last 18-months and is the prime reason behind the economy’s strengthening.

So, should you be worried? I would be worried if any of the following are true:

1) If my financial plan was built on an expectation that I’d be able to borrow at absurdly low rates forever. I’ve been building 4.5% rates in for the near term and 6-7% rates for 2015 and beyond into all client plans. Higher rates are unfortunate, especially if you’re hoping to buy a home soon, but rates are still within the tolerances of your plan. It’s important to note also that if rates move much higher over the short-term, prices will most likely come down as buyers simply won’t be able to afford the higher monthly payment that comes along with higher rates on the same amount borrowed. In hot markets like the SF bay area, higher rates, if matched by an expected increase in supply thanks to higher prices, could stop the housing recovery in its tracks.

2) If my financial plan was built on an expectation that my investment portfolio would only go up, day-after-day, with no volatility forever. If you believe that’s possible, you haven’t been listening to anything I’ve said or written in the past. No portfolio (except maybe Bernie Madoff’s) will do that and your financial plan certain doesn’t have that expectation built in if I helped to create it. We’ve seen stocks relentlessly increasing since March 2009 and have to expect pullbacks / corrections from time to time. It’s the price you pay as an investor for the reward of higher long-term gains. As a general rule of thumb, you have to be prepared to lose 50% of the portion of your portfolio that’s in the stock market in any downturn. If you’re 50% stock / 50% bond, that means a 25% loss can be expected at some point (it’s happened twice in the last 13 years). As I’ve said before, if you’re uncomfortable with the potential for loss, then you must be more conservative and must accept lower long-term return expectations. There’s no way around this point.

3) If I was invested only in stocks and long-term bonds for my short-term goals and I needed every dollar I had invested for those goals. I coach all clients to invest conservatively for short-term goals, in some cases extremely conservatively, and to maintain cash for ultra short-term goals where you need every dollar you have. I’m not using long-term bonds in any client portfolios, favoring shorter-durations which will fare better in a slowly rising rate environment.

4) If I was investing for long-term goals primarily in stocks, but couldn’t get past short-term results, even though they don’t matter over the long-term. This one is psychological, but is key. Unless you think you have a crystal ball that can predict the short-term future of the markets, you just have to accept the short-term in favor of higher expected long-term returns. Hopefully you’re all on board. If you’re not, investing may not be for you.

5) If I hadn’t communicated my goals and plans with my financial advisor, or if I didn’t have a financial plan at all. Here’s there’s room for worry if things have changed in your life, you’re a PWA-client, and you haven’t communicated those changes or kept up with your annual reviews, or if you’ve never completed or kept up with a financial plan to begin with. To quote Yogi Berra as I’ve done in past posts, “If you don’t know where you’re going, you might wind up someplace else”. A similar result can be expected if you haven’t told your financial advisor where you’d like to go!

On the flip side, instead of worrying, remember that a falling market creates opportunity as long as you continue to add to your portfolio. You’ll be much better off with some dips along the way to your goal than you would in a straight line where the market only goes up, counter-intuitive as that might seem.

With all of the above said, perhaps some of you are still worried that rates are going to soar, the market is going to plunge into an abyss, and we’re headed for the Great Depression v2.0. After all, the real danger in unstable markets is the circular feedback loop that they have on the economy and that the economy has on the market. If asset prices irrationally fall, consumer and corporate confidence tends to fall too, which can slow the economy and cause asset prices to fall. Normally, this kind of feedback loop has the potential to cause a catastrophic downward spiral where fear begets fear and markets crash. If the Fed was stepping away and saying, “we’ve done all we can”, I’d worry about that too. In this case though, the Fed hasn’t stepped away from the market. They haven’t taken the training wheels off the bike, given the child a push, and turned their back. They’ve told that precious child that they’re going to take the training wheels off when she’s mature enough and steady enough and they’re monitoring that regularly. When they do, they’ll be there running along with the bike keeping it steady until it has picked up enough speed that she can balance and pedal without falling. And, if by some chance she falls off that bike even with all the support, they may put the training wheels back on again, repair the damage, and try again later. Yep, there may be crying, there may be a sleepless night or two, there may be a scraped knee, but she’ll make it. There may be short-term dislocations in the market as selling causes margin calls which leads to more selling temporarily, but the economy and the markets will make it as well.

To summarize, don’t worry unless you don’t have a plan or you haven’t communicated your goals to your financial advisor. Market volatility is both normal, and even helpful over the long-term. Finally, realize that the Fed hasn’t spent 6 years trying to get the economy back in working order only to walk away and let it crash now.