Jan 2018 Comments: How Interest Rates Impact Stock Prices

Sam Ngooi Comments


Last month in our discussion of interest rates, we stated that ”one major interest rate story for the year 2017 deserves additional comment:  the fact that while there were three one-quarter point increases in the short-term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%.”  One month later, we see the ten-year yield at 2.71%, a substantial 30 bp rise in one month, clearly indicating that the buyers and sellers of bonds believe interest rates are on the rise. The question now is how much further rates will rise, and the speed at which they do so. As discussed below, a long, drawn-out rate increase should have less negative impact on portfolios by reducing the short-term price declines and thereby allowing the higher rates to offset the lower prices more quickly.

More generally, when interest rates rise, bond prices fall, with more price impact on longer maturity bonds.  The tradeoff, as we wrote last month, is that investors owning longer maturity bonds typically earn additional income in return for their willingness to absorb larger price declines in the bond portion of their portfolios, compared to the smaller price declines that occur with shorter-term bonds that pay less interest.  These bond price declines, should they occur, are typically modest compared to the extent of potential stock price declines, and bond price declines are offset in part over time by the higher interest received.

This brings us to the discussion of how interest rates impact stock prices. Our first observation is that the connection between interest rates and stock prices is far less clear than the direct impact of interest rates on bond prices.  Stock prices are affected by a host of factors, such as the pace of economic growth, expectations of corporate profits, and investor psychology as to the likely future direction of market prices. Interest rates therefore are but one of a number of factors to consider in relation to stock prices.

When economic growth is strong, and corporate profits are increasing, it makes sense for stock prices to rise.  But if growth becomes too strong, the Federal Reserve typically raises interest rates in an effort to slow the growth down and avoid (or at least mitigate) the harmful effects of inflation. How does this work in practice? Higher interest rates can slow economic growth by raising the cost of borrowing, which in turn tends to slow spending and reduce corporate profits. In the financial markets, when rates rise, bond prices fall and interest rate payments increase, setting the stage for potential stock price declines, as bonds become a more attractive investment.

The key point to recognize is that in the liquid markets, stocks and bonds compete for an investor’s accumulated savings. Stocks represent an ownership stake in a company’s future profits and offer the potential for significantly higher appreciation (see the period from 2009 to the present), even with significantly more downside risk (see 2008 through March 2009).  Investment returns from stocks come from price appreciation (or depreciation) and dividends.  Bonds, on the other hand, are a promise to repay a set amount of money in the future, plus interest, and the investment return comes mostly from the interest, with modest price changes (depending on the maturity) until the bonds mature.

When interest rates rise in the marketplace, and bond prices decline, this creates an opportunity for a flow of more income from the higher interest payments, and some number of investors become more likely to reduce their riskier stock holdings and increase the steadier bonds now paying more interest.  This provides a rationale for stock price declines even in the face of strong economic growth and strong profits.  Of course, how much the prices decline and for how long are always unknowns.

This brings us to a recent “Opinion” article by Professor Burton Malkiel (author of the many editions of “A Random Walk Down Wall Street) on “How to Invest in an Overpriced World”. The article begins by stating that “all asset classes appear overpriced;” bonds because of their low yields and stocks because of their historically high price earnings (P/E) ratios. “Investors have reason to worry, but they need to be aware of two basic facts.  First, no valuation metric can dependably forecast the future…. A corollary is that no one can consistently time the market… which involves two decisions, when to get out and when to get back in.  Timing both correctly is virtually impossible.”

Malkiel continues by discussing two strategies that can control risk, namely broad diversification and rebalancing. “Broad diversification…. By holding a wide variety of asset classes, investors have historically enjoyed smoother gains during bull markets and gentler losses during bear markets. In a diversified portfolio, declines in stocks are often partially offset by stability in fixed income markets…. Real estate equities, available through REITs, have also tended to stabilize portfolio returns…. Internationally diversified portfolios, including emerging markets, also tend to see less volatile returns over time and better risk adjusted performance.” Additionally, “Rebalancing helps control risk by ensuring your asset allocation has not strayed far from your desired levels. If the strong US stock market has lifted the proportion of domestic stocks in your portfolio to levels that are riskier than desired, it would be appropriate to reduce your equity share…. In general, staying the course in a broadly diversified portfolio is the best strategy when all asset classes appear overpriced.” He then suggests REITs and higher-yielding preferred stocks as potential replacements for positions sold while rebalancing.

The article closes with the advice to keep costs low, and avoid paying one percent for the investments and an additional one percent for the advice. He “recommends passive index funds and exchange traded funds, now available at virtually zero expense ratios, as the best investment vehicles for all investors.”

At Park Piedmont, we are advocates of Professor Malkiel’s advice, and recommend a broadly diversified mix of short and intermediate maturity bonds, along with high yield investments, and a mix of US (including REITs) and international/emerging market stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds and ETFs. Periodic rebalancing, a fiduciary relationship with our clients, and advisory fees at the low end of the profession’s fee schedules have all been key aspects of our work on behalf of our clients since our founding some fifteen years ago.


Special Memo: Current Stock Price Declines

Sam Ngooi Comments

Whenever stock prices experience large short-term declines, we make sure to check in with you to put the declines in perspective. The chart at the bottom of this memo provides figures that should help.

  1. The media likes to present large numbers in its reporting, but the focus should always be on percentages. Using end of January 2018 price levels, a 1,000 point decline in the Dow is less than 4%. This is comparable to a stock you own going from 100 to 96, a change you might not notice that much.
  2. Since the end of 2014, there have been two periods (August 2015 and Jan-Feb. 2016) of declines of 12%, which would be 3,000 points using the end of January 2018 price levels. Do you even remember those periods?
  3. Stock prices have had very large gains since the 2016 election, up approximately 7,800 points to the end of January 2018, which was a 42% gain since the election. Even with the declines of the last two weeks, stock prices are close to year-end 2017 levels.
  4. Some kind of stock price correction has been anticipated for many months now, as prices kept going higher. How much stock prices are likely to decline, and for how long, is of course in the realm of the unknown, although the media and the financial community will certainly provide their guesses.
  5. Note that stock prices have gone up in periods of both increases and declines in 10-year Treasury yields. These yields have increased significantly since the end of 2017.

 Stock Index % Changes, and US Treasury % Changes

End 2014 to Feb 5, 2018 (Using end 2014 as base year)

  DJ Indus   S&P 500   NASDAQ   10 yr USTr
End 2014 17,823 2,059 4,736 2.17%
Aug 2015 15,666 -12.1% 1,868 -9.3% 4,506 -4.9% 2.08%
End 2015 17,425 -2.2% 2,044 -0.7% 5,007 5.7% 2.27%
Jan-Feb 2016 15,660 -12.1% 1,829 -11.2% 4.267 -9.9% 1.64%
Election Nov 2016 18,333 2.9% 2,140 3.9% 5,193 9.6% 1.86%
End 2016 19,763 10.9% 2,239 8.7% 5,383 13.7% 2.45%
End 2017 24,719 38.7% 2,674 29.9% 6,903 45.8% 2.40%
Jan 31, 2018 26,149 46.7% 2,824 37.2% 7,411 56.5% 2.73%
Feb 5, 2018 24,345 36.6% 2,649 28.7% 6,967 47.1% 2.73%

Our general advice to firm clients is to stay the course, avoid attempts at market timing, and rely on asset allocation (specifically, the percentage of one’s portfolio not invested in stocks) to soften the extent of the declines.

Dec 2017 Comments: Bitcoin & Interest Rates

Sam Ngooi Comments

Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we outline our perspective below.

We start by referencing Warren Buffet, who is among the best, if not the best, investors of our time. A December 2017 article from WealthAdvisor.com (http://bit.ly/wb1227), quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”)

The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago they were almost worthless; in December 2017, their value reached $19,000.”

The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”

Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (http://bit.ly/shillerbc), Professor Shiller wrote, “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”

One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (https://nyti.ms/2DsEc97), the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can actually ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object.  Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?

Investment News, a weekly magazine mostly for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (http://bit.ly/inbc124).

Two recent NY Times articles provide excellent examples of the validity of the Investment News observations. In a front-page article (https://nyti.ms/2E2KLim), the Times reported that “Russian and Venezuelan officials are hoping virtual currencies can help their countries make an end run around American sanctions. Both governments … are looking to take advantage of the promise that Bitcoin introduces to the world financial system: a new kind of money and financial infrastructure, outside the control of any central authority, particularly the United States…. But economists and virtual currency experts have given these currencies low probability of success … because Bitcoin and other virtual currencies are decentralized systems with no one in charge, while Russia and Venezuela would give leaders of both countries a measure of control over the new currencies.” And in another NY Times article (https://nyti.ms/2E8fFpk), it was reported that the virtual currency Ripple has increased more than 30,000 percent in the last year, making the “largest holder of ‘Ripple tokens’ worth more than $59 billion.” (Yes, that’s billions).

If this isn’t a “bubble” of manic proportion, we don’t know what is.


One major interest rate story for the year 2017 deserves additional comment:  the fact that while there were three one-quarter point increases in the short term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%. The implications of this fact are discussed below.

Some context for this discussion: a key point in understanding bond price changes is that when market interest rates change, the longer the maturity, the more the price fluctuation. An example of this relationship follows: if market rates rise to 3%, a bond yielding 2% today and maturing in two years, will decline less than a bond yielding 2% today and maturing in six years, because investors get their money back sooner to reinvest at the higher rate with the shorter, two-year maturity.

Given this basic fact of bond investing, the question is how much more yield (interest income) do longer-term investors have to receive to be compensated for the extra price risk being taken?  In today’s bond market, the spread between a three-month US Treasury yielding 1.4% and a ten-year US Treasury yielding 2.4%, is quite clearly 1.0%.  So the question is: why would presumably rational investors take the risk of owning a bond for almost ten more years just to receive 1% more interest?

The explanation, to the extent there is one, is that the ten-year investors think that future yields will be going down, not up, in which case the longer-term bond becomes more valuable, and its price increases. These investors may be right, if economic growth slows and inflation remains low. (Our note: Inflation is the declining purchasing power of a currency over time, and interest is one way investors are compensated for receiving currency with less purchasing power in the future).

In the current environment of an expanding economy, high employment, a recently enacted tax bill that many observers believe is likely to increase the budget deficit and increase inflation, and a Federal Reserve seemingly poised to raise short-term rates again in 2018 (the consensus is for three more quarter point increases), the 1% spread between 3-month and 10-year bonds seems quite small.

Many investors looking for additional income from the longer maturity bonds are likely to absorb price declines in the bond portion of their portfolios if rates rise. Smaller price declines would come from shorter-term bonds, but that would reduce the income from the portfolio. These bond price declines, should they occur, are typically modest compared to possible stock price declines, and the bond price declines are offset in part by the higher interest received on bond portfolios.

At Park Piedmont, we suggest a mix of short and intermediate bonds, along with high yield investments and stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds.

Nov 2017 Comments: Giancarlo Stanton & the Folly of Prediction

Sam Ngooi Comments

As you may know, the Levinsons are pretty big baseball fans. Vic and Nick actually coached Tom’s little league teams (photos are available upon request), and Nick and Tom (and their sister Lynn) grew up going to Yankees games on the 4 train in the 70s and 80s.  So there was some excitement upon the announcement, made this past weekend, that the Yankees had traded for Giancarlo Stanton, the reigning Most Valuable Player in the National League.

In the article on espn.com breaking the news, an interesting detail popped out: when Stanton was drafted back in 2007, he was the 76th player selected. Stanton is a towering slugger and four-time All Star. Yet, a decade ago, the teams of Major League Baseball selected 75 other players before him. Amazingly, of those 75, over twenty never played a single game in the Major Leagues.

How did so many teams, tasked with the most expertise and up-to-date information, get their predictions so wrong? Some players got injured, as you’d probably expect. Elbows wear down and knees give out. Some others just didn’t improve the way teams expected them to – in some cases the shortcomings were likely physical; in others, mental; in still others, both.

But the real answer is that fortune-telling is exceedingly hard.

At year’s end, forecasts for the year to come are everywhere. That’s especially the case in the financial markets. With various stock indices at or near all-time highs, analysts and pundits declare that it’s only a matter of time before a significant stock decline. “Whoa,” say other commentators, “why so gloomy?” With a growing economy both here and abroad, unemployment down, and significant tax legislation on the brink of passage, these observers exude confidence that there’s plenty of room for markets to rise.

Many – including many who are smart and sophisticated – attribute significance to the predictions. They base their actions on these predictions. They rely on them. Indeed, much of the investment advisory industry relies on the ostensible predictive ability of researchers and stock pickers, portfolio managers and quants. Are they reliably right?


According to the S&P Dow Jones Indices Persistence Scorecard, very few funds consistently outperform their benchmarks. The 2016 Scorecard reports: “Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016. Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile.”

In other words, roughly 97 percent of the active managers who are paid (handsomely) to outsmart the future failed to, even over a 2-year period. Jeff Sommer’s March 2015 column in the New York Times memorably explored this same territory.

Researchers have found that in various fields, experts have a hard time forecasting what’s to come. In a September 2011 episode of the Freakonomics podcast called “The Folly of Prediction,” Philip Tetlock, a professor of psychology and management at Wharton, explained that a signature challenge for experts lies in “think[ing] they know more than they do.” They tend to be “systematically overconfident.” As much of the field of behavioral economics continues to reveal, humans are predisposed toward emphasizing data that supports our positions, our viewpoints, and our biases, and undervaluing data that challenges those positions.

Perhaps needless to say, the difficulties of prediction aren’t limited to experts! We mortals aren’t too hot at predicting outcomes, either.

Frequently in conversation, the question is asked: where do you think the markets (or interest rates, or the economy) are going? You likely know our answer by now: we don’t know.

Park Piedmont has a deep institutional humility about our ability to forecast what’s to come in a complex world. It’s why our Comments routinely feature Larry Swedroe’s observation that “the biggest mistake investors make is treating the highly unlikely as impossible (such as having a massive crisis), and the likely almost as if it is certain (such as the probability that stocks will outperform bonds over twenty years).” It’s why we emphasize customized, broadly diversified asset allocations for you, our clients, in a way that’s respectful of your risk tolerance and designed to help accomplish your long-term goals.

It’s also why you won’t see us placing a wager on the Yankees’ World Series chances in 2018 after their blockbuster trade – even if that’s what the experts are predicting.

October 2017 Comments: Bond Investments

Sam Ngooi Comments

Last month we changed our focus from the surprising, ongoing advance of stock prices since the 2016 election, to bonds, the other major asset class in most client portfolios.

During September there was a substantial increase in market interest rates, which brought the benchmark ten-year US Treasury yield to 2.34%, up 21 bps from August’s close of 2.13%. October’s increase was a much more modest 4 bps, to 2.38%, still below the year end 2016 rate of 2.45%, even as the Federal Reserve has made two 25 bps increases (in March and June) in the ultra-short term overnight rates it controls during 2017.

Ordinarily, an increase in rates by the Fed would result in a similar increase in longer-term rates set by bond market buying and selling. Surprisingly, this has not occurred so far in 2017.  A new Fed Chairman replacing Janet Yellen, and a likely additional 25 bps short term rate increase by the Fed in December, provide some additional context to this discussion.

We are going to use Jeff Sommer’s recent article on bonds (NY Times, 10/29/17 Sunday Business, page 3) as background for our Comments.

The article observes, as we often do, that “Stocks and bonds are complementary partners in standard portfolios. While stocks typically have a higher return potential, bonds are generally less risky and provide a hedge against a stock market plunge, as they did during the bear market that started in 2007.”

PPA’s addition: the extent of the stock decline (and subsequent recovery) are most noteworthy, and add important detail to the rather bland statement of a “bear market that started in 2007.” The S&P 500 index declined from its October 2007 high of 1,565 to a March 2009 low of 677, a decline of 57%. That same index closed October 2017 at 2,575, a gain from low to high of 280%. This is an annualized gain of approximately 17% over the 8.5-year period.

The article continues that “despite a rocky bond market over the last month, bond prices are still too high, and their yields so low, that bonds simply can’t provide much buffering.”

PPA’s addition: we respectfully disagree. If long term market history is any guide, when stock prices fall 20% (the definition of a bear market), or more, the declines in bond prices attributable to rising interest rates are likely to be much, much smaller, and that is the whole point of owning an appropriately allocated and diversified portfolio of bonds and stocks.

The article then continues with a discussion of the wonderful returns in stocks over the last eight plus years, and whether they are likely to continue.

PPA’s addition: surely no one knows the answer to this question.

The article then returns to another recent article by the author: “the standard practice after a big run up in stocks is to rebalance, meaning to take profits out of stocks and put them into bonds. The goal is to create a well-diversified portfolio … the problem is that this is not an ideal moment to be putting money into bonds.” Reasons for the continuing upward pressure in interest rates are presented, ranging from the Fed’s desire to raise rates gradually to ward off future inflation, to the Fed program of selling bonds it had purchased in the aftermath of the financial crisis, to the identity and likely policies of the new Fed chairman, to the potential inflationary impact of the larger budget deficits coming from the government, including from possible changes in the tax law.

Sommer continues that “the bond market turmoil leaves investors in a bit of a muddle. The central reason for holding bonds remains intact: Bonds will still buffer a portfolio and generate income. But in the near future, they aren’t likely to do so as effectively as in the past.”

PPA’s addition: if the point of bonds is to offer a buffer against serious stock market declines, investors should focus on this purpose, and be less concerned about whether this is or is not a good time to buy bonds based on their future return potential.

The Sommer article concludes with some observations from John Bogle, the founder of Vanguard, one of which is that “compared to stocks, bonds are a good value, better than they have been in years … and it still makes sense to hold stocks and bonds in a diversified portfolio.”

PPA’s addition: we take no position on the relative valuations of bonds and stocks, but certainly agree that a diversified portfolio of stocks and bonds, allocated to the investment goals and risk tolerance of each investor, is the best defense against the unexpected (refer to Larry Swedroe’s observations about asset allocation above).

A few other comments may prove useful:

  1. Rebalancing (adding to bonds after large stock price advances) “is more a risk control measure than a return generator.” (This quote comes from Sommer’s article on rebalancing, and we agree. Note there is no mention in the quote of whether this is a good or bad time to own bonds, just that owning them is intended to provide risk control.)
  2. Investors expect to receive higher interest rates on their bond investments when inflation rises, to offset the reduced purchasing power of the money they receive when their bond investments mature. So when rates do rise, and bond prices decline, one other result is that investors receive higher interest payments in the future.
  3. The extent of price declines depends on maturities of the bonds, and on the amounts and time intervals of the interest rate increases.
  4. We are always available to discuss these issues in more detail, including how to balance stock and bond allocations in each client’s portfolio.

Don’t Touch My Money, Just Hold My Hand

Sam Ngooi Comments

A recent article by Wall Street Journal columnist Jason Zweig, entitled ‘Don’t Touch My Money, Just Hold My Hand’ (WSJ, June 9, 2017), touched on topics that reinforce the investment approach Park Piedmont has been conveying to clients since its founding in 2003.

First: many people look to investment advisers to boost their investment returns. If that’s your perspective, “you may be paying your adviser for the wrong thing,” according to Zweig. Just as investors tend to be their own worst enemy by “flinging money at whichever assets have gone up the most and then bailing out at the bottom, locking in losses” – typically during periods “when they are in the grip of greed or fear” – many advisers, driven by the perceived need or desire to outperform, act the same way. In their efforts to chase performance, advisers can lag significantly behind those who maintained a discipline in maintaining their long-term plan.

Second: investors often feel the urge to do something, when nothing may actually be a better investment decision. Zweig writes that investors tend to add and subtract money at inopportune times, leading to “what is often called the ‘behavior gap’ between the performance of an investment and its investors.” For instance, mutual fund investors earn average annual returns that are approximately 1 to 1.5 percentage points lower than the returns of the funds themselves. Zweig adds that investors in hedge funds “may lag those vehicles by up to 7 percentage points annually.” That’s what a financial adviser “should prevent,” writes Zweig.

Finally: Mr. Zweig closes his piece with the following quote, which further reinforces another of Park Piedmont’s consistent message to our clients. “You should hire an adviser not for his or her investing prowess, but to help organize your finances, prioritize your goals, minimize your taxes, and navigate the shoals of retirement and estate planning. Done right, those services can make you far richer – and happier – than the pipe dream of investment outperformance is likely to.”

There will always be events that affect the market in the short-term, in both positive and negative ways. But an adviser can give clients confidence and help them maintain their discipline, so that short-term events don’t undermine longer term goals.

Please contact us if you’d like more information about how Park Piedmont Advisors, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

Known Facts, Unknowable Future

Sam Ngooi Education

At Park Piedmont Advisors (PPA), we advise clients that trying to predict future events, and the financial market’s reactions to future events, can often lead to disappointing results.   Rather, we advocate ignoring most current events and focusing instead on long term financial goals and the cost efficient investments that help achieve those goals.

Here is an example of how even knowing future events can lead to disappointing results.

On Monday May 23, 2016, the US S&P 500 index was 2,048.

Since then, we have experienced the following events- some surprising- that, to most observers, would have been considered negative for financial markets:

  •   England’s vote to leave European Union (“Brexit”, June 23-24);
  •   Donald Trump elected US president (Nov 8);
  •   two Federal Reserve quarter point interest rate increases (Dec 14 and Feb 15);
  •   world wide hacking (mid-May);
  •   North Korea weapons testing (ongoing);
  •   Trump problems with FBI and Russia (ongoing).

Assuming you were able to predict the future and knew all this was going to happen, would you have thought the US stock market, as measured by the S&P 500 index, would be:

a)   closer to 1800 (approximately 12% lower than mid May 2016);

b)   2100 (approximately the same as mid May 2016); or

c)   2300 (approximately 12% higher than mid May 2016)?

Of course, we now know the answer is the 2300, but who would have thought that before the fact?

The moral of the story is to try and ignore the short term news, and focus instead on your long term goals. This is the ongoing message PPA provides its clients. Contact us to learn more about our investing approach.

“Dream Paychecks”: Thoughts on Hedge Fund Returns & Fees

Sam Ngooi Comments

We’re going to start commenting on investing/financial items we read or hear about in the media, in the hope that it’s interesting and informative for you. Please let us know if you have any comments or questions.

Our first post involves the 5/16/17 NYT article titled “Dream Paychecks.” It discusses the enormous 2016 earnings for hedge fund managers (ranging from $1.6 billion [not a typo] to about $100 million), many of whom significantly underperformed the broad stock and bond market indexes for the year. “The 25 best-paid hedge fund managers earned a collective $11 billion in 2016, according to an annual ranking published … by Institutional Investor’s Alpha magazine…. Nearly half of the top-25 earners made single-digit returns for their investors, a lackluster sum in a year when the S&P 500 stock index was up 12%, accounting for reinvested dividends.” To be fair, not all hedge funds invest exclusively in stocks, and so the S&P 500 might not be the best benchmark for all of the funds managed by the highest-paid managers. And as the article notes, “the original allure of a hedge fund was the promise of smoother returns during market upheavals along with risk-adjusted returns that would stand out.” But many of these funds and their managers have risen to prominence, and outsized pay, by taking enormous risks in search of market-beating returns, which have not occurred recently for several well-known managers. The article mentions John Paulson, “who is best known for reaping a windfall by betting on the collapse of the housing market in 2008, [and] has made $15.45 billion over the 16 years Institutional Investor has been compiling the list. But he was bumped off the list after double-digit losses in 2016…” Also mentioned is William Ackman of Pershing Square Capital Management, who “has had percentage losses in the double digits for two years in a row.”

The main points from PPA’s perspective are that active managers, whether of hedge funds, private equity funds, or simply actively-managed (as opposed to passively-managed or indexed) mutual funds, take big risks that might generate outsized returns over certain periods, but always have the possibility of significant declines in other periods. This lack of “persistence” in the returns of active managers is one of the main reasons PPA prefers index funds to implement client portfolios. And the cost of this significant risk, which is in turn “the key to these large paydays [at least for most hedge funds,] is the fee system known as 2-and-20. Hedge funds typically charge investors 2% of their investment annually, regardless of performance… In the event they make a profit, the funds take 20% of that as well.”

Please let us know if you’d like more information about how PPA, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

The Presidential Election and Financial Markets

admin Uncategorized

In the immediate aftermath of Donald Trump’s unexpected election as President of the United States, global stock prices are experiencing substantial short-term volatility.  As always, when events create this kind of volatility, we think it useful to step back and think more long-term with regard to your investment portfolio.  Here are some points worth considering:

  • The meaning of “big” declines: While the media likes to present declines in large numbers, a 900 point decline in the Dow Jones Industrial Average (DJIA) is a 5% decline. That means a portfolio allocated with 50% in stocks and 50% away from stocks should show a decline of 2.5% — significant but not devastating. The value of an appropriate asset allocation – for mitigating risk and cushioning against volatility – is always most clear when stocks experience substantial declines.
  • Your time horizon as an investor: It’s always important to understand how much of your money you’ll need to use, and when. The further away in time you need to use it, the more you can think of yourself as a long-term investor — measured in years, not days.
  • Historical perspective: At the end of October 2008, just before Barack Obama was elected President, the DJIA was 9,325, in the midst of an historic decline from 13,265 at the end of 2007 caused by the financial crisis of that time. In those first few months of the Obama presidency, the DJIA fell to as low as 6,547 in March 2009, or 30% below October 2008.  Since March 2009, the DJIA has advanced to over 18,000, a gain of almost 200%.  An even more recent example of short-term volatility that didn’t last was the late-June “Brexit” event, where Britain voted to leave the European Union. Despite a nearly 5% decline in the days immediately after Brexit, stock prices are now higher than they were the day before the Brexit vote.

Beyond money

We recognize that, for many people, this election result is about much more than finances and stock prices.  We understand that initial reactions can be powerful and offset longer term thinking.  Uncertainty about what the future holds is always uncomfortable.  But planning thoughtfully for an uncertain future is an important part of our work together.  As investment advisors, we continue to advocate a long-term approach, built around appropriate asset allocations. We are, as always, available to speak with you if you’d like to talk further.

Update on “Brexit”

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On Thursday, June 23, British voters, by a majority of 52% to 48%, voted to have their country leave the European Union (EU), an event dubbed “Brexit” by the media. Since the financial markets reacted sharply to this event (stock prices down, then quickly recovering; bond prices sharply higher, meaning continuing lower yields to investors), and the media proclaimed the event historic, this month’s Comments are devoted to this topic.

The print media’s immediate treatment of Brexit can be seen in the following headlines:

  • June 25, NY Times front page: “Global Shocks After Upheaval in Britain.”
    • Sub Headline: “Investors Gripped by a Panic Last Seen in ‘08”
  • June 28, NY Times, page B1: “Brexit Spreads Fear Far From Britain’s Shores.”
  • June 25-26, Wall Street Journal: “UK Vote Sets Off Shockwaves”
  • June 25-July 1, Economist Magazine cover:  “A Tragic Split”
  • July 2- July 8, Economist Magazine cover: “Anarchy in the UK”

The media discussion of Brexit covered many consequences: political (resignation of British Prime Minister and other political leaders), societal (vote partly against immigration), economic, and financial.  Our focus will be on the economy and financial markets, using the July 2nd-8th issue of The Economist (a magazine based in London, with a decidedly liberal, global, and upscale point of view) as the basic source of information.

In describing the outcome, the first of many Economist articles (page 9) states: “Anger stirred up a winning turnout in the depressed, down-at-heel cities of England. Anger at immigration, globalization, social liberalism and even feminism, polling shows, translated into a vote to reject the EU…. Unless these voters believe that the global order works to their benefit, Brexit risks becoming just the start of an unravelling of globalization and the prosperity it has created…. Proponents of globalization, including this newspaper, must acknowledge that technocrats have made mistakes and ordinary people paid the price. The move to a flawed European currency led to stagnation and unemployment and is driving Europe apart.”

Elaborate financial instruments bamboozled regulators, crashed the world economy and ended up with taxpayer funded bailouts of banks, and later on, budget cuts…. Trade with China, which lifted hundreds of millions of people out of poverty and brought immense gains for Western consumers, also left many factory workers with lost jobs, and they have been unable to find a decently paid replacement…. While American GDP per person grew by 14% in 2001-15, median wages grew by only 2%…. As Brexit shows, when people feel they do not control their lives or share in the fruits of globalization, they strike out, and the distant, baffling, overbearing EU makes an irresistible target.”

The next article (page 10), rather than seeking causes, focuses on the future. “The country needs a new leader, a coherent approach to negotiating with the EU, and a fair settlement with those nations within its own union that voted Remain (in the EU)…. Brexit comes in many varieties, from an arrangement, like Norway’s, involving continuing access to Europe’s single market, in return for allowing free movement of people from EU countries and a contribution to the EU budget, and at the opposite extreme, cuts its ties entirely, meaning no more payments to EU and no more unlimited migration, but no special access to the market which buys nearly half of Britain’s exports…. Britain’s next leader must explain to 17 million voters that the illusion they were promised – all of the EU benefits with none of its obligations – does not exist.” [Our note: negotiations on the terms of the British exit from the EU have a two year deadline from a still-to-be determined start time).

The next article (pages 17-20) focuses on the EU, and what Britain has chosen to leave (terms of departure currently unknown). Recent EU issues range from the “debt crisis in the euro zone (our note: mostly Greece; Britain is not a member of the euro zone), and the mass influx of refugees and other migrants. But Brexit is qualitatively different, since it strikes at the very idea of a union…. The EU is the world’s biggest single market, counting some 500 million rich-world consumers. It stabilized new democracies in southern and eastern Europe…. Two big questions… will anyone else follow Britain out of the union, and what reforms are needed if the institution is to cohere and survive?  Eurosceptics across Europe have similar dissatisfactions as Britain’s ‘Leave’ voters: resentment of globalization, estrangement from elites, a sense the EU is distant and undemocratic, and above all, the EU has let in too many foreigners who take away jobs, benefits and national identity.”

The article focusing on the “economic fallout” begins on page 21. “Business and financial markets hate uncertainty. The vote for Brexit gives rise to a surfeit of it…. Forecasts for economic growth are being revised down – markedly for Britain, materially for Europe, and modestly for the world.  A lot depends on the kind of trade deal Britain can negotiate with the EU and how quickly its outline will emerge…. Three broad scenarios cover most of the possibilities; … the Norway arrangement, reached quickly, in which case the spillovers to Europe and the global economy would be small and transitory. In the second case, discussions are considerably longer drawn out, key issues of disagreement remain, and businesses in Britain, and to a lesser degree other countries with which it has close ties, defer whatever spending they can… The pound remain weak, pushing up the costs of imported goods. Hours and wage growth fall…. In this middling scenario, the combined effects of business uncertainty and a weaker pound would be likely to cut the economy’s growth rate by 1-2 percentage points in the next 12-18 months….”

“A decent rule of thumb is the reduction in GDP growth in Europe will be between a third and a half as big as the loss to Britain’s rate of growth…. The worse outcome (third scenario) would occur if trade talks stall, the politics of Europe sour, and agitation for referendums in other parts of the EU grow…. Broader anti-EU or anti-euro sentiment would likely cause worried business leaders across Europe to cut back on investment. Europe’s banks might be spooked by tumbling stock prices into choking credit for firms and households.”

The article continues that “many forecasters are treating Brexit as a regional economic event, rather than a global one. Britain accounts for a bit less than 4% of world GDP; it is not big enough to make the global economic weather as America or China can.  Even so, there are worries that Brexit might disturb some existing fault lines in the world economy in a way that amplifies its impact.”

The financial market reaction is discussed in the Buttonwood column (page 62). “Shock, followed by frantic recalculation, was how astonished financial markets reacted to the British vote to leave the EU. The initial phase saw a worldwide sell-off in riskier assets, such as equities, and a flight to safe ones, prompting further declines in government bond yields. After the sell-off, equities started to bounce again on June 28th, in part because central banks may respond with easier monetary policy (or in the case of the Federal Reserve, slower tightening); in part because Brexit may not have much impact on the Chinese economy.”

The article continued that “the biggest casualty was the pound sterling, which went from $1.50 before the vote to $1.32, a 31-year low. A big drop in the pound, to make British assets more appealing to foreign investors and imports less appealing to Britons, is a necessary adjustment…. Now the initial shock has passed, investors need to work out what the economic impact will be…. One question is whether consumption will suffer because of the vote…. The bigger worry is investment, …many companies are waiting to see whether Britain decides to join the European Economic Area, alongside Norway, which would keep it in the single market…. In the meantime, uncertainty means few businesses will be inclined to invest in new projects…. For the rest of Europe the question is whether Brexit will encourage other anti EU movements.”

Given the extensive and fear-provoking media coverage of Brexit, we think it important to spotlight the actual price (and percentage) changes of some key stock indexes, starting with the day before the vote (June 23), and then over the next six business days (ending July 1)

               Dow Indus.      S&P 500      NASDAQ       FTSE 100

6/23      18,011                  2,113                4,910                6,338

6/27      17,140 (4.8%)    2,000 (5.3%)  4,594 (6.4%)   5,982 (5.6%)

7/1         17,949 (0.3%)    2,103 (0.5%)  4,863 (0.9%)   6,578 +3.8%

7/15       18,516 +2.8%     2,162 +2.3%   5,030 +2.4%   6,669 +5.2%

It is worth noting that this totally unexpected recovery of stock market prices in a few short days received much less prominent coverage than the initial declines. This again illustrates the point that much of the media coverage of financial events appears designed to frighten people, emphasizing the bad news, while addressing improving news in a far more muted tone. This suggests that the best course of action, far from hanging on the media’s breathless pronouncements, is to ignore the media’s play-by-play account of what’s happening, and instead focus on your longer term goals.

The fact is, had you missed all the news, you would have returned to stock prices that were almost unchanged, except for the Financial Times-London index (FTSE), which actually was 5.2% higher! As usual, after the fact, commentators fashion reasons for this totally unexpected price recovery. The focus now is on the idea that central banks are likely to continue to keep interest rates very low. (The low interest rates can be seen in the very high prices for high credit quality bonds in the US and certain other developed countries like Germany and Japan.) But since it will take two years from a still uncertain future date for Britain to negotiate its new status with the EU, it now appears that Brexit is likely to be a footnote in the history of stock price fluctuations.