Special Memo: March 16-20

Sam Ngooi Comments

As the coronavirus continues to raise major issues related to people’s health, to the general economy, and to the financial markets, we are writing again with an updated discussion. This is our fifth Special Comment (in addition to our regular February Monthly Comments) on the subject, which will draw from the earlier material and feature some new content. The primary caveat to all this is the presumption that, at some point in time, with tremendous public cooperation and governmental coordination, the disease is likely to run its course sufficiently to allow for some return to normalcy. This appears to be happening now in China, where it all began, providing some timeline of hope for the countries suffering the most now.

In our first Special Comments, dated Feb 25th, we presented a chart with the history of the five most recent serious contagious diseases since 2003, and stock prices during those periods. The chart showed that the negatives were modest and not long lasting, and we added the following comment: “while we certainly understand the past is not necessarily predictive, and ‘black swan’ events do occur, it is also worth having the information to consider.”  We now know that this disease is doing far more damage than the previous five, noting also that over time, factors other than the disease itself come into play.

In our second Special Comments, dated Feb 27th, we discussed corrections (declines of 10% or more from the previous high), and bear markets (declines of 20% or more from the previous high).  The US stock market (S&P 500) is in a bear market now, down approximately 32% from its all-time high reached in mid-February 2020 and following the year 2019 when US stocks rose approximately 29%.  Almost all the gains from the start of Trump’s presidency are now gone (for the S&P 500 and Dow Industrials; NASDAQ is still up approximately 25%). But history also suggests recoveries from these kinds of declines. There have been 12 bear markets since World War II (1945), with an average decline of 32.5%, lasting an average of 14.5 months, and taking an average of two years to recover.  The most recent was October 2007 to March 2009, when US stocks dropped 57% and then took more than four years to recover.

We also noted that “your asset allocation away from stocks reduces the impact of the declines.  A 50-50 allocation to stocks and bonds means that a 30% stock market decline should have a 15% impact on your portfolio.  The allocations are intended to allow you to get through sharp stock market declines and take a long-term view of your investments.”

In our regular February 2020 Monthly Comments, we discussed how “PPA advises clients on allocating manageable portions of their investment portfolios to stocks, behaving as long-term investors looking to grow their portfolios at rates above low interest rates and the rate of inflation.  What we avoid is acting as traders, who seek to profit from short-term price movements by being in the markets when prices are rising, and out when they are declining; or selling stocks short and then trying to buy back at lower prices. We refer to all of these trading activities as “market timing.”  As appealing as market timing appears, the record shows it is extremely difficult to make two correct decisions — the time to sell, and the time to buy back in.” The adverse consequences of missing the best performing days for stocks are discussed.

We also quoted extensively from Ron Lieber’s NYT article, “Freaked Out by the Stock Market? Take a Deep Breath,” (NYT 2/27/20, page B1), which advocated taking a long term view of investing, measured in multiple years,  rather than days or months. “Ignore predictions and seek perspective. When the stock market falls, as it has all week, there is a natural desire to search for explanations and consult crystal balls. While the spread of the coronavirus has been a catalyst, nobody knows exactly why the market moved the way it did, including whether underlying economic troubles are contributing to the severity of the gyrations. And nobody can tell you how the virus will affect the US, including whether the outbreak’s short-term economic impact will reduce long term profits. And you are a long-term investor, right? Most of us fall into that category… We invest in stocks because doing so has consistently proved to be a good way to buy a little piece of capitalism. Hold on long enough to a diverse collection of stocks, and the system has tended to generously repay patient people over six or seven decades of working, saving, and drawing down a portfolio.” Further, we noted that even people close to or in retirement can have many years to go in their need for money, and therefore some growth potential in their allocation is in order.

Bonds are the major asset class used to diversify away from stocks, and the focus of our Special Comments dated March 9th.  Bonds pay interest and have historically experienced much lower price volatility than stocks.  At PPA, we divide the bond (or non-stock) category into: (A) cash equivalents/money markets: shortest maturities, no price changes, pays the least interest, currently close to zero because of recent Federal Reserve interest rate reductions on the rates it controls); (B) high credit bonds (HCB): short and intermediate maturities (one to six years); price changes based on maturities, interest rate changes, and changes in credit quality; interest payments and prices determine yields to investors; prices determined by the activity of bond market buyers and sellers establishing prices in much the same way stock prices are determined by the activity of stock market buyers and sellers; and (C) high-yield bonds: various maturities, which pay more interest because they have more credit risk. Their prices are also set by buyers and sellers in the bond market.

PPA uses substantial bond allocations for older clients, as a source of money needs, one main reason being to avoid selling stock positions when stock prices are declining.  Clients can have five or ten or more years of their spending needs invested in a mix of these three bond categories, usually mostly HC bonds. In the current market environment, when HC bonds are coming under increased credit scrutiny and HC bond interest rates have declined, there is some discussion about selling some of the HC bonds and buying the money markets.  In doing so, the bond sellers would have to accept lower prices from the buyers than would otherwise be the case in more normal times, with the extent of the lower prices determined in the markets. The alternative is to hold the bonds, use them as needed in small increments for cash needs, and eventually have the yields to maturity restored to normal levels.  This idea of going from HC bonds to money markets is a form of market timing that would normally not be considered by long term investors drawing monthly money needs from their portfolios.  The bond investments PPA makes are primarily in Vanguard funds, with bond funds from Dimensional Fund Advisors (DFA) added more recently. These major financial institutions do the credit analysis for the bonds in their fund portfolios.  As usual, our advice regarding bonds is to maintain the allocation of short and intermediate maturities, with some high-yield mixed in, all providing an allocation away from the stock market.

Our most recent Special Comments, dated March 12th, returned to the stock market declines, which were becoming more severe at that time, and have increased in severity through March 20th.  As we have written many times previously, “the long-term overall gains in stock prices come with the risk of periods of significant declines.  No one is promised that the high for stock prices will be their particular exit point.”  These Comments referenced a separate New York Times article by Ron Lieber advising people with long-term investment goals to remain focused on the long-term and try to avoid taking action based on short-term fluctuations. Lieber wrote again on the same subject (NYT 03/10/20, page B4) as follows: “Current stock market activity, driven in part by out of control algorithms and professional traders with wildly different goals from every day investors like you… Have your long-term goals changed today? If not, there is probably no reason for your investments to change either… Your actual asset allocation may mean that the declines in your portfolio aren’t as bad as those flashing red numbers.”

As stock prices continue to decline and the response to the coronavirus is to shut down a great deal of economic activity, the idea that the US economy, and many economies throughout the world, are likely to experience a recession has become widely accepted.  A recession is defined as two quarters of negative economic growth (measured by GDP). Even if this happens, the length and severity of recessions are always variables, unknown until the recessions end, and historically their impact on stock prices is not always direct. Indeed, some of the current stock price declines may well be pricing in the expectation of recession, as stock prices are often a forward-looking guide to what investors/traders see in the future.

Another subject is whether to rebalance your portfolio. Rebalancing refers to the idea of selling the higher performing asset class (these days bonds) and buying the poorer performing asset class (these days stocks), to return your portfolio to a previously established allocation.  Selling stocks and buying bonds or money markets is not rebalancing, since you are selling the poorer performing asset class to buy the higher performer. The sell low/buy high activity (“flight to safety”) is more closely related to market timing. While we are not necessarily suggesting rebalancing, because of the current extreme level of uncertainty, we also recommend retaining the stock allocation, albeit at a reduced level. No one knows when these declines will stop or at what prices, and how long a recovery might take. That said, we do continue our advocacy of appropriate allocations both to and away from stocks, and a long-term time horizon when considering what that allocation should be. While we should all be aware that history may not repeat itself, and that the history we know is only one of many variations that could have happened (see Nick Taleb discussed in January Comments, and Larry Swedroe quoted every month in our Monthly Comments), PPA’s view is that all the history we present to support a point of view is at least worthy of consideration.

In the absence of a better indicator, we repeat our consistent bottom line suggestion: stay the course and think long-term. Please feel free to contact your advisor for additional conversation.

Special Memo: Stock Price Declines of March 9th, 11th, and 12th, 2020

Sam Ngooi Comments

On March 9th, and then again on March 11th and 12th, all three major US stock indexes experienced serious declines.  When measured from their recent mid-February highs, the three indexes are down between 27% and 28%, which means all three are now officially in a “bear market.” The spread of the coronavirus and its feared health and economic impacts appears to be driving these declines.  Taking a modestly longer view than day-to-day, the chart below shows the performance of these indexes at various points from President Trump’s November 2016 election through March 12th, 2020.  From the 2016 election close, all indexes are still reporting at least some gains.  Note the huge gains from the Q4 2018 lows to the end of 2019; also how those gains have been mostly, if not all, reduced through March 12th.

  S&P 500 % DOW Jones % NASDAQ %
Election Day Close 11/8/16, Base 2,163 18,590 5,163
Q4 2018 Lows 2,351 +8.7% 21,792 +17.2% 6,193 +19.9%
Year-End 2019 3,231 +49.4% 28,538 +53.5% 8,973 +73.8%
March 12, 2020 Close 2,481 +14.7% 21,201 +14.0% 7,202 +39.5%

As we have written many times previously, the long-term overall gains in stock prices come with the risk of periods of significant declines.  No one is promised that the high for stock prices will be their particular exit point.  Please refer to our Feb 27th Special Comments for some longer-term information on the number of corrections (down 10%) and bear markets (down 20%), since 1945. Those same Special Comments referenced a New York Times article by Ron Lieber advising people with long term investment goals to focus on the long-term and try and avoid taking action based on short-term fluctuations. Lieber wrote again on the same subject (NYT 03/10/20, page B4) as follows: “Current stock market activity, driven in part by out of control algorithms and professional traders with wildly different goals from every day investors like you… Have your long-term goals changed today?  If not, there is probably no reason for your investments to change either… Your actual asset allocation may mean that the declines in your portfolio aren’t as bad as those flashing red numbers.”  Also, allocations to bonds should provide ample money for short-term needs, so stock allocations need not be disturbed during times like these.

To conclude, we do not know when these declines will stop, and at what prices, and how long a recovery might take. That said, we do continue our advocacy of appropriate allocations both to and away from stocks, and a long-term time horizon when considering what that allocation should be.  Please feel free to contact your advisor to discuss, and take care.

Special Memo: Bonds

Sam Ngooi Comments

As the financial markets respond to the new health and economic uncertainties stemming from the spread of the coronavirus, most of the attention has been focused on the dramatic fluctuations of the US stock market. After the last week in February, the S&P 500 had declined 11.5%, from 3,338 to 2,954. In the first week in March, surprisingly, the index rose 6/10 of 1%, from 2,954 to 2,972. During this period, Park Piedmont wrote two Special Comments (February 25th and 27th) and our regular end of month Comments, discussing: (1) past declines during recent virus outbreaks; (2) the number of corrections and bear markets since 1945; (3) the difficulties of market timing; and (4) the notion that your allocation away from stocks reduces the negative impact of the reported stock declines, all in the context of the basic advice to think like a long term investor and maintain your allocations to both stocks and bonds.

Since bonds are the major asset class used to diversify away from stocks, we thought it timely and important to discuss current bond prices and overall returns.  First, a quick review: A bond is essentially a loan made by investors to the bond issuers, which can be a governmental entity or business.  Bond returns are a combination of price changes and interest received by the investor, based on the relationship among three factors: interest payments, maturity, and credit quality.  When yields/interest rates fall, prices of existing bonds rise, because the higher rates being paid on existing bonds are worth more when new bonds are being issued at lower rates.

As an example, an existing bond with a 1.5% interest payment will be worth more before its maturity than a newly-issued bond with a 0.7% interest rate and a similar maturity and credit rating. That higher value is expressed as a rising price for the existing bond, because the actual interest payment does not change. The extent of the price increase is often a function of the bond’s maturity; the longer the bond remains outstanding and pays more interest than the new bonds, the larger the price increase.  A change in credit quality – meaning the likelihood of the bonds paying interest and repaying the principal – can be a major factor, too.  Hence, the existence of a separate asset class of high-yield bonds; these involve more concern for the financial capabilities of the bond issuer, so the issuer must pay more interest to compensate the investor for the additional risk.

Currently, ten-year US Treasury yields, established by the daily buying and selling of investors and traders in the bond market, have declined from 1.92% at year-end 2019 to a historic low of 0.77% on March 6th, even as the Federal Reserve has cut the short-term rates it controls by one half of one percent (50 basis points, or “bps”).  As interest rates decline and bond prices rise, the good news of higher prices is offset, in part, by the decline in interest investors will receive as their current bonds mature and are replaced by bonds paying less interest (this is true of owning individual bonds, or bond funds that invest in many individual bonds). Keeping maturities short reduces the extent of the price changes, both up and down (prices will decline when rates start to rise again, but that might not happen for a while). The tradeoff is that shorter maturity bonds earn less interest. The recent “inverted yield curve”, when longer bonds yielded less than short, has since given way to all maturities with low rates.

As usual, our advice regarding bonds is to maintain the allocation of short and intermediate maturities, with some high-yield mixed in, all providing an allocation away from the stock market.

Coronavirus & Stock Market Declines

Sam Ngooi Comments

During the last week, Park Piedmont has written two Special Comments regarding the major financial issue of the day, which is the negative impacts of the newest coronavirus on the health, economic activity, and stock prices around the world. You will note the first one dated February 25th focused on the percentage declines of the S&P 500 index during five earlier periods of significant  contagious disease outbreaks, also noting that other factors come into play over any extended time period measuring stock prices; and the second, dated February 27th, focused on the number of stock price corrections and bear markets since 1945, regardless of the apparent causation, and the time it has taken for prices to recover from those declines. Both Special Comments noted that portfolio percentage allocations away from stocks reduce the impact of the price declines on client portfolios.

For these Monthly Comments we would like to first note that the impacts of this new virus, and the efforts to contain its adverse health impacts, have created significant economic issues, as businesses around the world have had to curtail their normal activities, creating all sorts of problems for those consumers and businesses dependent on their goods and services. One apparent result of these problems has been declining stock prices, especially in the context of very recent (mid-February 2020) historically high stock prices, with historically low ten-year US Treasury yields, and unusually high price earnings ratios. By the end of February, the S&P 500 was down more than 12% from its recent mid-February high (a correction is defined as a decline of between 10 and 20%), and ten-year US Treasury yields declined to 1.16%, (P/E ratios are hard to come by as earnings estimates keep changing based on the news about the spread of the virus).

For our PPA clients, we advise on allocating manageable portions of their investment portfolios to stocks, behaving as long-term investors looking to grow their portfolios at rates above low interest rates, and the rate of inflation.  What we avoid is acting as traders, who seek to profit from short-term price movements by being in the markets when prices are rising, and out when they are declining; or less common, selling stocks short and then trying to buy back at lower prices;  both trading activities (referred to as “market timing”). As appealing as market timing appears, the record shows it is extremely difficult to make two correct decisions- the time to sell, and the time to buy back in.  Further, there may be costly tax consequences when selling stocks with substantial unrealized gains in non-retirement accounts.  Consider the following information:

 

  • From Sarah O’Brien’s CNBC article “Here’s What Can Happen If You Flee the Stock Market for Cash,” (CNBC 2/28/2020): For the 20 years starting 1999 through the end of 2018 (which includes two significant bear markets of 2000-2002 (dotcom crash), and 2007-2009 (financial system crisis and resulting recession), and does not include the banner year of 2019, with US stocks up 28.9%), $10,000 would have grown to $30,000 (before dividends) if left untouched (5.6% annual return, which is actually well below the long-term average gain for stocks of approximately 10%). But if you were out of the market for the best performing ten days over that 20 year period (approx. 500 days), your return would have declined to 2.0%, and missing the twenty best days would have resulted in a negative return of -0.3%. Further, six of the S&P’s ten best-performing days during the 20-year period occurred within two weeks of the 10 worst days, according to J.P. Morgan, indicating that selling during declines is likely to result in missing some of the best days.  For example, the worst single day in 2015 — Aug. 24, when the S&P dropped nearly 4% into correction territory — was followed two days later by the year’s best day of returns (again, nearly 4%).  (PPA note: March 2nd, 2020 S&P 500 price increase of more than 4%, erasing half of the 2020 YTD stock declines, but March 3rd saw the significant declines resume).

The chart below shows how $10,000 invested in the S&P 500 index, for the 20-year period of 1999 through 2018, would have performed under various scenarios.

  • From Ron Lieber’s NYT article “Freaked Out by the Stock Market? Take a Deep Breath,” (NYT 2/27/20, page B1): “Ignore predictions and seek perspective. When the stock market falls, as it has all week, there is a natural desire to search for explanations and consult crystal balls. While the spread of the coronavirus has been a catalyst, nobody knows exactly why the market moved the way it did, including whether underlying economic troubles are contributing to the severity of the gyrations. And nobody can tell you how the virus will affect the US, including whether the outbreak’s short-term economic impact will reduce long term profits. And you are a long-term investor, right? Most of us fall into that category…We invest in stocks because doing so has consistently proved to be a good way to buy a little piece of capitalism. Hold on long enough to a diverse collection of stocks, and the system has tended to generously repay patient people over six or seven decades of working, saving and drawing down a portfolio.”

The article continues… “still, declines like the one investors experienced this week rarely feel good. And maybe you’re getting queasy about the economic implications of an outbreak that could force millions of Americans to shut themselves in for awhile. If so, remind yourself of the following: stocks are how your savings fight inflation, the market is not an absolute proxy for your personal finances, and you’re playing a long game.  (Our note: this is true even of 70+ year old clients who may need their money to last through their 90s, and/or who want to pass money to family and/or charities.  As Lieber puts it “if you are on the cusp of retirement, keep in mind the big idea is to live at least 20 more years, which is usually plenty of time for stocks to bounce back from even an extended decline in the stock market, referencing the decade of 2000 to 2010, when stock prices made no upward progress.”)

The article then discusses the difference between market timers and long term investors, and observes that “owning a big basket of stocks and paying very little for the privilege, via an index mutual fund or exchange traded fund is generally the best way to execute this long term strategy.”  One topic not discussed in this article is how an allocation away from stocks moderates the impact of declining stock prices, which is a major point of emphasis in PPA’s work for our clients.

 

While we should all be aware that history may not repeat itself, and that the history we know is only one description of events that have happened, as compared to all those other versions that could have happened, PPA’s view is that all the history we present to support a point of view is at least worthy of consideration.   In the absence of a better indicator, we repeat our consistent bottom line suggestion: stay the course and think long-term.      

Special Memo: Longer Term History of Stock Price Declines

Sam Ngooi Comments

The US stock market (S&P 500) has declined 12% from its all-time high of 3,386 reached on February 19th (measured from its close of 2,978 on February 27th).  A decline of 10% to 20% is referred to as a correction. This decline, attributed primarily to the likely negative economic impacts of the spread of the new coronavirus, comes in the context of the following:

  • Year 2019, with a 28.9% gain (2,507 to 3,231), an all-time high, which reached 3,386 in mid-February 2019, as mentioned above;
  • Year 2018, with a decline of 6.2%, (2,674 to 2,507), which was down as much as 12.1% (at 2,351) just before year-end;
  • Year 2017, with a 19.4% gain (2,239 to 2,674);
  • November 2016 post-Trump’s election, with a gain of 3.5% (2,163 to 2,239). From the start of Trump’s term to the current date, the gain is still 37.6% (2,163 to 2,978).

A February 27th CNBC article, “Here’s How Long Stock Market Corrections Last and How Bad They Can Get,” provides some additional longer-term historical context for declines:

“There have been 26 market corrections (not including today) since World War II with an average decline of 13.7%.

Recoveries have taken four months on average.

The most recent corrections occurred from September 2018 to December 2018. The S&P 500 bounced into and out of correction territory throughout the autumn of 2018.

This is the fastest 10% decline from an all-time high in the index’s history, according to Bespoke.

But there’s one possible big caveat. This is only if it does not fall into bear market territory, down 20% from a high. If the losses stretch to 20%, then there’s potentially more pain ahead and a longer recovery time.

There have been 12 bear markets since World War II with an average decline of 32.5% as measured on a close-to-close basis.

The most recent was October 2007 to March 2009, when the market dropped 57% and then took more than four years to recover. The S&P 500 closed in a bear market in December 2018 using intraday data.

Bear markets have lasted 14.5 months on average and have taken two years to recover on average.”[1]

It’s also useful to remember that your asset allocation away from stocks reduces the impact of the declines.  For example, a 50-50 allocation to stocks and bonds means that a 10% stock market decline has a 5% impact on your portfolio.  The allocations are intended to allow you to get through sharp stock market declines and take a long-term view of your investments.  Ron Lieber’s New York Times article, “Freaked Out by the Stock Market? Take a Deep Breath” (NYT 2/27/20, page B1), makes similar points about taking the long-term view, which we will discuss at more length in our next regular monthly Comments.

[1] Source: Franck, Thomas. “Here’s How Long Stock Market Corrections Last and How Bad They Can Get.” CNBC, 27 Feb. 2020, https://www.cnbc.com/2020/02/27/heres-how-long-stock-market-corrections-last-and-how-bad-they-can-get.html

Special Memo: Coronavirus & Market Declines

Sam Ngooi Comments

After the substantial declines of 3% or more in US and international stock prices on Monday, February 24th, we are writing to provide some additional information on the situation.  The media has attributed the declines to the spread of the new coronavirus, even as there are some signs of improvement in China, where this all began (NYT, front page, 2/25/20).  Although we are always skeptical of attributing causation for financial market price moves, it is probably reasonable in this situation to accept the spread of this illness as an important factor.

First, it is worth noting that the US stock market (S&P 500) is now basically back to its year-end 2019 level, and 2019 was a banner year for stocks, with a gain of approximately 26%.

Second, interest rates continue to decline on high credit bonds, making it even more difficult to earn an acceptable investment return from less risky, income-oriented investments. This has likely been an important upward driver of stock prices in the recent past.

Third, an asset allocation of 50-50 bonds and stocks means a decline of 1.5% in your portfolio. Each of our clients’ allocations is different and tailored to help withstand unsettling declines.

Fourth, the history of serious contagious diseases and their effects on stock prices indicates that the negatives are typically not long lasting. While we certainly understand that the past is not necessarily predictive, and “black swan” events do occur, it is worth having the facts to consider.  Also, over time, factors other than the disease obviously come into play. The chart below shows the five most significant previous disease outbreaks since 2003, how far the S&P 500 declined during each of those periods (again, not all of the decline can be attributed to the disease), and how long each of the declines lasted. It is worth noting that there have been stock price recoveries after each period, right up to the recent highs in February 2020.  As usual, we advise maintaining your allocations, and avoiding any effort to time when to be in and out of stocks.

S&P 500 Performance During Virus Outbreaks

Virus Date Range Trading Days S&P 500 % Change
SARS Jan. 2003 – Mar.2003 38 -12.8%
Avian Influenza Jan. 2004 – Aug. 2004 141 -6.9%
MERS Sep. 2012 – Nov. 2012 43 -7.3%
Ebola Dec. 2013 – Feb. 2014 23 -5.8%
Zika Nov. 2015 – Feb. 2016 66 -12.9%
Coronavirus Jan. 2020 – Present 23 -2.2%

Source: Nova, Annie. “History Shows Stocks Typically Rebound from Disease Outbreaks before Long.” CNBC, 24 Feb. 2020, https://www.cnbc.com/2020/02/24/past-disease-outbreaks-show-investors-shoud-ignore-the-noise-of-coronavirus.html.

Uncertainty and Financial Markets

Sam Ngooi Uncategorized

The recent appearance of the fast-spreading and at times fatal Coronavirus; the tragic deaths of Kobe Bryant, his daughter, and seven others; and the warning from Larry Swedroe (above) that we repeat each month; all have a common underlying theme, which is that the future is unknowable, and uncertainty is very much part of the human condition. This has been a basic principle of Park Piedmont’s investment management since its inception in 2003. That said, we thought it would be of interest to reach back into our archives and share an updated version of our October 2007 Comments, offering a detailed review of a book all about uncertainty, namely Nassim Nicholas Taleb’s The Black Swan: The Impact of the Highly Improbable.

Note also that for most of the first week in February, stock prices gained, even with Coronavirus impacts expanding. This is another totally unexpected short-term result, since the same virus was blamed for the declines at the end of January.

It would seem obvious that no one can predict the future. But in the investment world, many investors seem willing to listen to the predictions of so-called experts regarding many crucial pieces of information that influence their investment decisions. Wall Street analysts, economists, and media personalities on financial networks and in the financial press are constantly making predictions about such market-moving subjects as the likely growth rate of the overall economy, employment rates, the direction of inflation and interest rates, oil prices, the value of currencies, and corporate earnings. Why investors pay so much attention to predictions on these subjects, when they would likely concede that the future is unpredictable, is a question addressed by Taleb.

The book’s Prologue explains the idea of the Black Swan. “Before the discovery of Australia, people in the Old World were convinced that all swans were white… The sighting of the first black swan… illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single black bird” (Prologue, xvii).

He continues that “a Black Swan is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable…. To summarize: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives” (xviii). In a footnote, he also states that “the highly expected not happening is also a Black Swan” (xviii).

Taleb writes that “Black Swan logic makes what you don’t know far more relevant than what you do know… The inability to predict outliers implies the inability to predict the course of history… Our inability to predict in environments subjected to Black Swan, coupled with a general lack of awareness of this state of affairs, means that certain professionals, while believing they are experts, are in fact not… Black Swan, being unpredictable, we need to adjust to their existence (rather than naively try to predict them)” (Prologue, xix and xx). So before the Prologue has been completed, Taleb makes his case for not relying on experts to predict matters “in environments subjected to Black Swan,” which includes the financial markets.

Taleb presents the Black Swan problem in its original form: “How can we know the future, given knowledge of the past; or more generally, how can we figure out properties of the (infinite) unknown based on the finite known?” (pg. 40). He writes about the turkey which, after being fed one thousand days in a row, and expecting the same indefinitely, encounters the day before Thanksgiving. Taleb observes that “the history of a process over a thousand days tells you nothing about what is to happen next. This naïve projection of the future from the past can be applied to anything” (Figure 1, pg. 41). In a footnote (pg. 42), he discusses a hedge fund that lost most of its money in a few days during September 2006, as follows: “A few days prior to the event (that is, the huge losses), the company made a statement to the effect that investors should not worry because they had twelve risk managers – people who use models of the past to produce risk measures on the odds of such an event. Even if they had 112 risk managers…, they still would have blown up. Clearly you cannot manufacture more information than the past can deliver… We just don’t know how much information there is in the past.” While the managers believed they could control risk by analyzing past occurrences, they missed the whole idea that something could happen that was not captured in their analysis of the past.

Another major idea presented in the book is referred to as “silent evidence.” The example Taleb uses to present this idea is of a nonbeliever shown portraits of survivors of a shipwreck who had prayed for survival. The nonbeliever asks, where are the pictures of those who prayed, then drowned (pg. 100). “Drowned worshippers do not write histories of their experiences (it is better to be alive for that), so it is with the losers in history, whether people or ideas…” (pg. 102). “People who fail do not seem to write memoirs, and if they did, business publishers would not even consider returning their call… The graveyard of failed persons will be full of people who shared the traits of courage, risk taking, optimism, etc.… What truly separates the failed from the millionaires is for the most part a single factor: luck. Plain luck” (pgs. 105-106). Taleb uses the fund management industry as an example: “The industry claims that some people are extremely skilled, since year after year they have outperformed the market. They will identify these ‘geniuses’…He (Taleb) used computer simulations to show how it would be impossible to not have these geniuses produced just by luck. Every year you fire the losers, leaving only the winners, and thus end up with long-term steady winners. Since you do not observe the cemetery of failed investors, you will think that some operators are considerably better than others” (pg. 106).

The problems are that: (1) no one can identify the consistent winners in advance of the achievement, and (2) the fact of the past achievement in no way indicates future success. Taleb suggests “not to compute odds from the vantage point of the winner, but from all those who started. If you look at the population of all those who begin, you can be close to certain that one of them (but you do not know in advance which one) will show stellar results just by luck. From the reference point of all those beginning, this is not a big deal. But from the reference point of the winner (who does not take the losers into account), a long string of wins will appear to be too extraordinary an occurrence to be explained by luck. Note that a ‘history’ is just a series of numbers through time” (pg. 119). In a further pertinent observation, Taleb writes that “randomness and uncertainty are abstractions. We respect what has happened (history), ignoring what could have happened” (pg. 132).

Taleb then moves to a section entitled, “We Just Can’t Predict”: “You would expect our record of prediction to be horrible: the world is far, far more complicated than we think, which is not a problem, except when most of us don’t know it… We have seen how good we are at narrating backward, at inventing stories that convince us that we understand the past…. I find it scandalous that in spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude rare events (pg. 135).  The problem with experts is that they do not know what they do not know (pg. 147). “Our predictors may be good at predicting the ordinary, but not the irregular, and that is where they ultimately fail… What matters is not how often you are right, but how large your cumulative errors are (pg. 149). Experts, when they are wrong, invoke the outlier defense… given that what happened was not predictable, they are not to blame. You cannot predict the Black Swan…. When experts are right, they attribute this to their expertise; when wrong, they attribute this to the situation, which was unusual, or worse, they did not recognize they were wrong” (pg. 152).

“We cannot truly plan, because we do not understand the future – but this is not necessarily bad news. We could plan while bearing in mind such limitations. It just takes guts. Even if you agree with a given forecast, you have to worry about the real possibility of significant divergence from it. These divergences may be welcomed by a speculator; a retiree however, with set risk attributes, cannot afford such gyrations. It is the lower bound of estimates (i.e., the worst case) that matters when engaging in a policy – the worst case is far more consequential than the forecast itself. This is particularly true if the bad scenario is not acceptable” (pgs. 157-163).  (Note these last few observations, and the paragraph that follows, bring Larry Swedroe’s quoted comments to mind.)

The implications of this inability to predict what will happen with an investment allocation and the choices used to implement it are most important. As Taleb notes, what is good for the speculator is unacceptable to the retiree. We agree and believe that the soundest investment advice focuses on reducing your exposure to the unacceptable scenarios, even if it means reducing expectations for your investment returns at the same time. Taleb’s arguments: (1) warn against relying unquestioningly on history repeating itself with regard to investment returns, since the history we know is only one possible series of outcomes as compared to all those that could have happened; and (2) call for acknowledging that the inability to predict makes efforts at setting expected future returns a highly questionable activity.

Returning to the text, and specifically with regard to investments, Taleb writes that “people are often ashamed of losses, so they engage in strategies that produce very little volatility but contain the risk of a large loss… If you accept most ‘risk measures’ are flawed because of Black Swan, then instead of putting your money in ‘medium risk’ investments (based on so-called experts, and history), put a large portion of your money in the safest investment (T-Bills), and take the rest and make extremely speculative bets” (pgs. 204-5). “You need to focus on the consequences (which you can know) of an event, rather than its probability (which you can’t know), and this is the central idea of uncertainty. Invest amounts you are not willing to ever lose in less risky securities” (pg. 211).

It is here where we part company from Taleb. Our allocation and implementation advice is based more on David Swensen’s views of investing, set forth in his book Unconventional Success and discussed in many of our Comments (references available on request). Swensen advocates developing an asset allocation that seeks to reduce risk by controlling the allocation to the historically higher-returning but more volatile asset class (i.e., stocks), and implementing the allocation with a mix of low-cost, market-mimicking, tax-efficient indexed stock and bond investments (see section titled “Portfolio Construction” (pgs. 81-91), and consider this quote: ”Rational investors allow risk preferences to influence portfolio choices, increasing the likelihood of maintaining asset allocations through the inevitable rough patches and ultimately benefiting from expected portfolio risk and return characteristics… Incorporating personal preferences in portfolio decisions guards investors from counter-productive actions to adverse developments after the fact by limiting exposure to poorly loved asset classes before the fact” (pg. 84-85).

Swensen clearly relies more on historical returns than Taleb would ever consider. And Swensen’s portfolio mix of stocks and bonds is not in line with Taleb’s advice to invest most money in ultra-safe US government bonds, and then use some modest percentage to invest in very high-risk ventures with very high potential payoffs. According to Taleb, in these high-risk ventures you can at least identify and recognize them as high-risk ventures. He worries more about the “promising” stock market and the “safe” blue chips than he does about speculative ventures; the former present invisible risks while the latter offer no surprises, since you know how volatile they are and can limit your downside by investing smaller amounts (pg. 296).

Our problem with Taleb’s allocation advice is that if the high-risk investment “blows up” and declines significantly (or, in the worst case, goes to zero), the investor is left only with the T-Bill investments, which could end up providing too low a return to meet the investor’s goals. Therefore, we advocate the more balanced stock and bond portfolio recommended by Swensen. But Taleb’s points on uncertainty, and the inability to predict, also influence our advice that clients have the smallest allocation to the broadly-based stock market consistent with providing the opportunity to earn a return adequate to their needs. This is our effort to combine two points of view that we highly respect.

On Asset Allocation

Sam Ngooi Comments

This month we present an expanded discussion on asset allocation, which we think is pertinent in light of the major gains in US stock prices for the year 2019. Using the S&P 500 as a proxy for US stocks, the index advanced from 2,507 at year-end 2018 to 3,231 at year-end 2019, a 724 point, or 28.9%, increase. (Unless otherwise noted, the quoted passages below come from a Jeff Sommer article titled Forget the Less Than Worthless Stock Market Forecasts (NYT, 12/29/15, page B5).)

Asset allocation, a fundamental principle used by Park Piedmont Advisors (PPA) in the management of client portfolios, refers to the percentage mix of the four major asset classes –Stocks, High-Yield Income, Bonds and Cash Equivalents– in our clients’ liquid investment portfolios. (Note: we split high-yield income (HYI) off from high-credit bonds (HCB) based on their very different investment characteristics, as exemplified during the 2008-9 financial crisis.)  Appropriate asset allocations consider each client’s specific financial objectives, and that client’s risk tolerance in reaching those objectives. Once clients have accumulated enough money to carry out their objectives, PPA regularly advises that stock allocations be reduced, as stocks are the riskiest part of the overall allocation.  (We define risk as the likelihood of significant declines in portfolio values that would jeopardize our clients’ ability to meet their objectives.) Once an allocation has been agreed upon, PPA monitors over time to determine whether it is still appropriate for each client’s circumstances, in case of a significant change in personal circumstances and/or a major change in the value of one asset class compared to the others.

When one asset class does deviate from a specific allocation, either because of relative over- or under-performance compared to the other asset classes, rebalancing to return to the original allocation may be in order. To illustrate the idea: assume a $1 million portfolio with an allocation of 40% stocks and 60% bonds at the start of 2019. By year-end 2019, the stock portion would have increased from $400,000 to $515,600. The bond portion (using high credit, intermediate-term taxable bonds as a proxy), which also had an excellent year, increasing approximately 9% (prices plus interest), would have a value of $654,000. The total year-end 2019 value would be $1,170,000, and the percentage mix would be 44% for stocks and 56% for bonds. This 4% of change (higher for stocks and lower for bonds) could merit a conversation about returning to the original 40-60 mix, by selling the higher performing asset class (stocks) and buying the lower performing asset class (bonds).

It is important to note that in 2019 both stock and bond markets had excellent years compared to their historic average annual returns, so any rebalancing done in this time frame would be at very high prices for both asset classes.  Further, since a major factor in rising bond prices is declining interest rates, and declining interest rates have been cited as a reason for investors to turn to more aggressive investments to achieve a suitable investment return, there is caution in all parts of the financial markets. “When (interest) rates on safe securities go negative (as in parts of the international developed world) — or ultra-low, as they are in the US, investors feel compelled to take on greater risk to get what they consider an acceptable return on their money” (Bloomberg Business Week 12/23/19, page 9).

A few other important points to note:

  • PPA uses broad-based, low-cost index mutual funds and exchange traded funds (ETFs) to implement our clients’ asset allocations, so the portfolio investment results should closely approximate the actual index results.
  • Rebalancing may involve sales with capital gains tax consequences in taxable, non-retirement accounts. We take these potential consequences into account when making portfolio change suggestions.
  • Rebalancing is not market timing. Market timing, which PPA does not engage in, describes investors who make predictions about the future direction of markets, and then execute transactions designed to profit from those predictions. We consider this extremely difficult, if not impossible, to do with any consistency over the long-term. By contrast, rebalancing involves returning to a prior asset allocation when certain criteria are met, without reference to any future market predictions.
  • For more on the futility of market timing, Sommer writes: “It is the time of year for predictions, and I will make one. You will be better off ignoring the Wall Street stock market predictions for 2020.… Many Wall Street strategists are flagrantly inaccurate…. It is true they are right about the market’s direction more often than they are wrong. But that’s only because most of them say the market will rise in the next year, which happens about 70% of the time. The more specific forecasts – like how high or low the market will go in a given year, and whether it will lose half its value or rise 30% – should be treated as fiction… There is a more reliable and simpler way to make investing decisions, one that doesn’t rely on putative forecasts. It is based instead on long term historical data on the stock and bond markets. They show that stocks outperform bonds over extended periods, but that stocks are far more volatile than bonds. Holding both stocks and bonds makes sense because they tend to buffer one another. Investing over the long run through low cost index funds in a broadly diversified portfolio is a reasonable approach for most people.”
  • Sommer’s article cites Jack Bogle, the founder of Vanguard, and David Booth, co-founder of Dimensional Fund Advisors (DFA, about which we have been writing recently now that PPA has access to the DFA funds). Booth is quoted as follows: “We don’t try and forecast the future. We have no ability to do it. Nor does anyone else…. Forget the forecast and for purposes of investing forget about the current news too…. Take on only as much risk as you can handle. Find a stock-bond mix that you are comfortable with and then stick with it…. One way of thinking about risk is to imagine a terrible downturn is about to occur…” Then, consider how much percentage decline your portfolio will incur based on the market’s percentage downturn (e.g., a 30% stock market decline for a portfolio allocated 30% to stocks results in a 9% decline). Asset allocation can therefore play an important role in managing the risk inherent in all investments.

Joyful & Mindful: PPA’s Guide to Holiday Gift-Giving

Sam Ngooi Comments

The holiday season is here, and while it may be the “most wonderful time of the year,” holiday shopping can make the season of giving one of the most busy and stressful.  Finding the perfect gift for loved ones can feel next to impossible; according to Harvard Business School professor Michael Norton, “being obligated to give and worrying about how people will react interferes with the happiness we typically feel at the pure act of giving,” (Forbes, 12/12/2017).

While 7 in 10 Americans would skip exchanging gifts if their friends and family would agree, we wanted to share a few ways to make holiday giving a bit more joyful and mindful, without saying “bah humbug” to the custom altogether.

  1. Set Reasonable Expectations

A pre-holiday conversation with people in your gift-giving circle can help align expectations around the number of presents, cost, or type of gifts.  Asking “how do we want to handle gifts this year?” can generate creative gift arrangements, such as pooling money for larger gifts.

  1. Shop Thoughtfully

Retailers spend millions on ploys to get shoppers to spend more. One study found that when stores played holiday music, customers spent 34% more time browsing and were 17% more likely to buy something.  Likewise, one-day sales and limited-time store credit impose a sense of pressure on customers to buy things they might not have felt compelled to otherwise. Recognizing these sales tactics, making and sticking to a list, and using tools to help research the best deals can help you avoid being sucked in.

  1. What Makes a Good Gift?

Research shows that gift recipients are more likely to value an experience or activity as a gift over material objects, due to the enduring memories generated by the experience.  A personal note or token gift (think: a pair of hiking socks in advance of a camping trip) can further enhance the excitement and anticipation that make experiences more appreciated than material gifts.

People also feel happiest when they receive something they’ve asked for, rather than a surprise.  Gifts of the practical, homemade, or time-saving (i.e., services) variety are also well-received, provided some careful observations and considerations are made about the recipient’s likes, wants, and needs.  Finally, charitable gifts on someone’s behalf tend to yield the most happiness when they have a well-defined purpose and a way to report back to donors on their impact.

  1. Get Kids Involved

The holiday season is a great opportunity for families to practice thoughtful gift-giving.  Taking time to discuss the “whys” behind holiday traditions and the feelings elicited by giving and receiving gifts is an effective way to reinforce shared values.  Ron Lieber, author of The Opposite of Spoiled: Raising Kids Who Are Grounded, Generous, and Smart About Money, notes that a holiday budget not only allows kids to practice money management, but also allows parents to add parameters to encourage family values, such as matching funds allocated to homemade or philanthropic gifts.

  1. Savor Gratitude

Relishing warm emotions can strengthen positive attitudes in the brain and increase happiness and satisfaction.  Throughout the gifting process, it’s okay to be a little selfish, and enjoy the feeling of making someone you care about feel appreciated. Similarly, it’s worthwhile to savor the experience of gratitude when receiving a gift; communicating your appreciation and acknowledgement for the work that went into the gift spreads the good cheer and strengthens your connection with the gift-giver.

  1. Focus on Values

Reflecting on values and priorities during the holiday season serves as a reminder of what gift-giving is all about: creating special connections and enriching our relationships through caring, kindness, and empathy towards others. Taking time — either individually, with friends, or as a family — to think about this deeper meaning can help refocus the reason behind the rituals of the season.

Wishing you a meaningful, fulfilling, and stress-free holiday season!

Interest Rates and the Current Financial Markets

Sam Ngooi Comments

At the end of October, the Federal Reserve reduced the short-term interest rate it controls by a quarter percentage point (1/4%), the third such decrease during 2019. Ten-year US Treasury yields continue below 2%, although they have now moved higher than the three-month yield, reversing at least for now the so-called “inverted yield curve.” This unusual circumstance describes a time when longer term yields are lower than shorter term yields.

Lower interest rates almost always send bond prices higher, and often are cited as an explanation for rising stock prices. The reasons for these impacts are worth reviewing again as the Fed’s actions on interest rates make headlines (e.g., NYT, 10/31/2019, Page A1).

Bond prices move higher as interest rates decline because the higher rates being paid on existing bonds are worth more when current bonds are being issued at lower rates. As an example, an existing bond with a 2% interest payment will be worth more prior to its maturity than a newly-issued bond with a 1.5% interest rate and a similar maturity and credit rating.  That higher value is expressed in a rising price for the bond, because the actual interest payment does not change. The extent of the price increase is often a function of the bond’s maturity; the longer the bond remains outstanding and pays more interest than the new bonds, the larger the price increase will be.

The impact of lower rates on stock prices is less direct, given the many factors that affect stocks.  If rates are being lowered by the Fed because the economy is perceived as going into a slowdown/ recession, then stock prices may go down even as interest rates decline. The New York Times article cited above (10/31/19, Page A1) mentioned that GDP in the US increased by 1.9% in the third quarter, a slowdown from recent previous periods, and added that inflation remains under 2%.  An economic slowdown could have as one effect lower profits for businesses, and ultimately it is the profits/earnings of companies that determine stock prices (the price/earnings, or P/E, ratio we have discussed in many prior Comments).

That said, lower interest rates can instead help to move stock prices higher, as investors come to believe that stocks are the primary place to earn a decent return on their money.  When interest rates go down and bond prices rise, the overall return from bond investments can become quite low, as the interest payments as a percentage of the investments declines.  Therefore, investors looking for a satisfactory return on their money are pushed into the higher-risk/higher-returning asset class of stocks, or higher yielding, so-called “junk bonds” which have more credit risk. This can create a dangerous situation for people whose goals are best met by conservative investments with modest price changes, rather than by investing more in the asset classes with much higher volatility , namely the stock and junk bond markets. (As a warning, look no further than the observation from Larry Swedroe at the top of page 3, which we quote every month). It is also worth noting that when rates begin to rise again, and investors receive higher interest payments, they will also most likely be looking at declining bond prices, the pace and extent of which depends on a variety of factors.  This is the ongoing dilemma of investing in bonds.

We continue to help our clients navigate these various impacts, which are unknowable in advance of their occurrence, and develop asset allocations appropriate to their particular financial situations. We also suggest revisions as situations change over time, or when one asset class becomes over weighted compared to others (i.e., rebalancing).