Early Comments on the Upcoming Election

Sam Ngooi Uncategorized

With all that is going on in the world, there is an additional wildcard, namely the upcoming US presidential election. As our regular readers know, we at PPA maintain that who is President is only one of several factors affecting stock and bond prices. Even if we know who is going to be President, no one can predict what will happen during that presidency.  Trump’s presidency is a perfect example (see July Comments). Even now, with Biden leading in the polls, stock prices have been rising for most of the past few months.

During August, the coronavirus continued to spread health and economic misery; protests about systemic racial injustice intensified; and the Democratic and Republican parties held their respective conventions. None of this news appeared to slow the advance of US stock prices, although we have to acknowledge that the advances are primarily taking place with a small number of high tech stocks that appear to have benefited from the otherwise negative impacts of the virus.

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.

Important Investment Definitions and Principles

Sam Ngooi Comments

The month-end August 2020 US stock and bond market investment results continued to be mostly favorable, even though the declines during the first week in September (3rd, 4th, and 8th) reduced these positive results somewhat. We think this is an opportune time to present certain basic investment definitions and principles that we at Park Piedmont (PPA) consider important to know.

Before doing so, we would like to note another significant August event: the Federal Reserve Board Chairman has “announced a major shift in how the central bank guides the economy, signaling it will make job growth preeminent and will not raise interest rates to guard against coming inflation just because the unemployment rate is low… laying the groundwork for years of low interest rates” (NYT 8/27/20, page A1).

Asset Allocation: the percentage mix of your investment portfolio among riskier assets, generally stocks, and less-risky assets, generally bonds. At PPA, we further divide the less-risky bond asset class into three separate categories: short-term cash equivalents (money markets, or MM); high-credit bonds (HCB); and high-yield bonds (HYB).

Stocks represent an ownership interest in a business. Stock prices change every day, based on the activity of buyers and sellers in the financial markets. Some of these market participants are long-term investors, and others are short-term traders and speculators. History indicates that stock prices vary, up or down, much more than the bond categories over almost every time period (the extent of price changes is referred to as “volatility”). The tradeoff for stock investors accepting more volatility is the opportunity for higher expected returns. In addition to gains/declines from price changes, many stocks pay dividends. Dividends are usually a return of some portion of a company’s profits back to the owners. While dividends are often much appreciated by stockholders, they do raise the question from the paying company’s standpoint as to whether the money is better used reinvesting in and trying to grow the business.

There are many factors that affect stock prices, but over time the most significant one is the profits (also referred to as “earnings”) of the company and the number of shares outstanding that have ownership of those profits. The relationship of one company’s stock price to that of another company, and the reasonableness of the stock price itself, can be examined by knowing the dollar amount of profits, and the number of shares the company has outstanding, and using these figures to develop the P/E ratio (price per share divided by earning per share). Working with simplified numbers, if the company has one million shares outstanding and has $1 million of profits, the earnings per share are $1; if the stock sells for $10 per share, the P/E is 10; at $15 per share, the P/E is 15; and at $20 per share, the P/E is 20.

The higher the P/E, the more profitable investors/speculators believe the company will be in the future. But as you should note, what a reasonable P/E should be for any company is constantly changing, and subject to the many varying views of the financial markets. Knowing past profits is one thing, but the problem with stock pricing based on P/E ratios is that the profits used are most often based on future forecasts, which is how Wall Street earns much of its living. PPA, on the other hand, typically ignores such forecasting as being an impossible effort to predict the unknowable future (as is the case for financial analysts’ attempts to predict the course of the ongoing coronavirus pandemic).

Stocks can be bought in individual companies, or in mutual funds/exchange traded funds (ETFs) that own a diversified portfolio of individual stocks. The diversification can be as narrow as within a specific sector of the broad stock market (e.g., technology or finance), or can be as broad as all the stocks in the world stock market. Stock mutual funds can be actively managed by portfolio managers trying to earn a better investment result for the fund owners than the result of some applicable benchmark. Stock funds can also be passively managed, in which case the fund invests in the stocks contained in the relevant benchmark and accepts the benchmark results. The issue with active management is that the managers frequently underperform the benchmarks, with an underlying tendency to do so because of the higher expenses charged by actively managed funds. ETFs are another type of index fund; they allow for intraday buying and selling, whereas mutual funds are priced at the end of each day. PPA uses index mutual funds and ETFs for almost all stock investments in client portfolios.

Stock splits have been in the news recently, as Apple and Tesla both split their stock. In a typical stock split, the owner receives additional shares, but the price of the stock declines to account for the additional shares, so there is no change in the company’s overall valuation just because there are more shares outstanding. To use a popular food analogy, if you have a whole pizza pie, and it is cut into quarters, you have more slices, but still the same overall amount of the pizza to eat.

When interest rates are low for bonds, as they are now (see below), stock prices often move higher because the competing returns from bonds are low. But how high stock prices should go is of course an unknown, especially in times when the overall economy is doing poorly, as it is now.

Bonds represent a promise by a borrower to repay money plus interest over time. A bond is a loan from the bond owner to the borrowing entity, which can be a government or company. Unlike stocks, there is a date when the original amount invested (referred to as “principal”) is to be repaid (referred to as a bond’s “maturity”). That maturity can be measured in years or days, depending on the terms of the loan. Bond prices change during the time they are outstanding prior to maturity, also based on the activity of buyers and sellers in the financial markets. But history indicates that bond prices change much less than stock prices, and that within the broad category of bonds, the extent of price changes varies based on bond maturities (also referred to as “term”), credit quality, and interest rate changes. The prevailing rate of inflation has a major influence on interest rates, which in turn has a major influence on bond prices. Typically, the higher the inflation rate, the higher interest rates need to rise to provide bond investors with a positive return adjusted for inflation. (Note however the Fed’s recent policy statement on interest rates and inflation, all related to job growth; NYT 8/27/20, page A1). Inflation is defined as the declining value of the purchasing power of money over time.

Short-term high-credit bonds, the shortest of which are money markets, have the least price change and smallest interest payments. The further out in time the maturity, the greater the price change while the bond is outstanding (that is, not paid off), but the higher the interest received (another investing tradeoff). The usual correlation between interest rates and the prices of outstanding bonds is that as rates increase (good for the investor), the price of the bond should decline (not good for the investor). Conversely, as rates decline, bond prices increase. So even if bonds are bought with the expectation that the initial principal will be returned plus interest, if the bonds need to be sold prior to maturity, there is a chance the investor will receive less than the initial principal.

The other significant wrinkle with bond pricing is their credit quality, which refers to the likelihood the bond issuing entity has/will have enough money to pay the interest and repay the initial principal at the maturity date. Credit ratings can change while the bond is outstanding; if the credit rating is lowered, the bond price almost always declines. At the beginning of the 2020 pandemic, many companies faced credit downgrades, even those thought to be good credits. The Federal Reserve stepped in and gave assurances to the marketplace that it would not allow large scale defaults. At that point, prices stabilized. A low credit rating at the time the bond is issued forces the issuer to pay more interest (these are called high-yield bonds), which is good for the investor, but not good at all if the issuer cannot make the interest/principal payments.

Bonds, like stocks, can be bought in the specific name of the issuing company or governmental entity (federal, state, and local). Mutual funds and ETFs, both actively- and passively-managed, are also available to bond buyers, with similar characteristics as discussed above with stock mutual funds and ETFs. There are times when investments are described only as mutual funds or ETFs, without identifying them as owning stocks or bonds, and this can cause confusion for investors. PPA uses almost all bond index and index-like mutual funds and ETFs for our clients’ bond investments.

One other point worth noting: if you own an individual bond, there is a specific maturity date when you are scheduled get your money back. If you own a bond mutual fund or ETF, by contrast, the bonds owned by the fund mature, but the fund itself typically does not. The fund takes the proceeds of maturing bonds and reinvests the money in bonds with similar maturity and credit quality characteristics. The major difficulty with owning individual bonds is not being able to determine the underlying current and likely future financial health of the issuer. Even though there are credit agencies that purport to do this, their advice can be flawed (the mortgage crisis of 2007-2009 provided a serious recent example of the failure of credit agencies). With mutual funds and ETFs, the investor relies on the fund managers to do an adequate job of ongoing credit checking, at least under normal circumstances, which is also an important caveat.

As you can see, there are many points of investment definitions and principles, even in the brief discussion above. In future Comments, we plan to present additional detail on indexed investing, which is the predominant way PPA invests our clients’ portfolios. While we encourage clients to be as knowledgeable as possible on these matters, PPA is of course available to provide additional assistance as needed.

Mortgage Refinancing

Sam Ngooi Comments

The historically low interest rates of the past year represent an attempt by the US Federal Reserve to stimulate a faltering US economy. The correspondingly low rates determined in the bond market have hurt investors who need income. But these rates have been a boon to borrowers, as the Fed intended. Now is therefore a very good time to consider refinancing loans, especially mortgages, which are usually the largest debt most households carry.

Thirty-year fixed-rate loans are available in the low 3% range, often with few or no closing costs. Rates for 15-year fixed-rate loans are in the low- to mid-2% range. You can contact your current lender and/or a mortgage broker to get specific quotes.

To help you assess whether a refinance makes sense, we present below a list of basic terms; some ideas for how to analyze the refinancing opportunity; and some practical considerations as you go through the process. Please feel free to contact PPA for additional details and help analyzing whether a specific refinance makes sense for you.

Defining Terms

The most basic features of a home mortgage are the rate and term. Rate refers to the annual percentage interest you pay on the total amount of the loan (also known as “principal”). Term specifies how long you have to pay back the principal and interest. Rates can be fixed, i.e. set for the full term of the loan, or variable, in which case the rate can change over time. Fixed rate loans typically have terms of 15, 20, or 30 years. Variable rate loans often have fixed rates for terms of three to seven years, then adjust each year based on market conditions. Rates are typically lower for “conforming” loans, which are below $510,400 for 2020, than for larger dollar amount “non-conforming” loans. For a typical fixed-rate, amortizing (see definition below) mortgage, each monthly payment you make consists of interest and principal, with payments early in the term consisting mostly of interest.

Another key concept is amortization, which refers to the repayment of principal on the mortgage. Amortization schedules show how a specific loan will be repaid over the relevant term. Different types of loans, such as “interest-only”, can lead to situations where a loan is not fully repaid over the term, but typical fixed-rate loans are structured to “fully amortize.”

Basic Refinance Analysis

Deciding whether to refinance usually depends on whether you can find a lower rate for a comparable term, or a shorter term with a comparable rate. The lower rate calculation is typically straightforward; if you can reduce your current rate significantly, and in turn lower your monthly payment, refinancing often makes sense. The shorter-term calculation can be more complicated because it often involves paying more each month than on the current mortgage (based on amortization over the shorter time period). Even so, shorter terms can save significant amounts of total interest over the full term of the loan, especially in today’s low interest rate environment. PPA advisors can help you with these pre-tax calculations, and it also makes sense to contact your tax professional for further advice.

The other key consideration in the current mortgage market is whether to pay closing costs and/or points to further reduce the interest rate. Closing costs include an appraisal of the property value, lender’s fee, and “title and escrow” charges, which allow the lender to secure and fund the loan. Points refer to an additional fee you can pay up-front to lower the rate. Payment of one point (1%, or 100 basis points) on a $500,000 loan, for example, would cost $5,000 (to be paid at closing), and in turn might decrease the rate on a 15-year loan from 2.5% to 2%. Lenders now also allow you to avoid closing costs if you’re willing to pay a higher rate over time (technically you’re still paying the closing costs, but they’re factored into the higher rate). This decision often comes down to whether you plan to remain in your current home long enough for the lower interest rate to offset the up-front closing costs or points. PPA advisors can prepare a basic “break-even” analysis to help make this determination. Consultation with your tax professional is a good idea for this analysis as well.

Practical Considerations

Once you decide to refinance, the lender will underwrite the loan. One of the main factors in underwriting is determining the value of the property, or “collateral”, which is typically done with an appraisal. Once the value has been determined, lenders establish a loan-to-value (LTV) ratio, which sets the maximum loan amount they’re willing to extend. A typical LTV these days is 70%, which means, for example, that you can borrow up to $350,000 on a house appraised for $500,000. (Different types of property, including cooperative apartments, or “co-ops”, and condominiums, often have different maximum LTVs based on the lenders’ assessment of risk in repayment of the loan.)

In addition to the property value, underwriting assesses the creditworthiness of the borrower. This typically involves review of one or more credit reports from the main credit rating agencies, as well as the borrower’s income, expenses, and other assets and liabilities (i.e., debt). Lenders require documents to verify these figures: for income, you’ll need to provide recent tax returns, pay stubs, and K1s (for partnership interests); for expenses, statements for property taxes and homeowner’s insurance; for assets, brokerage statements; and for liabilities, mortgage and, if applicable, other loan statements. These assessments have tightened up significantly since the late 2000s, when inadequately-underwritten loans contributed to the financial crisis of 2008-09. In general, you should expect to provide several documents for the last two calendar years, and several more if, for example, you own other property and/or over 25% of a company.

Depending on how quickly the borrower provides the required documentation, underwriting, loan approval, and closing (i.e., obtaining the funds needed to pay off the current loan and record the various documents in the public record) can take 90 days or more in this period of high refinancing volumes.

In conclusion, mortgage rates are now low enough to justify refinancing in many situations. Please feel free to contact PPA if you’d like some assistance either before, or during, your discussions with a lender or mortgage broker.

Financial Market Prices and “Real Economy” Disconnects & Upcoming Election

Sam Ngooi Comments

The US stock market has continued its significant and highly improbable advance from its recent March lows, even as the “real world economy” continues to post record breaking negative figures in many categories, including employment and most recently GDP (Gross Domestic Product), amid the continuing coronavirus.  Trying to make sense of this disconnect is now a favorite topic for the financial media. The following S&P 500 figures highlight the point:

Trump election, November 2016 (Base Period) 2,140    
Year-End 2019 3,231 +1,091 +51%
February 19, 2020 (All-Time High) 3,386 +1,246 +58%
March 23, 2020 (Low) 2,237 +97 +4%
July 31, 2020 (Current Close) 3,271 +1,131 +53%

Even a casual follower of stock prices also knows that these recent gains have been powered by a modest number of large high tech stocks (e.g., Apple, Amazon, Facebook, Microsoft, Tesla, Netflix), as evidenced by the NASDAQ Composite being up an astonishing 20% YTD. As long as stock market participants believe these companies can prosper in the midst of a pandemic and end up stronger at the end of the pandemic, it is at least possible that these upward trends can last.

Other explanations for the stock price advances include:

  • the Federal Reserve making it clear it will do everything it can to support the economy and the financial markets;
  • the Fed keeping interest rates low, so that investment returns from bonds will be low, providing stocks with the opportunity for growth, even with their downside risks;
  • the assumption that the US government will also continue to provide significant financial support to individuals and businesses, even with rising deficits, given the current absence of inflation;
  • sporadic optimism about medical advances to counteract the virus;
  • modest optimism regarding openings of various parts of the economy; and
  • speculation (discussed last month in detail, which still begs the question of why the speculation has been more on the positive side).

The June 15th issue of Bloomberg Business Week (BBW, front page) featured the title question, “The Great Disconnect: Why do stocks keep going up?”  First, we note that the S&P price referenced on the BBW cover at that time was 3,207 (6/9/20), which was up 43% from the March 23rd low, even in the face of the extremely disheartening news about the economy (5% GDP decline for first quarter; 14.7% unemployment for end of May; 16.3% retail sales decline for May); the virus (100,000 US deaths); and widespread protests over racial injustice.  Not only have stock prices continued to increase from June 9th (see chart above), but the bad news about the economy, the virus, and the protests has also continued.  We turn now to what BBW had to say on this subject, in a series of three separate but related articles in the June 15th issue (pages 24- 27).

The first BBW article, “Why Robinhood Day Traders are Greedy when Wall Street is Fearful,” states: “Wall Street strategists – who are as flabbergasted as the journalists – have found with vivid hindsight, the obvious explanations in the numbers. They have pointed to a surprise uptick in jobs, interest rates plunging, cheap valuations of certain kinds of stocks, and short sellers being forced to buy shares. But none of that fully explains what is happening in the minds and emotions of investors… Then there is the army of individual investors who have just stuck to their buy and hold plans, perhaps putting some money in stocks automatically with each paycheck (401k plans)…It’s a popular truism that the stock market is not the economy…[Traders] are often willing to ignore what’s happening in the world every day… Quoting Nobel economist Robert Shiller, “the stock market is just that – a market for shares of companies. It does have some relation to the economy, but it is not as strong as people think. It depends on the story and the story is always changing,” (Our note: there are shades here of John Maynard Keynes and the psychological dimensions of investing, discussed in our May Comments).

The second BBW article, “Pessimistic Pros Missed the Big Rally, and So Did Many Americans,” notes: “The Federal Reserve put a floor under the market by liberally making loans and buying bonds.  That mattered more to investors [our note:  traders?] than record job losses did…. The case for today’s high stock valuations is that profits will snap back as the economy reopens and that the Fed will continue to keep interest rates low, spurring growth and making stocks look attractive in relation to interest-earning securities such as bonds.”

The third article, “A Booming Stock Market Could Come Back to Bite the Recovery,” makes the point that the better the stock market is doing, the less likely Congress, the President, and even the Fed may find it necessary to continue their various stimulus efforts. This is not a reason for the gains, but a reason to beware the impacts of the gains.

As for bonds, their mostly higher prices make sense, because of the historic low interest rates being maintained by the Fed to help stimulate the economy.  But these rates are now so low that any further price advances for bonds may be difficult. So long as inflation remains under control, the Fed seems committed to retaining these ultra-low interest rates.

 

Initial Comments on the Upcoming Election

With all that is going on, there is an additional wildcard, namely the upcoming presidential election.  As our regular readers know, we at Park Piedmont Advisors maintain that who is president is only one of a number of factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency.  Exhibit A for this statement is Trump himself. At the time of his unlikely election in November 2016, the conventional wisdom was that if he won, stock prices would decline. That clearly has not been the case (see chart above). It took the coronavirus in early 2020 to slow down the 2019 stock price increases. Even now, prices are advancing rather than declining, while most early polls indicate a possible Biden win. There is also the related question of whether the same party can control the presidency and both Houses of Congress to effect truly meaningful change.

Another example of the possibly mixed impact of an election: if a Democrat were to win and roll back the recent corporate tax cuts, which some would consider a negative result for stocks, the new money available to the government could well go into stimulus construction projects that would be a positive to overall economic activity, corporate earnings, and stock prices. It is worth repeating that corporate earnings and a sustainable price/earnings ratio are valid reasons for stock price gains.

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

As for  the more general future, which is always an unknown, but even more so in the midst of the pandemic, we quote Warren Buffett from Berkshire Hathaway’s second quarter SEC filing: “We cannot reliably predict when business activities in our numerous and diverse operations will normalize. Nor can we predict how these events will alter the future consumption patterns of consumers and businesses we serve” (NYT 8/8/20, page A24),  If Mr. Buffett acknowledges that he doesn’t know, it seems safe to say that no one knows.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.

June Speculation & Market Prices

Sam Ngooi Comments

In our May Comments, we quoted from The Price of Peace by Zachary Carter (May 2020), which chronicles the work, life, times, and impact of John Maynard Keynes. This month we return to a subject we have discussed before, namely the extraordinarily important distinction between investors on the one hand, and traders/speculators on the other. We start with some observations from Keynes, written many years ago, and then reference a few recent newspaper articles that have finally picked up on the impact of the extreme volume of trading/speculating in the current stock market.

As Carter details in his book, Keynes’ The General Theory explains how “financial markets and stock exchanges had enabled disparate individuals to pool their resources and knowledge to support enterprises that had been inconceivable only a century or so before. Classical theorists believed the more liquid the market the better. More money and more investors enabled the market to settle on the right price of various companies and securities. But that was not the way it worked in practice, as Keynes had observed over the course of his nearly two decades as a speculator. People didn’t actually bet on the value of different enterprises, they bet on the judgment of other speculators.” What follows is his now famous description of financial markets resembling a beauty contest, where the judges are asked not to pick the prettiest contestant, but rather the contestant who is chosen prettiest by the greatest number of judges.

The section continues as follows: “This meant that there was no reason to believe the market ever [emphasis in original] actually gauged the value of various investments… Speculators and investors have to make their judgments under conditions of uncertainty [our emphasis; see also last month’s May 2020 Comments on “Uncertainty”] about the future… Who knows the yield from an enterprise ten years hence… At best, capital markets could only magnify the hunches and disputations [that is, subjects about which people cannot agree] of the participants. But the market prices of stocks, bonds, and other assets created the illusory sense of mathematical certainty about prospective investments.”

The impact of speculation on the current markets has been discussed recently in the financial media. Jason Zweig, writing as The Intelligent Investor in the Wall Street Journal (WSJ, 6/13/20), observed as follows: “Wall Street also resembles a casino, even more than it normally does… partly driven by people who are flocking to the stock market for the thrill of taking big risks, whether they pay off or not. Such gambling can be fun, but you should never confuse it with investing [our emphasis]… People, mainly young men, with the lack of professional sports to bet on because of the virus, have turned to trading stocks. For them, the magnitude of moves matters as much as the direction; a big loss can be as much fun as a big gain…Yet, however crazy the stock market may seem, it isn’t really a casino. Play most games in most casinos long enough and you are sure to lose.  The stock market, on the other hand, tends to reward those the best who hold on the longest [our emphasis]. Speculating has some entertainment value, and you might learn something useful, and there’s even a remote chance you will make money, but always know you are speculating.”

In the same WSJ edition appeared an article titled, “Investors Bet on Volatility, Making Markets Even Wilder,” written by Gunjan Banerji (WSJ, 6/12/20). Before quoting from that article, we emphasize that this headline misses the key distinction we are making in our material, which is that “investors” do not bet on the financial markets, and “bettors” are not using those markets as investments. For us, investments are intended to remain in place for lengthy time periods, with asset allocations to help achieve client goals while accounting for risk and rebalancing the allocations under certain circumstances.  Gambling and speculating, on the other hand, are activities where the gain or loss is known in a short time frame, sometimes the same day.

Returning to the WSJ article, Banerji writes that “[m]arkets were once dominated by bulls who thought stocks would go up and bears who thought they would go down. These days another animal is on the rise, one who doesn’t care what stocks do, as long as they do something. These investors are focused on volatility, the amount of movement in prices over time.  In recent years, volatility has gone from a specialty of derivatives traders to a vehicle for trading in its own right. Investors big and small are wagering hundreds of billions of dollars on volatility, including by betting directly on the moves of measures like the S&P 500, shares of individual companies, and oil prices…Volatility trading, and volatility itself, is likely to stay elevated as investors seek to either protect themselves from it, or increasingly, to make money from it.”  The article continues at length, discussing the various ways this trading is accomplished.

The New York Times presented its view of this subject (NYT, 6/15/20, page A1) in an article with the headline, “Arenas Empty, Sports Fans Bet On Wall Street,” by financial writer Matt Philips. “Some Wall Street analysts see people who used to bet on sports as playing a big role in the market’s recent surge, which has largely erased losses for the year… Millions of small time investors have opened trading accounts in recent months, a flood of new buyers unlike anything the markets had seen in years [our note: again, the author is referencing investors while discussing their trading activities]. On most days, the overwhelming majority of stock investors do nothing, while the buyers and sellers establish the prices. So even a small influx of hyperactive speculators can have a significant effect [our emphasis]. Gamblers were a small but important segment of these new arrivals, along with video game aficionados… The short-term swings make betting on stocks no different from betting on a game… The bettors stress they play the market as entertainment. Many have 401(k) plans filled with plain vanilla index funds that are the bedrock of retirement planning.”

And finally, the well-known economist Paul Krugman wrote an Opinion Piece (NYT, 6/15/20, page A31) entitled, “Market Madness in the Pandemic”. Krugman notes that “First came the huge declines as the threat from the virus became clear. The decline reflected justified concerns about future profits, but also a developing financial crisis… Next came the Federal Reserve to do whatever it took to lubricate markets and keep money flowing freely, the result of which was a stock rebound that made up half the losses from the initial plunge. Up to that point, the behavior of stock prices generally made sense. But then came another surge in stock prices that eliminated most of the previous losses… Most of the evidence suggests that a major role in this latter surge was played by small investors, looking for an alternative source of excitement.” [Note that even Krugman appears to refer to the new traders as investors; going forward, a focus on more precise terminology among the financial press might help reinforce the difference between speculation and investing.]  Krugman quotes Keynes: “even staid investors who usually stabilize the market tend to abdicate judgment in ‘abnormal times’.”

All this speculation is important because it creates unnecessary volatility. This in turn makes the media strive for daily explanations, and prods long-term investors to consider portfolio changes they would otherwise not make.  During June, the S&P 500 changed by a modest 56 points in 22 trading days (from 3,044 to 3,100), but within June there were 14 up days totaling 478 points, and 8 down days totaling 422 points. The relatively new trading activity described above may well be a factor in this volatility. We continue to advocate maintaining asset allocations developed for the long term, unless rebalancing is in order based on the change in market prices, which means selling the better performing asset class and buying the weaker performer.                       

May Markets and Observations on Uncertainty

Sam Ngooi Comments

The US stock market continued the highly unlikely gains that started in April through May, following the steep declines from mid-February to late-March. With only modest examples of reopening the economy amid the coronavirus, the ongoing stock gains appear to be taking a highly optimistic view of the future. The various actions by the Federal Reserve to keep interest rates extremely low and to buy various categories of bonds appear to have stabilized financial markets and provided a foundation for the stock gains. The Economist discussed this situation as follows: “Financial markets look forward. Yesterday’s news is stale. What matters is the future, in particular the returns that today’s buyers of securities can expect… Stock prices have had a substantial recovery from their lows, even as the economic news continues extremely negative (e.g. GDP down 4.8%; unemployment of 20 million)… So what are reasons for the stock rally?… Federal Reserve efforts to backstop the economy… Bond yields are paltry, making equities appealing by  comparison” (our note; we would add, as long as stocks are going up) (The Economist, 5/7/2020).

The year 2020 is providing several examples of unforeseen events and consequences, and we will be commenting on the subject of uncertainty next.  First, a few data points for the S&P 500 are worth noting:

  • Feb 19th high to the March 23rd low, down from 3,386 to 2,237, a decline of 1,149, or 34%;
  • Feb 19th to April 30th; 3,386 to 2,912, a decline of 474, or 14%; the gain from the low was 675, or 30%;
  • Feb 19th to May 29th, 3,386 to 3,044, a decline of 342, or 10%; the gain from the low was 807, or 36%
  • At the beginning of 2019, the index was 2,507; with end of May 2020 value of 3,044, there has been a gain of 537, or 21%. For all of 2019, the S&P 500 was up just short of 29%.

UNCERTAINTY

What does the future hold?

Over the past weeks, as “stay at home” orders have lifted and communities have gradually reopened, there has been much public discussion of what a “new normal” might look like. We’re the first ones to admit we don’t know what’s going to happen tomorrow, let alone next year or over the decades to come. (Neither does anyone else.)

Is it possible the stock market offers clues? As we’ve written before, the stock market is forward-looking. Wharton Finance Professor Jeremy Siegel explained in a recent NY Times article that “[o]ver 90 percent of the value of stocks is dependent on earnings more than a year in the future.” The stock market’s rapid recovery over the past two-plus months, following its precipitous decline in late February and early March, suggests that investors see a promising future. A welcome “new normal.” In many ways, this is good news.

Yet, as the protests of the past week over the killing of George Floyd have shown, we have a powerful opportunity to reflect on the “old normal” – bountiful for many, agonizing for many others. COVID-19; widespread protests against racism and police brutality; an upcoming national election; geopolitical flux; the interruptions to our daily lives and closest relationships have all contributed to what seem like unprecedented uncertainty. But of course, all times are uncertain as we’re living through them.

We have written frequently over the years about how uncertainty plays a major influence in financial market pricing. Since no one can predict the future, uncertainty must be considered. The whole point of asset allocation is to try and exercise some decision-making that takes into account the risks of an uncertain future.  Our favorite spokesperson on this topic is Nick Taleb, the author of both The Black Swan (2007) and Fooled by Randomness (2001).  His work is well-illustrated for us by the parable of the turkey. The turkey is fed excellent meals every day and develops the expectation that these meals will continue indefinitely, only to encounter Thanksgiving.  The Black Swan references the idea that there was a time in the past when only white swans appeared, to the point where people thought only white swans existed. It took the appearance of one black swan to change that ”certainty.”

A recently published book, The Price of Peace: Money, Democracy, and the Life and Times of John Maynard Keynes, by Zachary Carter (May 2020), provides additional insight on the subject. Carter writes: “Financial markets, Keynes had discovered, were very different from the clean, ordered entities economists presented in textbooks. The fluctuations of market prices did not express the accumulated wisdom of rational actors pursuing their own self-interest but the judgment of flawed men attempting to navigate an uncertain future. (Our emphasis). Market stability depended not so much on supply and demand finding an equilibrium as it did on political power maintaining order, legitimacy, and confidence. These observations became central tenets of the economic theory presented in his magnum opus ‘The General Theory of Employment, Interest and Money’ (page 17).

In our advisory work, when an asset allocation becomes too risky, or too conservative, for a particular client, we evaluate, and then, where appropriate, recommend and implement portfolio rebalancing. Rebalancing is a method of adjusting an investment portfolio’s risk exposure based on the assets held, informed by a client’s risk tolerance, time horizon, and overall goals.

Are we undergoing a broader, society-wide rebalancing? There are significant risks in persisting with the “old normal.” To paraphrase Keynes, here we are, “flawed people attempting to navigate an uncertain future.” The stock market suggests that future might be promising. But it remains on us, both personally and professionally, to continue doing the hard, daily work to make that promising future more equitable, accessible, and just.        

“Random” Stock Price Movements, Revisited

Sam Ngooi Uncategorized

As stock prices in April continued their March pattern of wide daily fluctuations, both up and down, and amidst the financial media’s ongoing reporting of the severe negative economic impacts from the global responses to the coronavirus, we have been looking for a word or phrase to capture what is happening.  The word that comes to mind is random.  And the investment icon most associated with that word and idea is Princeton Professor Burton Malkiel, who wrote the investment classic A Random Walk Down Wall Street (first published in 1973).  The basic thesis of the book (paraphrased from the book’s Wikipedia entry) is that:

Asset prices typically exhibit signs of a random walk so that no one can consistently outperform market averages… Actively managed, diversified stock portfolios, whether using individual stocks or mutual funds, following fundamental or technical analysis, and/or relying on past performance, are likely to produce inferior results compared to passive strategies. Using past performance for mutual funds is a problem because outperformance in one year is often followed by underperformance in years following their success, with results regressing to the mean. Over the long term, the benchmark index for that investment category is likely to outperform.  [Emphasis added.]

In October 2003, right around the time of Park Piedmont’s founding, our Monthly Comments quoted directly from Malkiel’s book (8th edition):

“[t]he problem is that there is no persistency to good performance; it is as random as the market. If a manager beats an index in one period, there’s absolutely no guarantee that the performance will be repeated in the next… The top funds of the sixties had dismal performances in the seventies…the top funds of the seventies badly underperformed the market in the eighties, and the top funds of the eighties underperformed in the nineties… Yesterday’s genius turned into today’s disaster… It is true that there are always some funds that beat the market… [But] there is no way to choose the best managers in advance.” Malkiel, A Random Walk Down Wall Street, pages 128-130 [Emphasis added.]

Next is a sample of Malkiel’s advice in times of crisis, written two weeks after the September 11, 2001 terrorist attacks on America. (Our note: Could it be that some of this discussion is applicable currently? The figures are different but the ideas resonate. Presumably, time will tell). The title of the article is “Don’t Sell Out,” (WSJ, 9/26/01):

“The horrific events of late have focused the attention of the world on the U.S. stock market and the potential influence it will have on the likelihood of a global recession. As of yesterday’s close, the Dow is more than 10% below its level prior to the terrorist attacks and consumer confidence has collapsed. While more than a $1 trillion loss in market value was punishing enough, many commentators have expressed concern that the market is still overpriced and that the potential for further declines is large. Simply put, the worry-warts argue that with today’s price/earnings ratio (P/E) still in the low 20s (well above its long-run average of about 15), stocks are overpriced and corporate earnings are greatly overstated, making the actual P/E dangerously high. While stocks may continue to fall in the short-run, investors should reject such a negative view.

There is no reason to believe that 15 or any other number is the correct earnings multiple at which the market should sell. Two important factors influence the ratio. The first is the level of long-term interest rates.  And when long-term interest rates are very low, as they are today, higher P/E ratios for the market are warranted. The appropriate P/E for the market also depends on the risk premium (the extra return over safe bonds) demanded by market participants. One very good proxy for the risk perceived by equity investors is the recent inflation rate. The normal relationship today, based on bond yields and inflation, is for the S&P to sell at about 22, not 15. Bond yields are low and inflation is well contained, so it is perfectly appropriate for the S&P to sell at a level above its long-run average. The market today appears to be fairly valued.

But do the tragic events of September 11th throw all the historical analogies out the window? I think not. I have looked at previous shocks to the economy: the Gulf War, the crash of 1987, the resignation of President Nixon, and the U.S. bombing of Cambodia in 1970, among others. While one can discern temporary market perturbations, there do not seem to be any long-run deviations from the prediction line. Even if I extend the analysis back in time to the Korean War and Pearl Harbor, I find only temporary effects. Of course, it is always possible that this time is different, but history suggests that investors who make an emotional decision to sell during times of crisis are unlikely to derive any benefit.

Yes, earnings are likely to decline in the coming quarters, but there has always been a tendency for P/E multiples to rise during recessionary periods. And even if we do have a recession, the market is likely to look beyond depressed current earnings and to capitalize earning power during the following recovery. While the market today seems reasonably priced, no one can make a short-term prediction of where prices will go in the future. Certainly, the world is a much less stable place than it was before September 11th, and risk premiums should be higher. Moreover, if irrational exuberance characterized 1999 and early 2000, unreasonable anxiety could influence prices over the next several months. Indeed, figures released yesterday showed the biggest monthly drop in the consumer confidence index since 1990. But history tells us that anyone who sells stocks today in the hope of getting back in at just the right time is likely to be making a large and costly mistake.”

Turning now to these April 2020 Monthly Comments, the extreme negative impacts of the coronavirus on people’s health and their ability to conduct normal activities continues. This in turn continues to present major economic issues for businesses around the world, which have had to curtail or shut down their operations, generating high levels of unemployment and creating all sorts of problems for those consumers and businesses dependent on their goods and services. And yet the S&P 500 stock index gained 12.7% in April, with many days up or down more than 2%, even with days of no apparent new news, giving rise to our observations about stock prices being random.  Here is evidence of “randomness,” based on the recent extreme price movements of the S&P 500 index:

  • from the February 19th high to the March 23rd low, down from 3,386 to 2,237, a decline of 1,149, or 34%;
  • from February 19th to March 31st, down from 3,386 to 2,585, a decline of 801, or 23.6%; the gain from the March 23rd low was 348, or 15.5%;
  • from February 19th to April 30th, down from 3,386 to 2,912, a decline of 474, or 14%; the gain from the low was 675, or 30%.

The information in the chart below makes a similar point:

S&P 500 Trading Days Days

Up

Days

Down

Up

Amount

Daily Up Average; % Down

Amount

Daily Down Average; % Net Amount Daily Average; %
Feb 19-Mar 31, 2020 29 10 19 +1,273 +127; 3.8% (2,076) (109); (3.2%) (803) (28); (0.83%)
April 1-30, 2020 21 11 10 +757 +69; 2.0% (430) (43); (1.3%) +327 +15; 0.46%
Totals Feb 19-Apr 30 50 21 29 +2,030 +97; 2.9% (2,506) (86); (2.5%) (474) (9.5); (0.28%)

Note: All % measured from Feb 19th all-time high of 3,386, unless otherwise indicated.

Also, a few additional reference points: The S&P 500 index at the end of 2018 was 2,507; compared to the April 30, 2020 figure of 2,912; the change is +405, or 16%.  For all of 2019, the S&P 500 was up just short of 29%.

In our March Comments, discussing the stock price volatility from that month, we wrote: “what if this same result occurred with an even decline each day of 28 points, or 0.83% of the index (801 divided by the 29 trading days)? At some point you would have noticed, but the reactions would likely be much more subdued.”  Factoring in April’s surprising positive result, the overall result is even more muted, even with all the continuing bad news and frightening events. Over 50 trading days, there is a net decline of 474 points, which, if spread evenly, would be just under 10 points a day, or (0.28%). Hardly worth much of a reaction. It would seem as if the volatility/randomness of the daily price changes has been much more frightening than the 50 day start-to-finish numbers.

And to what can we attribute the April stock gains? Does the Federal Reserve’s maintenance of ultra-low interest rates, and their calming of the bond market, carry enough weight in the financial markets to explain these stock price results?  “The Federal Reserve said the US economy has deteriorated due to coronavirus and pledged to take aggressive action to support an eventual recovery” (WSJ 4/29/20). When interest rates are close to zero, investors cannot earn a reasonable yield from their bond holdings, and the price gains from declining rates are pretty much over, so many investors are forced to turn to the far more volatile stock markets in hopes of earning a positive return. Another possible explanation for the April result is that some market participants are already anticipating an economic recovery from the impacts of the virus, but that would certainly fly in the face of the media’s mostly downbeat reporting.  It is also an open question where daily trading activity comes into play to impact stock prices, as distinguished from the presumed lack of activity from long-term buy-and-hold investors.  We simply do not know and continue to be quite concerned about the near-term health and finances of all.

As we wrote in March: the danger of this kind of extreme short-term price volatility in the markets is that it gives investors a reason to “do something.” If in fact your long-term goals have not changed, the likely best action is to do nothing, relying on the history of stock price recoveries from bear markets, some even deeper than this one.  Of course, a health pandemic with no clear finish line presents major uncertainties for all. But reacting to the risk by following and acting on the day-to-day extreme (often random) ups and downs in the stock market does not seem to us (or Malkiel) to be that useful.  And remember, your asset allocation away from stocks to bonds, tailored to your particular situation, provides risk reduction and a source of money as needed so that stocks need not be sold during periods of steep declines.

BONDS: (from March Comments):

“Bonds are designed to provide a buffer for your investment portfolio, normally generating income and much lower price volatility as compared to stocks. Typically, the older people get, the more their investment portfolio allocation should be tilted towards bonds, even with some stock allocation providing a potential for growth in case they live a very long time. Currently, bond price fluctuations are considerably lower than they are for stock prices. But interest rates are also very low for bonds, so the tradeoff between price stability and price volatility is particularly stark. Bond prices have come under pressure recently, even as interest rates have declined, because of perceived credit risks. The Federal Reserve has made it clear, however, that it is ready to support the bond market in a variety of ways (NYT, 4/1/20, page B1). Bonds also provide a source of cash for everyone who needs to be using money currently, so that stocks need not be sold in periods of decline. This is a very brief discussion of a complex topic, but we believe the allocations away from stocks and into bonds, established in more normal times based on each client’s particular situation, are doing their job as intended.”

While searching for the Malkiel quotes in our Monthly Comments archives, we came across the following set of our personal observations from September 2001. They seem pertinent again now.

“Beyond the figures and the history and the media reports, there are some other, more personal thoughts we would like to convey… We find that there is more reason for additional engagement with the rest of the world, and that our own well-being is interrelated with people and places far away.  Since the demise of the Soviet Union, and the Gulf War, we achieved increased prosperity for ourselves and other developed areas, while at the same time we seemed to have reduced our interest in the less economically developed and troubled parts of the world.  Thomas Friedman’s excellent book, The Lexus and the Olive Tree, previously discussed in the Comments of March, 2001, highlights some of the implications of the increasing divergence between the “haves” and the “have nots”, and those willing to break with tradition and those clinging to tradition.”

Finally, although the world as we knew it for the last number of years has changed irrevocably, it should also be clear the world has not, as the expression goes, come to an end.  In the post 9/11/01 world, we are likely to be, for some time, more insecure, less confident, and less financially well-off.  But the world is still out there, and we still have our lives to lead in this world.  As we get used to these new circumstances, we all need to, in our own time, overcome our feelings of sadness, depression, even despair, and move on to productive lives.  On both a personal and a national level, these productive activities will get us to a better place.”

STAY SAFE AND TAKE CARE.

Updates to Tax and Other Laws Providing Assistance During Virus Outbreak

Sam Ngooi Comments

The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed on March 27th, 2020. This is the third significant piece of Federal legislation dealing with the pandemic, and likely not the last. It joins other efforts by state and local governments, for-profit and non-profit companies, and individuals to address this unprecedented challenge to the world’s healthcare, economic, and social systems.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in late 2019, also made several relevant changes to IRA rules.

This summary will likely be the first of several that we prepare to keep you informed about these efforts in general, as well as more specific programs that might have a direct impact on you, your family, and your community. It is based on our current understanding of the relevant programs, all of which are subject to revision over time. Before relying on any information provided below, please feel free to contact us to confirm whether anything has changed.

Please also don’t hesitate to send us any questions, comments, or concerns you have. In the words of the classic High School Musical song, we are profoundly, and at many levels, “All in this Together.”

Tax-related

Filing deadlines

  1. Federal 2019 filing and payment deadline postponed from April 15, 2020 to July 15, 2020
  2. Most states, including CA, NY, NJ, CT, and IL, have also postponed their deadlines to July 15th (check websites for other states to confirm)
  3. You should file sooner if you expect a refund
  4. Filing extensions until October 15, 2020 still available, but tax payments need to be made by July 15th in any case
  5. Most will have to file a return to receive a check from the CARES Act (see below under Direct Payments; currently, social security recipients do not have to file returns to receive direct payments)
  6. Q1 2020 estimated taxes postponed from April 15, 2020 to July 15, 2020
  7. For now, Q2 2020 estimated taxes still due on June 15, 2020

Retirement Accounts

  1. CARES allows for penalty-free early withdrawals up to $100,000 from most retirement accounts (401k, Traditional and Rollover IRAs, SEP, SIMPLE)
    • Eligibility requires self-certification that individuals or their dependents have Covid-19 OR suffer from “adverse financial consequences” of the disease
    • Funds need to be withdrawn before the end of 2020
    • Can be repaid without tax consequence or penalty (typically, permanent withdrawals before age 59.5 incur taxes and penalties) within 3 years (as opposed to the current 60-day limit for IRA “loans”)
    • If not repaid within 3 years, taxes due on withdrawals can be spread over 3 years
  2. SECURE allows for contributions to an IRA or 401K as long as you have earned income (prior rules ended contributions at age 70.5 whether working or not)
  3. SECURE raises the starting age for required minimum distributions (RMDs) from 70.5 to 72
  4. SECURE requires Inherited IRAs to be withdrawn, and taxes paid for all IRAs except Roths, within 10 years for IRAs inherited after December 31, 2019 (old “stretch” withdrawal rules still apply for IRAs inherited before January 1, 2020)
    • RMDs eliminated for Inherited IRAs; withdrawals can be taken, and taxes paid, any time in the 10-year window
    • Exceptions apply for spouses, minor children, beneficiaries less than 10 years younger than the account owner
    • Rules don’t take effect until 2022 for inheritors of 403Bs (non-profit plans) and 457Bs (government plans)

RMD changes

  1. Required Minimum Distributions (RMDs) from IRAs, Inherited IRAs, and workplace retirement plans (401Ks, 403Bs, 457Bs) waived for 2020
  2. RMDs already taken in 2020 can be rolled over if the re-deposit occurs within 60 days of the original distribution date. If the 2020 distribution happened more than 60 days ago, it could be “repaid”, and therefore avoid 2020 taxation, based on the revised IRA distribution rules described above

Roth conversions

  1. With the significant stock market declines so far in 2020, conversions of tax-deferred retirement accounts (IRAs, including Rollovers, SEPs, and SIMPLEs) into tax-free Roth IRAs are worth considering.
    • Conversion requires that taxes be paid on every dollar of converted amounts at ordinary income tax rates
    • But with lower asset values, current tax consequences will be reduced
    • Potential for tax advantages assuming long-term recovery in tax-free Roth IRAs
  2. New Inherited IRA rules under SECURE Act (see above) might make Roth conversions more attractive for these accounts

 Charitable Contributions

  1. Cash contribution limitations raised to a maximum of 100% of 2020 adjusted gross income (up from 50% currently) if you itemize deductions
  2. Maximum $300 deduction of contributions allowed if you don’t itemize

 Investing

Re-balancing

  • Consider buying stocks/stock funds if your current allocation to stocks has fallen below targets
  • “Dollar cost average” back into stocks over time to avoid potential large additional declines and benefit from long-term recovery

Tax-loss harvesting

  • Consider sales of investments with recent declines, coupled with immediate re-purchases of comparable investments (i.e., stock funds to replace stock funds) to maintain overall asset allocation
    1. Realized losses can be used to offset gains elsewhere in the portfolio, as well as capital gains from real estate sales
    2. Losses can also be deducted against $3,000 of ordinary income each year, and carried forward indefinitely
    3. PPA makes sure to avoid “wash sale rule”, which disallows losses if the same security/fund is purchased 30 days after (or before) the sale

Benefits

Unemployment

  1. Unemployment benefits administered by individual states
  2. CARES Act provides for additional $600 per week in addition to State unemployment benefits
  3. Federal coverage extends State coverage by 13 weeks
  4. Self-employed and part-time workers eligible in addition to full-time workers
  5. Broad definition of who qualifies for coverage based on quarantines, stay-at-home orders, and required care for affected family members
  6. People already on unemployment also eligible for additional benefits

Direct Payments

  1. Direct payments are based on 2019 tax returns, or 2018 returns if you haven’t yet filed for 2019, to determine the amount, if any, you’re eligible to receive
  2. Amounts received in 2020 will be checked against 2020 tax returns and potentially increased if 2020 income is lower (but no funds will be re-claimed if 2020 income is higher)
  3. $1,200 lump sum for each individual with 2019 adjusted gross income (AGI) less than $75,000
  4. $2,400 lump sum for each married couple filing jointly with less than $150,000 of 2019 AGI
  5. Amounts phase out for individuals with up to $99,000 of AGI and couples up to $198,000 of AGI
  6. Additional $500 for each dependent child 16 or younger
  7. Social Security recipients not required to file return if they don’t typically file

Business loans

  1. Paycheck Protection Program (PPP): $349B in partially forgivable loans available to small businesses
    • Small businesses defined as 500 or fewer employees, including non-profits
    • Sole proprietors, independent contractors, and self-employed people all qualify
    • Applications available now through lenders for small businesses and sole-proprietors; 4/10/20 application start date for independent contractors and self-employed; application deadline is 6/30/20 or until program funding runs out (although additional funds might be made available in the future)
    • Good faith certification of adverse coronavirus impact required
    • No personal guarantees or collateral required; Small Business Administration (SBA) backs lenders; contact your bank or credit union to get started
    • Loan amounts limited to 2.5 times average monthly payroll expenses from previous year; maximum loan of $10M
    • 2-year maturity, 1.0% interest rate, interest payments deferred 6 months
    • Loans forgivable based on eligible spending (payroll and other typical business expenses) during first 8 weeks after loan approval, assuming similar staffing and compensation levels as before CARES Act passed
    • Salaries above $100K NOT eligible for forgiveness
    • PPP loans could eliminate eligibility for other benefits, including payroll tax deferral, employee retention credits, and Economic Injury Disaster loans

401K Loans

  1. Loan maximums increased to lesser of $100,000 (up from $50,000) or 50% of the account balance until September 30, 2020

Real Estate/Education

Mortgage and rent relief

  1. Varies by lender and State/locality; contact your lender and/or landlord for details

Education loan freeze/suspension

  1. Federal student loan payments and interest automatically suspended until September 30, 2020
  2. Private loan changes vary; contact your lender for details

Observations on March Financial Markets

Sam Ngooi Comments

For these Monthly Comments we would like to first note the continuation of the extreme negative impacts of the coronavirus on people’s health and their ability to conduct normal activities. This in turn has created major economic issues, as businesses around the world have had to curtail or shut down their operations, generating high levels of unemployment and creating all sorts of problems for those consumers and businesses dependent on their goods and services. There is little doubt that the impacts of the virus have been a major factor in the current substantial stock price declines in the US and worldwide, as well as a reason for the Federal Reserve to take actions  that have driven US Treasury yields to historic lows, with mixed impact on other bond prices.

From its recent February 19th all-time high of 3,386, the S&P 500 stock index has been as low as 2,237 (March 23rd),  a decline of 1,149 points, or 34%. This means we are currently at the start of the thirteenth bear market (defined as a decline of 20% from a previous high) since the end of World War II. What is different about this bear market is how brief a time it took to reach this level, which in turn brings us to the idea of volatility. Volatility refers to the extent to which prices vary around an average, either up or down, in a given time frame. Consider this:

Starting with the business day of February 20th  (with the S&P 500 at 3,386), and ending March 31st (with the S&P 500 at 2,585), there have been 29 trading days, of which 19 days have been down a total of 2,076  points, averaging approximately 109 points a day, or 3.2% of the February 19th closing value; and 10 days that have been up a total of 1,273 points, an average of about 127 points a day, or 3.8% of the February 19th closing value.  End result: down 801 points, or 23.6% of February 19th closing value. Now what if this same result occurred with an even decline each day of 27.6 points (801 divided by the 29 trading days), or less than one percent a day of the February 19th closing value?  At some point you would have noticed, but the reactions would likely be much more subdued.

The danger of extreme short-term price volatility in the markets is that it gives investors a reason to “do something.” If in fact your long-term goals have not changed, the likely best action is to do nothing, relying on the history of stock price recoveries from bear markets, some even deeper than this one.  Of course, a health pandemic with no clear finish line presents major uncertainties for all. But reacting to the risk by following and acting on the day-to-day extreme ups and downs in the stock market does not seem to us to be that useful.  And remember, your asset allocation away from stocks to bonds, tailored to your particular situation, provides risk reduction, and a source of money as needed so that stocks need not be sold during periods of steep declines.

Or consider that at the March 31st closing level of 2,585, the S&P 500 is actually 78 points, or 3%, higher than the year-end 2018 closing level of 2,507.  So, if you had been traveling in the remotest parts of the world for fifteen months, with no news about stock prices, you would have encountered a very modest gain, but certainly not a bear market. Put another way, while almost all the gains from 2019 (when the S&P 500 index started at 2,507 and closed at 3,231, a gain of 724 points, or almost 29%) are gone, this information does provide a perspective on what is happening currently.

We would also note that as much as these declines can be attributed to the negative impacts of the coronavirus, those same impacts are not likely to be cited as a reason for the up days. We think that stock market moves by traders seeking to profit from short-term price movements are at least partly responsible for all of this volatility. In our February 27th Special Comments, we referenced a New York Times article by Ron Lieber advising people with long term investment goals to 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.”  (Years ago, we wrote to advocate banning short-term trading because of all the harm it does to long-term investment planning; perhaps this idea should be reviewed again.)

The economic damage done by the “stay at home” policies being implemented to slow the spread of the virus seems certain to result in a recession (defined as two quarters of negative GDP growth). But the question remains whether current stock price levels already reflect this widespread expectation, so that when glimmers of good news appear about slowing the spread, providing reasons to think some relief is in sight, the stock market might be poised to recover. Stock prices reflect investors and traders’ views of the future, both short and long term, which is perhaps a reason for ongoing price volatility, both up and down. Further, how long a recession lasts, and how much economic growth declines during the recession, are always crucial variables.  At this point, it is anyone’s guess what the future holds on these matters.

BONDS:  Bonds are designed to provide a buffer for your investment portfolio, normally generating income and much lower price volatility as compared to stocks. Typically, the older people get, the more their investment portfolio allocation should be tilted towards bonds, even with some stock allocation providing a potential for growth in case they live a very long time. Currently, bond price fluctuations are considerably lower than they are for stock prices. But interest is also very low for bonds, so the tradeoff between price stability and price volatility is particularly stark. Bond prices have come under pressure recently, even as interest rates have declined, because of perceived credit risks with bonds. The Federal Reserve has made it clear, however, that it is ready to support the bond market in a variety of ways (NYT, 4/1/20, page B1). Bonds also provide a source of money for everyone who needs to be using money currently, so that stocks need not be sold in periods of decline. This is a very brief discussion of a complex topic, but we believe the allocations away from stocks and into bonds, established in more normal times based on each client’s particular situation, are doing their job as intended.

To repeat our recent conclusion: 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 (see Nick Taleb discussed in January Comments, and Larry Swedroe quoted every month in our Monthly Comments). PPA’s view is that the history we present to support a point of view is at least worthy of consideration. In the absence of better indicators, 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: 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.