“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.

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 Comments

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.