What We’re Thinking

After the substantial declines of 3% or more in US and international stock prices on Monday, February 24^th, 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

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.

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.

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

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

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

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

A few other important points to note:

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

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

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

1. Set Reasonable Expectations

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

2. Shop Thoughtfully

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

3. What Makes a Good Gift?

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

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

4. Get Kids Involved

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

5. Savor Gratitude

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

6. Focus on Values

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

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

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

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

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

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

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

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

The financial media continues to assign reasons for current stock and bond price movements, up and down, including: (a) the extent of economic slowdown in the US and internationally; (b) progress, or lack thereof, in the ongoing trade war with China and other countries; and (c) the Federal Reserve’s willingness, or reluctance, to continue lowering interest rates to stimulate economic activity without generating unwanted inflation.

Towards the end of September, a new factor entered the narrative, as the likelihood of impeaching President Trump seemed to be on the rise.  Whether that event would help or hurt financial asset prices became a question. There were up and down days during this period, which would seem to make causation quite difficult to assign. That said, and with the understanding there are many different views on this topic, we will discuss an article by Neil Irwin on this subject (NYT, 9/26/19, page B3).

The article begins by noting that during the two-year period starting with the 1972 Watergate break-in  and ending with President Nixon’s resignation in 1974, the S&P 500 fell 25%. During the Clinton impeachment in 1998, by contrast, the S&P 500 gained 22%. The article takes the position that “in the 1970s markets were not responding to troubles and high drama in Washington; they were adjusting to oil embargoes and a spike in inflation. In 1998, the markets reflected a booming economy…. These historical episodes of impeachment drama show that any moves driven by political headlines tend to be modest and short-lived. Economic fundamentals matter a lot more. So don’t be surprised by an occasional day in which activity in Washington appears to move markets…. But do be surprised if these effects turn out to be more than temporary blips.”

The article continues by citing a report from economists at Cornerstone Macro, concluding that:  “Although there were days when market moves were outsized, in both historical examples, markets simply continued a trend that was already in place and attributable to other factors…. So the existing market trend – reflecting a global economic slowdown particularly concentrated in manufacturing – is likely to persist, unaffected by the president’s latest troubles.”

Mr. Irwin adds a caveat: “The question for a potential Trump impeachment seems less about the instant reaction to the latest developments, and more about whether there could be a feedback  loop between impeachment and economic policy.” He cites the ups and downs of  trade policy as a major factor in today’s markets, “much as the oil embargo in 1973 and the dotcom boom in 1998, and that trade is an area over which President Trump has direct control.” He also notes that impeachment will likely make any legislative deal-making highly unlikely, and questions whether it is more or less likely to drive Trump to resolve some of the current trade conflicts. He concludes: “All of which means that to assess the eventual market implications of a Trump impeachment, it’s not really a matter of economic analysis.  It may ultimately be about behavioral analysis.”

In our view, impeachment is a “wild card,” adding uncertainty to an already uncertain political and financial environment. We tend to agree with the Irwin article’s basic point that impeachment may not be a major factor in how markets react over the long term, but also retain our general skepticism about predictions of any kind. Instead, as usual, we advocate developing asset allocations appropriate to your financial situation, and revising them only as your situation changes over time.

Usually in our Monthly Comments, we share our observations about the financial markets. But this month, we’d like to shift the focus, onto some thoughts about how we live with money. We start with a question:

How did you learn your early lessons about money? 

Was it from your family? Or maybe from your friends? Were you in a classroom, or possibly the corner store? How old were you? Does a single incident stand out? Or maybe a few smaller moments? Is now the first time in a long time you’re recalling them? Who else knows about these early lessons?

Money is a fascinating, complicated subject. From the time we’re little kids, money shapes us: where we live and what we do, our life experiences and aspirations. We all have unique personal histories and priorities when it comes to money. Even partners and siblings – maybe especially partners and siblings – can have dramatically different approaches to financial life.

At the same time, it’s a frequently taboo topic. Important as it is, a lot of our “money life” happens in silence and isolation, conversations that don’t happen, memories that linger but stay buried. This taboo isn’t just imagined. In her 1922 book, Etiquette in Society, in Business, in Politics and at Home, the American manners expert Emily Post wrote, the “very well-bred … intensely dislikes the mention of money, and never speaks of it (out of business hours) if he can avoid it.” Unfortunately, this taboo can have toxic repercussions.

There’s a concept in the field of education, known as “the hidden curriculum,” which refers to all the things we learn, even though they’re not explicitly taught. On reflection, it’s easy to start to see how powerful the hidden curriculum of money is, and how perverse and misaligned our cultural expectations often are around the topic. Consider: Money drives so much of our decision-making … but we’re not supposed to talk about it! No wonder money routinely tops the list of the most stressful topics in peoples’ lives.

Most of us don’t learn the fundamentals of money or personal finance when we’re young. There’s no formal, widespread curriculum. So we get our lessons in fits and starts, through what we see and hear – as well as from what we don’t see and fail to hear. As a result, money can often feel like a Gordian knot, an unsolvable puzzle.

The complexity is frequently compounded by the financial industry and press. “Financial speak” can seem like a whole other language. The people who explain money for a living typically stand to gain when the rest of us are befuddled. They’re the “experts”, and just as we do to other experts – electricians, pilots, engineers – we cede the field to them.

But money is too important, too central, and too learnable to wave the white flag on. That’s why, for Park Piedmont, we focus a lot of our time trying to inform and educate. To limit, wherever possible, the financial jargon. To share with you what we know – and freely admit when, as is so often the case, something is unknowable (like where the markets are headed). And to help you, our clients, feel increasingly competent and confident in your own life with money.

We see those roles as a big part of our work, and an important part of our purpose as a firm: to help make financial decision-making less complex, more understandable, and more of an ongoing, open conversation.

To keep the conversation going … please feel free to share your formative money moments with us, and/or your thoughts on other aspects of the “hidden curriculum” of money. We’d be happy to hear them!

In our most recent July 2019 Monthly Comments, we discussed the media coverage of early August stock price volatility on days when prices were lower. Key market movers were presented as 1) the direction of interest rates; 2) tariff and currency disputes with China; and 3) the inverted yield curve for ten-year and three-month US treasuries, perhaps signaling an economic recession. One additional point on the relationship between stock prices and recession not frequently discussed in the media is that stock prices do not necessarily fall in response to recession (a lengthy subject for a future Monthly Comments).

Those same July Comments pointed out the surprising upturn in stock prices since Trump’s election. The updated figure as of Friday, August 16 (using the S&P index close of 2,888) was 35%, 4% lower than end of July. That same index is still up 15% for 2019 year-to-date.

Another key point in those July Comments was to focus on percentage changes and not just absolute numbers (e.g., an 800-point drop in the Dow Industrials translates to a 3% decline). Any percentage decline is further modified by your specific portfolio allocation away from stocks, and into the less volatile, lower returning asset classes of bonds and cash equivalents.

As for bonds, they continue their recent trend of yield inversion, with the ten-year Treasury yielding 1.56% and three-month Treasury yielding 1.87% (as of the August 16 close), an unusual situation the length of which is pure guesswork.

The additional thought we would like to add in this update is to suggest that the media ‘s efforts to assign reasons for and economic significance to this recent volatility may be misplaced. Rather, this volatility may just be the effect of short-term trading among financial market participants looking for short-term gains.  This thought may be supported by the fact that there are up days for stock prices sprinkled among the down days, which might not occur if the price movements were truly economically significant. We and others have expressed this idea during other periods of volatility, but it remains one we should keep in mind as we all follow the news.

After relatively modest price changes during July in both stock and bond markets, early August witnessed a return of substantial stock and bond price volatility.

• Although the recent declines (and gains) appear large in absolute numbers, the important figures are the percentage gains and declines. A drop of 500 points on the Dow, for example, sounds huge, but at current price levels it’s a more modest 2% decline. And depending on your specific allocation to stocks, these declines are moderated even further.
• Markets currently seem to be responding to the daily news, focusing on the Fed’s position on US interest rates and the China trade dispute, involving both tariffs and more recently currency exchange rates. These factors have a direct bearing on the growth outlook for the US economy.
• News that does not appear to be driving daily market price swings, for now at least, are the problems surrounding the Trump presidency and various international conflicts. These issues tend to have a more indirect bearing on the outlook for the US economy.
• History has demonstrated that stock returns are determined by the underlying corporate earnings that support the price level of stocks (the Price/Earnings, P/E, ratio), an analysis that plays out over time and is impacted by many factors. To the extent the daily news items are likely to impact earnings, then there may be some connection of the news to market prices. But because the mix of factors and their significance are changing all the time, it is extremely difficult to make judgments on a day-to-day basis as to the appropriate level of stock prices. (As you know, we do not try to predict future stock price movements or their causation.
• A few reference points for stock prices (S&P 500 index) may be useful:
  • At the time of Trump’s election in early November 2016, the index was 2,140.
  • At the end of 2018 (a year when the S&P 500 declined 6.2%), the index was 2,507, or a gain of 17.1% from Trump’s election.
  • At the end of July 2019, the index was 2,980, a gain of 39.2% from Trump’s election. With all the current day-to-day news that appears to be negative, stock prices have somehow continued to move considerably higher.
• As for bond prices, they continue to move higher, as the benchmark ten-year US treasury yield has declined to around 1.7% in early August from its October 2018 high of 3.15%, a very substantial move. The Fed reduced the short-term rates it controls by 0.25% at the end of July 2019, but the ten-year yield has declined much more than short-term rates have (the inverted yield curve discussed last month), apparently anticipating a slower economy going forward and further rate reductions by the Fed. With a relatively modest 2.1% gain for Q2 2019, the most recent GDP report did show that “the American economy is slowing…but there are few signs that the decade-long expansion is on the brink of stalling out” (NYT, 7/26/2019, page A1).
• When yields fall and bond prices rise, this is a mixed blessing for bond investors, since the yield is the income they receive from the bonds. At some point this cycle will reverse, with declining prices and rising income. The timing of this eventuality is very much an unknown.

What to do with this information? As our clients know, we advocate the long-term, stay-the-course approach, since timing markets is extremely difficult, if not impossible, and the allocations we recommend to clients have already taken into account the potential for declines in stock prices.

During June, stock and bond prices in the US increased. Some of the likely reasons for these increases seemed to be contradictory, but all centered on the likelihood that an economic recession may be on the horizon. A recession refers to an economy that has two consecutive quarters of negative gross domestic product (GDP) growth.

In the current economic and market environment, the bond market is signaling an expectation of a recession with ten-year US Treasury yields falling below the short-term (3-month) yield. This is called an inverted yield curve, since most of the time longer maturity bonds come with higher yields to offset the price risk of holding longer maturity bonds when rates rise. As interest rates on the ten-year Treasury have fallen since last October, the prices of these bonds have increased, adding to the investment return of bonds. This good news is tempered by the fact that interest received from these bonds has declined. The other consequence of lower rates is that at some point in time these rates will go back up, and prices will decline even as interest received increases.

The bond market is also expecting some reduction in interest rates from the Federal Reserve, after nine quarter-point increases over the past few years.  These reductions are supposed to have the impact of stimulating economic growth, assuming a recession is coming.  The Fed has taken the position that it will watch the progress of the economy to see if and when an interest rate decrease is warranted.

Other government action that can stimulate the economy would be to increase government spending and/or lower taxes. While these actions can have the negative effects of adding even more to the budget deficit and increasing inflation, they will likely be used if needed in an election year featuring President Trump running in part on his economic record.

But if a slowdown in the economy is good for bond prices, it would seem to be a negative for stock prices, because an economic slowdown presumably means more unemployment, less business activity, and falling profits, which are the main determinant of future stock prices. The current Price Earnings ratio (P/E) for the S&P 500, using twelve-month trailing reported earnings, is 22 (source: multiple.com S&P 500 pe ratio). Note that the 22 P/E is considerably higher than the long-term average P/E of 15, but this has been the case for several years now. If future earnings (the “E” in P/E) are likely to decline, stock prices would appear vulnerable. But we also know that many factors affect stock prices, and it’s possible that easing trade conflicts, a compliant Fed, and a supportive federal government can avoid and/or minimize a recession and thereby keep stock prices from declining.

None of this information comes as a surprise to the investment community, so it is up to investors to decide whether to stay the course and see whether a recession does occur, and if so how significant the decline in economic growth proves to be. The alternative is to try and time the market impact from a potential recession, by selling ahead of it and then buying back in when it ends.  As our clients know, we advocate the long term, stay-the-course approach, since timing markets is extremely difficult, if not impossible, and client allocations have already taken into account the potential for declines in stock prices.