What We’re Thinking

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.

As has been discussed in many previous Comments, interest rates (also called yields) are typically higher on longer maturity bonds, to compensate for the greater price risk associated with having to wait longer to get the initial principal back, called “maturity.” At maturity, investors can buy new bonds at then-current interest rates.

When yields on longer bonds fall below those of shorter-term bonds, the investment community labels that an “inverted yield curve”, since the normal yield curve, with higher longer-term rates, has a positive slope. This is highly unusual, but happened during the last week in March. The following chart shows the normal slope of a positive yield curve (from March 2018), and the inversion of that slope with the current (2019) slightly negative spread between ten-year and three-month Treasuries.

A recent New York Times article (NYT, 3/22/19, page B4) discussed this situation and its potential implications as follows: “[i]nvestors normally demand higher yields to buy longer-term bonds, and when those long-term yields decline it can signal a slowdown in economic growth. On rare occasions, long-term yields can actually fall below yields on short-term bonds, a ‘yield curve inversion’ in the parlance of the markets. Such unusual occurrences have preceded every recession over the last 60 years.”

The article continues by discussing the views of Duke Professor Campbell Harvey, whose research in the mid-1980s first showed the predictive power of the yield curve. “[Professor Harvey] stressed that an inversion must last, on average, three months before it can credibly be said to be sending a clear signal. If that does occur, history shows that the economy will fall into a recession over the next nine to 18 months. But even with the yield curve’s track record for predicting recessions, Professor Harvey emphasized that there was no such thing as certainty in economic forecasting. He is quoted as follows: ‘A model is just a model, it is not an oracle. It helps us the forecast future, but it might at any point fail.’”

To these observations we would add the following points:

1. Even if a recession is on the horizon, it does not necessarily mean stock prices will decline from current levels.
2. As a corollary, it is always possible that the chance of a recession is already priced into the current level of stock prices.

Most clients, when starting to use their investment portfolios for part or all of their spending, have as an objective to spend the income but not the principal. We would like to take this opportunity to discuss this objective and why it is so difficult to achieve in a low-interest rate environment.

First, some definitions:

• Income is interest on bonds/bond funds and dividends on stocks/stock funds.
• Total return is income plus or minus the changes in the value of your portfolio. During periods when stock and/or bond prices are higher, total return will likely exceed income. During periods when stock and/or bond prices are lower, total return will likely be less than income. Note also, stock and bond price changes sometimes move in the same direction in the same time frame but sometimes do not, and that stock price fluctuations are far greater than bond price changes.
• Required Minimum Distributions (RMDs) from retirement accounts are not simply income, even though they are taxed as ordinary income. They are a combination of income and principal based on the composition of the portfolio.
• Higher-yielding bond-like investments carry more price fluctuation risk than basic bonds, which is why they pay more interest.
• Annuity payouts are part income and part return of principal, not all income (a subject all its own).

Next come some necessary facts to relate to the issue of income and total return:

• Over the last 19 years (early 2000 to year-end 2018), the stock market (as measured by S&P 500 price change only), has gained a surprisingly low 2.6% annualized (S&P 500 index change from 1527 to 2507). If, however, you measure the price gain from the 2009 low (677), the annualized gain is an unusually high 14%. The ten years from 2000 to 2009 were basically flat, with two multi-year periods of very large price declines (2000 to 2002, and October 2007 to March 2009). Assume also that dividends added approximately 2% annually to stock returns over the entire 19-year period.
• As for bond prices, they also fluctuate, but much less than stock prices. Bond price changes are mostly in response to changes in market interest rates. When rates decline, prices rise, but the interest received is lower. Conversely, when rates rise, prices decline, but interest received also rises. From the years 2000 to 2009, rates declined and prices rose, and the annualized total return approximated 6% (a far better return than stocks in the same ten-year period), with at least half the return coming from interest rates and the other half from rising prices. But at some point, the rate declines stop, and that is essentially what has happened from 2010 through 2018 (with a few years of modest exceptions). Although rates have recently increased slightly, investors have been left collecting relatively little interest income (approximately 2.0% to 2.5% annually on the Vanguard Intermediate taxable bond fund), and are no longer seeing the rise in bond prices.

Putting all this information together, you can see that, over the last 19 years, annualized price gains/declines have been quite erratic, and income much more stable. No matter what your allocation to stocks and bonds, for every $1 million in total portfolio value, the annual income was likely to be no more than 2.5%, or $25,000. If the spending need from your portfolio was more than $25,000 per $1 million of capital, some of your withdrawal must have come from the principal value of the portfolio, which is fine as long as portfolios are gaining in value more than the withdrawals. Problems arise when markets and portfolio values decline, and spending is coming from income plus the declining value of the principal. The recent history (since 2000) of market price changes has indicated that there are gains to be expected, especially after periods of decline. But the periods of decline can be quite scary to people living off their investment portfolios.

We often see investors trying to earn more income from their portfolios, but there is always some tradeoff with the risk being incurred. We think it makes more sense to acknowledge that principal will likely be spent, unless your principal value is large enough to generate the spending need all from income. (For example; a $3 million portfolio could reasonably be expected to currently generate $75,000 of annual income at 2.5%. If $75,000 is the annual withdrawal needed, then the income may be sufficient).

PPA can run illustrations to show how long your funds are likely to last, spending both income and principal, based on assumed investment returns and inflation-adjusted spending amounts. Please let us know if we can be of assistance on this very important matter.

Once again, for some time perspective, we are using the chart below from our Special Comments to set out a few price points for the S&P 500 index since Donald Trump’s 2016 election (point and percentage increases calculated from November 9, 2016).  Other charts providing long-term context appear on pages 6-9.

A few comments from these figures:

• The December 24^th low was 19.8% below the September (“Summer” in the chart above) 2018 all-time high, just less than the 20% that constitutes a “bear” market;
• The recovery from the December 24^th low to the end of January has been substantial, approximately 16%;
• As for the somewhat longer view, the index is back to 25% higher for the two plus years since the election, well below the level reached in September, but not so far from the November 30^th – December 1^st

When stock prices stage such a rapid “U-turn” recovery, the normal instinct is to look for underlying reasons. For January, the financial media has focused on favorable corporate earnings, the Federal Reserve’s comments about holding off on raising interest rates, and progress on trade negotiations with China. Ignored in the explanations for this rally appear to be the US government shutdown and the ongoing negative issues surrounding the president, as well as the drumbeat of expert commentary that a recession is coming, somewhere in the world.  Note that corporate earnings reports are continuing, so the Price/Earnings (PE) ratio of the S&P 500 is in flux right now. The PE ratio gives us an idea of how reasonable stock valuations are in a particular time frame.

At Park Piedmont, we do not try to divine the reasons for short-term price movements, either up or down. Whether the events that created the 2018 September to December bear market for stocks have somehow dissipated to the point of providing solid ground for the January rally, or whether stocks are simply gyrating in a broad range to accommodate those who trade the short-term price movements of stocks, we simply do not know. We believe only the unknowable future will provide answers. Of course, this simply leads us to repeat our normal advice: try to ignore the short-term price fluctuations, develop and maintain an appropriate asset allocation for your particular needs, and hope that the historically favorable long-term results of the financial markets work in your favor.

Turning to bonds, returns were positive again in January, as interest rates on the ten-year US Treasury declined for a third consecutive month, this time to 2.63%. Comments from various Federal Reserve officials that their program of raising interest rates every three months would likely be put on hold for a while seemed to be a catalyst for driving interest rates lower and bond prices higher. It is worth noting that the full year 2018 saw four quarter-point rate increases (100 bps) from the Fed on the ultrashort rates it controls. By contrast, the ten-year US Treasury yield, set by buyers and sellers of bonds in the marketplace, increased only from 2.41% to 2.69%, an increase of 28 bps. When the ten-year rate gets close to the short-term rate, some market observers believe that is a signal for an economic slowdown.

The opposite view is that stronger economic growth is likely to continue, and with it the threat of rising inflation, which the Fed tries to limit with its interest rate policies. The debate about future rates of growth will surely continue, but for now, the allocation to bonds in investor portfolios continues to provide positive returns.

John Bogle, retired founder of Vanguard and champion of low cost index funds, passed away on January 16^th, 2019 at age 89. Two separate articles in the NY Times Business section (NYT, 1/17/19, page B1 & NYT, 1/16/19, page A23) pay deserved homage to Bogle’s contribution to the world of individual investors. The articles cite his emphasis on keeping investment costs as low as possible, and not trying to either beat the market’s long-term results or time the market’s ups and downs. These basic principles should be familiar to you as clients of Park Piedmont Advisors.

Since those articles contain many individual recollections of interactions with Bogle, we thought you might be interested in some of the history of how PPA came to be adherents of Bogle’s investment principles.  The first major influence was a book written by Burton Malkiel, a Professor at Princeton University who was a major influence on Bogle. As the title suggests, Malkiel’s book, A Random Walk Down Wall Street, took the position that the results of investing are random. As a corollary, investors should try to control what they can, which are costs and the allocation into and out of the stock market.

Along came the crash of 1987, when in one day the major stock averages declined by more than 20%. This event suggested to Vic (the only one working in the investment business at that time), that there had to be some better ideas and methods for investors to grapple with uncertainty, the tradeoff between risk and reward, and investing to meet clients’ specific long-term goals, rather than engaging in the apparently fruitless and possibly dangerous short-term trading of stocks.

After reading Malkiel’s book, and discovering Vanguard’s low-cost index mutual funds, Vic grew convinced that a sensible approach to investing could be established for families and individuals. The overall downside risk in the markets will always exist, but lower costs and appropriate asset allocations can buffer some of the downside. Thus was born Park Piedmont’s approach to investment advice. Over thirty years later, the approach is still going strong, into another generation, for which we thank all of our clients and John Bogle.

Even with no personal interaction, Bogle has been a major influence in the thinking and methodology of PPA, for which we are most grateful.  He will be missed.

Once again, for some time perspective, we are using the chart below from our Special Comments to set out a few price points for the S&P 500 index since Donald Trump’s 2016 election (point and percentage increases calculated from November 9, 2016).

A few comments from these figures:

• The December 24th low is 19.8% below the September (“Summer” in the chart above) 2018 all-time high, just less than the 20% that constitutes a “bear” market;
• The December 24th low is 12.1% below the year-end 2017 figure, and year-end 2018 is 6.2% below year-end 2017, the first significant down year for the S&P 500 since 2008;
• Note also that the recent high at the end of November (including December 3rd), which showed a gain for the year of 4.3%, was erased during December;
• As for the somewhat longer view, the index remains positive, at 15.9% for the two plus years since the election, albeit well below the levels reached in September and November.

A recent NY Times article (NYT, 12/27/18, page B1) about a particularly volatile day, when the S&P was down 60 points (almost 3%) but finished up 20 points (just under 1%), described the current climate as follows:

“Investors have struggled to find their bearings this month as the S&P 500 hurtled toward bear market territory, defined as a 20% drop from a recent high point. They are trying to assess the prospects for economic growth and corporate profits as interest rates rise and a trade war with China persists, while most recently factoring in internal White House turmoil and the President’s antipathy toward the Federal Reserve Chairman… Stock swings (aka volatility) have been larger and more frequent than at any other time since 2011. On 15 days in 2018, the value of the S&P 500 changed more than 3 percent, which did not happen at all in 2017 and on only five days in 2016. In 2011 that figure was 24 times… Traders have their own concerns with Mr. Powell (Fed Chairman) as well… Investors are concerned the Fed might not be willing to change plans for further increases in interest rates even if market turmoil persists.”

We reference this article in making some observations of our own:

• The article, to its credit, specifically links the current issues to prospects for economic growth and corporate profits. It does not, however, explain why these issues, well known for some time, became such problems during October and then again December.
• What is not mentioned is that the recent declines in the S&P 500 index have reduced the price (“P”) portion for the index, so that its P/E ratio, which reached approximately 25 during the highs of 2018, has declined to approximately 19 (http://www.multpl.com/), based on trailing 12-month reported earnings. As the P/E for stocks declines, they become more reasonably valued, unless of course the declining prices are correctly foreseeing declines in corporate earnings, which will only be known as the future unfolds.
• Does anyone remember the volatility of 2011, or the underlying events that were cited as factors back then? Note that since the 2008 decline of 38.5%, the S&P 500 index has gained in all years until 2018, except for two years (2011 and 2015) with basically flat results.
• The biggest problem with the article is the lack of distinction between investors and traders. As we wrote in our December Special Comments, ”we suspect that much of this volatility is the result of traders trading with each other, using market pricing as the measure of their daily gains and losses. This trading activity does not appear to be based on financial or economic reasons, but rather on an effort to gain from the next, often daily, market price movements… Unlike investors, traders do not have a long term perspective.”
• Our December Special Comments concluded that “We do not know when these declines will stop, and at what levels on the S&P 500. We also do not know which among the many factors cited as potential causes are the real reasons for the declines. We do continue our advocacy of appropriate allocations to stocks, and a long-term time horizon when considering what that allocation should be.”

Turning to Bonds, prices rose in December, as interest rates on the ten-year US Treasury declined for a second consecutive month, this time from 3.0% to 2.77%. This was surprising, because higher interest rates are one of the media’s main reasons for the recent stock market declines, even though stock prices had moved higher until the end of September (note: the Federal Reserve made its fourth quarter-point (1/4 of 1%) 2018 rate increase in December). One explanation is that the ten-year Treasury price is set by market participants buying and selling these bonds, whereas the interest rates the Fed controls are overnight rates charged to banks (ultra-short term), which the Fed uses to try and modulate inflation rates and economic growth.  There are times when there is a divergence in the direction between these two rates, and if the ten-year rate gets close to the short-term rate, some market observers believe that is a signal for an economic slowdown. In any event, for now, the allocation to bonds in investor portfolios is providing positive returns to offset at least some of the stock declines.

OBSERVATIONS ON NOVEMBER 2018 STOCK and BOND MARKETS

Two front page headlines from the NY Times, nine days apart, tell a good deal about November volatility, both up and down, for the US stock markets: On November 19th (NYT, 11/19/18, page A1), “Tech Stocks Dive as Wall Street Loses Gains for Month,” and then November 28th (NYT, 11/28/18, page A1), “Markets Soar on Two Words From Fed Chairman.” By the time November ended, the three major US indexes all showed modest month and YTD gains (see page 1).

NOTE:  The closing value of the S&P 500 on November 19th (as reported in the 11/19/18 article), was 2,691, and the closing value on November 28th (as reported in 11/28/18 article), was 2,744, a 2% difference. The range of high and low for the month was 2,632 (November 23rd close), to 2,814 (November 7th close), a 7% difference measured from the low. By way of comparison, 2018 has had four other months of similar or higher volatility.

We will spare you the repetition of the media’s discussions of the day to day reasons for all this volatility, and instead acknowledge that the current financial markets are likely being driven more by current events than by fundamental economics. That said, there is still no reason to change your previously established asset allocations to and away from stocks, even with all this volatility. Long term investors learn to ignore the not uncommon, and noticeable, fluctuations in stock prices.

Turning to bond prices, they were modestly higher in November, as interest rates on the ten-year US Treasury declined from 3.16% to 3.0%. This was surprising, because higher interest rates have been presented as one of the main reasons for the recent stock market declines (even though they had been increasing for much of this year, while stock prices moved higher until the end of September). The above mentioned November 28^th article provides a rationale for this situation: the Fed may be close to ending its program of increasing interest rates in the future, which presumably benefits stock prices. But, as we always point out, stock prices are impacted by many more factors than just interest rates, whereas bonds are impacted almost most entirely by interest rates.

EARLY DECEMBER UPDATE

When preparing our Monthly Comments, it is our practice to limit the discussion to the month about which we are writing.  That said, we want you to know we are keenly aware of the early December market volatility, and stand ready to write additional one page Special Comments as warranted. We note that as of the close of December 6th, after an extremely volatile day ending with a small change, the S&P 500 index is still slightly above its year end 2017 level, and its recent February and October 2018 lows.

PPA BOOK CORNER: FACTFULNESS

We recently read a book we found very interesting, with some relevance to the financial issues we work on with you. It’s called Factfulness, by Swedish physician Hans Rosling, and we encourage you to take a look if you have some time.

In the face of much bad news in the world today (financial and otherwise), Rosling seeks to provide fact-based information to counter ten “instincts”, or barriers, that he claims prevent people from acknowledging many slow, steady improvements. He uses UN data to show, for example, that extreme poverty is declining and life expectancy is increasing in almost all countries. And he offers useful advice to help us understand that while certain situations continue to be bad, they are getting better.

Chief among these barriers is the “gap instinct”, or the propensity to see the world in binary terms – us vs. them, “the west and the rest”, developed vs developing countries—when the reality is much more complicated. Rosling presents a fascinating graphic on the inside front cover of the book that plots incomes and lifespan (his surrogates for overall wealth and health) for all 195 countries across the globe. Instead of dividing the world in two, he frames almost every discussion in the book around an analysis of four basic income levels, and focuses on how almost all countries have moved up and to the right on this chart (i.e., to more wealth and better health) over the past two centuries. (See YouTube also for a fascinating video called 200 countries, 200 years, 4 minutes, which illustrates the fluidity of this phenomenon.

The next major barrier is the “negativity instinct”, which involves an often vicious cycle of media reporting bad news – war, violence, scandal—and people thinking that’s the only news out there. Rosling again urges readers to look beyond the scary headlines to data showing improvements in many areas. He presents charts of 16 “bad things decreasing”, including many diseases, hunger, deaths from disasters, and environmental toxins, and 16 “good things increasing”, including girls in school, literacy and immunization rates, “protected” nature and clean water (pages 60-63). Rosling doesn’t want to be seen as a Pollyanna, but neither does he assume the cynical tone of the eternal pessimist. Instead, he considers himself a “possibilist”, acknowledging that while much work needs to be done, much can, and already has been, improved.

The third significant barrier is the “straight lines instinct”, in which people assume that troubling trends will continue at the same rate, instead of leveling off or even declining due to changes that reflect broader improvements. Rosling’s main example here is population increases, which have rocketed upward in the past 100 years. But according to UN forecasts, these increases are expected to grow less quickly over the next 100 years, due to declining birth rates that in turn stem from less poverty, better education, and more access to contraception in lower income countries (pages 80-86). More generally, instead of projecting from just two data points, Rosling encourages the search for additional data that might reveal the real long-term trend.

Rosling also addresses a number of relevant financial issues in the context of other barriers. Related to the “fear instinct”, he criticizes the media (page 104) for its often short-term thinking and scare tactics, a view PPA shares often in our monthly commentaries. Rosling provides a useful distinction between perceived risk (or fear) and real risk, which he calculates as danger multiplied by exposure (page 123). This is a helpful way to think about balancing risk and return in your portfolios, specifically by raising or lowering your allocation to stocks (i.e., adjusting your exposure to the “dangerous”, or most volatile, part of the markets). In his discussion about the “urgency instinct”, Rosling explains how we tend to focus on present risks (e.g., daily or monthly ups and, especially, downs in the markets) as opposed to future risks, such as not saving enough for retirement (page 228). He also encourages going beyond a single estimate (page 231), and instead testing at least three scenarios when making projections (e.g., expected, better, and worse), which PPA typically does with your retirement illustrations. And in terms of specific thoughts on investing, Rosling discusses the “destiny instinct” in encouraging investors not to dismiss opportunities in poor but growing parts of Africa, Asia, and South America (page 167). This might lead to an additional allocation to “emerging market” or even “frontier market” stock funds for the international stock part of your overall portfolio.

Sadly, Rosling died in 2017 (his son and daughter-in-law finished the book and continue his work). But his writing inspires an infectious enthusiasm for his wide-ranging interests, and we greatly appreciate his concluding plea for humility and curiosity: be humble in the context of a growing, uncertain world, and remain curious about other people, ideas, and possibilities for improvement.

During October, US and international stock prices fell sharply, although US stocks continued to outperform international for the year. These Comments will discuss mostly US stocks (we discussed international stocks last month).

Using the S&P 500 as a proxy for US stocks, the chart below shows results since Trump’s election in early November 2016, through the end of October 2018. (This chart also appeared in our recent October 24th special memo.)

These figures tell us that even after accounting for serious declines in February and October 2018, US stock prices are approximately 2% higher than year-end 2017, and a very substantial 25% higher since November 2016. Even with all the problems that the media is quick to highlight on down days, US stock prices have gained 25% in the past two years. For much of that time, the markets have known about and been dealing with most of these problems.

The more significant issues regularly cited in the media include “President Trump’s trade war with China; the Federal Reserve’s stated plans to keep raising interest rates; signs that labor and other costs could climb; slowing growth in Europe and China; and the tax cuts that increased growth in profits this year will not have the same year over year effect in 2019” (NYT, 10/31/18, page B1).

What follows are Park Piedmont’s (PPA) observations about these issues. The overriding question here is: why did dramatic stock price declines occur in October, after reaching new highs over the summer, since so much of this news has been known for many months?

1. Higher Interest Rates: The US Federal Reserve has raised the short-term rates it controls by 25 basis points (bps) three times this year. In 2017, there were also three increases of 25 bps. As the chart on page 1 indicates, ten-year US Treasuries yielded 2.45% at the end of 2016. Through 2017 and 2018 year to date, there have been six quarter-point increases. The ten-year Treasury could yield 3.95% to cover all six increases, but it currently yields 3.15%, well below that rate.  Taking a two-year view of interest rates, we see they haven’t risen as quickly as they could have.  This is barely discussed in the popular media.

   The Fed raises rates when it believes the economy is growing too quickly, with the objective of heading off inflation before it takes hold. But most people like a growing economy, which supports more employment, more wage growth, more consumer spending, more home purchases, more business investment, and more business profits. Fed rate increases are therefore not too popular.  But at some point, the rate increases take hold and the economy does slow down. That in turn reduces employment, along with the rate of rising wages, consumer spending, home construction, and business investment and corporate profits, which in turn has an adverse impact on stock prices.  If the stock market was predicting all this in last month’s price declines, the question is why did it take until October?

   Another consequence of higher interest rates is that they make investments in bonds more attractive, because investors receive the benefits of the higher rates as existing bonds mature.  When bonds become more attractive, there is some reallocation of investor money away from stocks.

   Higher interest rates also create a stronger US dollar, which has adversely affected a number of emerging market countries that borrowed money in dollar-denominated loans, and now have to find a way to pay the loans back with more expensive dollars.

2. Tariffs and “Trade War” with China: The Trump administration has decided that it is in America’s interests to reduce the trade deficit with China, and to get China to stop stealing technology secrets. To further these policies, the US has imposed tariffs on many goods coming from China, which effectively raises the price of those goods, reduces demand, and, presumably, overall economic activity. China has reacted with its own tariffs on US goods, but is apparently more adversely affected than the US, because its stock market has been down as much as 20% during 2018. This issue has been going on for months, and the media constantly references it as a reason for down days. But how then to account for the up days, and a 10% market gain in the US through the end of September 2018.
3. Increasing Budget Deficits: The Trump administration has also been successful in pressing Congress to pass large tax cuts that primarily benefit large businesses in an effort to stimulate growth in the US economy. With lower tax collections, the US budget deficit has increased substantially, which means more borrowing is necessary by the US government. The proponents of tax cuts take the position that the economic growth will eventually add to the taxes collected, by virtue of more and higher wages for individuals, and more profits for corporations. There are many sides to this question, but why would this be a reason for October’s declines, since it too has been known for many months?
4. Higher Wages Potentially Reducing Corporate Profits: This may be, but these same higher wages create more demand for businesses, and the opportunity to earn more profits. And the same question about why this factor should have been discovered in October remains.
5. Other Political Issues: It is very difficult to factor these in as causation for October’s declines, as they have been ongoing since Trump took office. And as our chart on page 2 indicates, US stocks are up 25% in the two years since Trump’s election.

As we have consistently maintained in many of these Comments, causation is difficult to attribute and even more difficult to prove, with so many factors affecting stock prices. Comforting as it might be to offer explanations for difficult times like October, we at PPA have no answers as to the day-to-day (or even month-to-month) swings, particularly since the next day the markets are just as likely to reverse course as to continue in the direction they were going.

In other words, volatility is a two-way street; note that on October 29^th, the S&P 500 had an intraday range from high to low of 100 points (almost 4%), which corresponded to a 900-point range on the Dow Industrials (also almost 4%). When this volatility strikes the markets, we re-emphasize our advice to think as long-term investors, with a time horizon of years. If you do need money from your portfolio, it is highly likely to be available from the sale of bond funds, which we recommend as part of most client allocations as a buffer against the inevitable times when extreme volatility affects the stock market.