What We’re Thinking

During the month of June, it was announced that General Electric’s stock would be dropped from the Dow Jones Industrial Average (DJIA) of 30 large company stocks. For those of us who remember GE as the largest company by market value in the stock market, this was shocking news.  The stock that people had been told never to sell had fallen so far in value that it no longer warranted being included in the DJIA. But what is the real significance of this event in 2018?

To answer this question, we thought it would be helpful to review the subject of investment indexes, since Park Piedmont Advisors (PPA) uses index funds for most of our client portfolio investments.

The stock market has many indexes that can be invested in using exchange traded funds (ETFs) or mutual funds, and we will discuss the main indexes below. The most popularly cited index in the financial media is the aforementioned DJIA. Started in 1896 with twelve stocks (the only stock that remained in the index from back then was GE), it has grown to include thirty large company, US-based stocks.  The ten largest stocks (measured by market value, defined below) in the DJIA  (as of June 26-27, 2018) are Apple; Microsoft; Johnson & Johnson; JPMorgan Chase; Exxon-Mobil; Chevron; Walmart; Intel; Visa; and United Healthcare.

The DJIA calculates its daily value by taking the sum of the price per share of all constituent companies, then adjusting with a factor that accounts for stock splits and stock dividends. Daily changes in the index are impacted most by the price of certain high-priced stocks. The stocks with the biggest impact on the value of DJIA are the highest-priced stocks. The current top ten are Boeing; Goldman Sachs; United Healthcare; Home Depot; 3M; Apple; McDonalds; IBM; Caterpillar; and Visa. Note that eight of the ten highest-priced stocks are not among the highest in market value.

This focus on price explains why GE was dropped from the index, since its price went as low as $12.61 during the past twelve months (see NYT, 6/19/18, page B2). Notwithstanding this odd methodology in measuring its value, and the fact it only contains 30 stocks, the DJIA is a popular and highly referenced measure of the price changes of the overall US stock market.

In contrast to the DJIA is the S&P 500 index, which contains approximately 500 stocks, making it far more diversified. The S&P 500 uses market value to weight the daily changes to its value. Market value is derived by taking the price per share (constantly changing in the financial markets, and easily obtainable) and multiplying by the number of shares outstanding of the company. The ten largest stocks in the S&P 500 index are Apple; Microsoft; Amazon; Facebook; Berkshire Hathaway; Johnson & Johnson; JP Morgan Chase; Exxon Mobil; Alphabet (Google) A and C.  So, five of the ten largest stocks by market value in the S&P 500 are not included in the DJIA. Apple, as the largest stock in the S&P 500, valued at $900 billion, represents only 4% of the overall value of the index (which comes to approximately $23 trillion at current values). The top ten stocks represent approximately 20% of the value of the index. GE is still large enough by value to remain #40 in the S&P 500, but is only 0.5% of the index value, making it no longer a meaningful component.

The other major US index is the NASDAQ Composite, which is very popular these days because of its emphasis on technology stocks. The top nine stocks by market value are technology-related (counting Alphabet/Google as two), namely Apple; Amazon; Alphabet A and C; Microsoft; Facebook; Intel; Cisco; and Netflix. The total current market value of these stocks is $4.3 trillion, or approximately 40% of the current total index value of $11.6 trillion.

There are also investable indexes for the Total US Stock Market, which tracks between 3,000 and 5,000 large, medium and small cap stocks, contained in all the indices mentioned above, and which represents all US stocks, with a current total value of approximately $30 trillion. One of the funds based on this index (the Vanguard Total Stock Market Admiral Index fund, symbol VTSAX) is a core investment for PPA and its clients.

Other core index investments used by PPA include Developed International (Vanguard fund symbol VTMGX) and Emerging Market International (Vanguard fund symbol VEMAX). VTMGX tracks approximately 3,800 stocks of companies in Europe (52%); certain Pacific region countries, dominated by Japan (38%); and Canada (8%). The ten largest stocks represent 10% of the index, including Royal Dutch (two classes); Nestle; Samsung; HSBC Bank; Toyota; Novartis; BP Petroleum, and Total Petroleum.

Interestingly, Chinese companies are still categorized as emerging market, so the VEMAX fund is dominated by China (20% of value is in Chinese companies, followed by Taiwan with 12% and India with 7%). VEMAX tracks approximately 4,000 stocks, and the largest ten represent approximately 18% of the index, including Tencent; Alibaba; Taiwan Semiconductor; Naspers; China Construction Bank; Taiwan Semiconductor Manufacturing; Industrial and Commercial Bank of China; Badu; and China Mobil.

There are also hundreds of sector index ETFs and mutual funds, allowing investors/traders to focus on specific parts of the overall stock market. In PPA-managed portfolios, we sometimes use a biotechnology stock index fund (symbol IBB) and a real estate investment trust, or REIT, stock index fund (symbol VGSLX), as these sectors are underrepresented in the broad index funds we use as core investments.  Bond funds can also be established and managed as index funds, although many large, diversified bond funds are not strictly speaking index funds.

While the end-of-June numerical value of the DJIA is approximately 24,000, the S&P 500 2,700, and the NASDAQ Composite 7,500, these figures have no bearing on the underlying value of the stocks in the indexes.  Rather, they represent the current figures of all the historical calculations that have been made to arrive at daily changes in value. Most media tend to focus on numerical changes to the indices’ values.

However, rather than focusing on the numerical value, the focus should be on the percentage change in the indexes over whatever period of time is being measured. For example, a 27-point change in the S&P 500 is 1%, while a 200-point change on the DJI is about 0.75%, and a 50-point change in the NADADQ is 0.67%. Note also that all the charts on the last two pages of each Monthly Comments use these three indexes to represent changes in the stock market.

With all this as background, a question arises: why not just invest in the high flying NASDAQ index? The answer comes back to the story of GE. No company or group of companies stays on top forever, even though at the time of their ascendancy it appears that way. The so called “Nifty Fifty” of the 1970s, starring Xerox and Polaroid, and the bankruptcy of General Motors, along with the example of GE, tells us that at some point even the most valuable companies can see their earnings slow down, competitors outperform, or regulatory issues impede growth, in addition to other concerns that may cause the stock price to decline.

At PPA, we prefer investing in the broadest and most diversified indexes, with a few sectors sprinkled in, to avoid the serious declines that can accompany a fall from favor of a few high flyers. In doing so, PPA accepts that it will not outperform the market by emphasizing the current high flyers, but rather should earn the returns provided by the broad-based, market-tracking index funds we use on behalf of our clients.

In our July 2017 Comments, we wrote that….”following Donald Trump’s surprising presidential election victory, the major US stock market indices have registered their own surprising gains, with the S&P 500 increasing from 2,140 on election eve 2016 to 2,470 as of the end of July 2017, a gain of 15.4 %. Without taking any position on the current political situation in the US (other than noting its extremely adversarial nature), many financial observers and investors are wondering how/why stock prices remain at or near all-time highs.”

In these May 2018 Comments, we revisit this same question of why stock prices have remained well above their post-election levels (from 2,140 to 2,705 as of May 31, 2018, a gain of 26%, even with a decline of 6% from the January 2018 all-time high of 2,873), although political dysfunction over serious domestic and global issues seems to be rising. The Economist Magazine makes an effort to explain what is happening:

“Most American elites believe that the Trump presidency is hurting their country. Foreign policy mandarins are terrified that security alliances are being wrecked.  Fiscal experts warn that borrowing is spiraling out of control. Scientists deplore the rejection of climate change. And some legal experts warn of a looming constitutional crisis. Amid the tumult there is a striking exception.  The people who run companies have made their calculations about the Age of Trump. On balance they like it. Bosses reckon that the value of tax cuts, deregulation and potential trade concessions from China outweigh the hazy costs of weaker institutions and trade wars. And they are willing to play along with President Trump’s home-brewed economic vision, in which firms are freed from the state and unfair competition, and profits, investments and, eventually, wages soar. The financial fireworks on display in the first quarter of this year suggest that this vision is coming true.  The earnings of listed firms rose by 22% compared with a year earlier; investment was up by 19%. But as our briefing explains, the investment surge is unlike any before – it is skewed towards tech giants, not firms with factories.  When it comes to gauging the full costs of Mr. Trump, America Inc. is being short sighted and sloppy.”

Note that our purpose in citing the Economist article is to provide some of the current rationales for stock prices remaining at favorable levels in spite of all the political turmoil. We are not presenting the remainder of what becomes a critical article on many of the Trump policies, because this would be beyond the scope of these Comments.

Note also that as these Comments are being written, governmental shifts in Italy and Spain, and the imposition of various tariffs by the US, have given rise to further concerns. These concerns have cited as reasons for one-day stock price declines, but generally they have been followed by one-day recoveries of similar amounts.

Returning to our July 2017 Comments, which quoted Jeff Sommer’s article in the Sunday NY Times Business section  headlined “Political Strife is High, but the Market Doesn’t Care”: “The US is so sharply divided that political consensus appears to fray almost daily. Yet two truths about politics can be demonstrated with hard numbers. The first is that partisan conflict doesn’t just seem to have become more intense this year: It has actually reached new levels of nastiness. The second is that the stock market doesn’t care. In fact, the rising acrimony has been a fine environment for stocks, though possibly detrimental to the economy itself.”  The article concludes that “even in the era of Big Data, some mysteries have not been unraveled with numbers. Right now, the sublime indifference of the stock market (to partisan political conflict) is one of them.”

The July 2017 Comments also presented historical information of troubled presidencies and the levels of the S&P 500 index during those periods. These figures come from a June 2017 “Clients’ Corner” article by Nick Murray, a well-known commentator on investments and advocate for investing in stocks for the long term:

1. Nixon fires Watergate Special Prosecutor, October 20, 1973; S&P 500 closed at 109
2. Carter’s 100^th day in office, end of April 1977; S&P 500 closed at 100 (the Carter presidency “encompassed the second of two huge oil shocks, runaway inflation, and a deep recession.”)
3. Vote on Clinton’s impeachment, December 19, 1998; S&P 500 closed at 1,203
4. US government shutdown during Obama administration, October 1, 2013; S&P 500 closed at 1,695
5. Trump election, November 8, 2016; S&P 500 closed at 2,140; July 31, 2017 close at 2,470

Murray also points out the following record of stock and economic results:  “Over this almost 71 year period (1946 to the 2016 election), the S&P 500 stock index has increased from 15 to 2,140, not including dividends, which have increased from 71 cents to $45, while US GDP has increased from $2 trillion to nearly $17 trillion.”

Murray concludes with the following statement: “If history is any guide, rational capital ultimately outlasts irrational presidencies. And that fleeing capital markets in reaction to distressing political events has in the past never proved to be a lastingly successful investment policy.”

Murray seems to be advocating ignoring the political turmoil, since the historical record shows recoveries over lengthy time periods. We would repeat our comments from July 2017: (1) the 44 years from Nixon’s S&P 500 level of 109 to the current 2,470 comes to an annualized gain of 7.35% (excluding dividends), a reasonable but not extraordinary return; and (2) stock price increases do not occur in a steady, straight line. For instance, in March 2009, at the low point of the stock market after the financial crisis and Great Recession of 2008, the S&P 500 index fell to 677. This decline, from the then previous all-time high of 1,527 during the first quarter of 2000, represented a 56% decline in stock prices, and also reduced the annualized return from 1973 to 2009 (36 years) to 5.2%

It is this potential for significant declines that creates concern for many investors, and which leads us to advocate prudent asset allocations, so our clients can maintain their investment portfolios through the inevitable periods of stock price declines.

Inflation refers to the declining purchasing power of money over time, caused by a general level of rising prices.  In an economy with a 2% annual inflation rate (the favored figure for the US Federal Reserve; see NY Times article cited below), items that cost $10,000 today would have cost $5,000 36 years ago, using that 2% rate. This also means that for people with life expectancies of 36 years, for every $100,000 accumulated currently, you need to have that amount grow to $200,000 just to be able to buy the same items. If inflation rose 4% per year, then prices would double every 18 years, making it much more difficult for investors to keep up (the $100,000 investment portfolio would have to grow to $400,000 just to stay even over the 18-year period). Financial markets in stocks and bonds provide a way to increase assets in excess of inflation.

It is important first to note that no investment result caused this erosion in purchasing power. Rather, central banks seem to have determined that a growing economy can absorb some price inflation, that 2% is a reasonable figure, and that zero inflation would signal an economy in recession. So it is the rising prices in the economy at large that create inflation. In a recent NY Times article discussing the possibility that years of low inflation and low interest rates may be coming to an end, Neil Irwin writes that “if this really is the start of a resetting of inflation and interest rates toward more historically normal levels, it will be mostly good news for the world economy. Central bankers have spent years trying unsuccessfully to get inflation to the 2% level many of them aim for.”

There is a close and direct connection between inflation and interest rates (and changes in bond prices, which are determined by changes in interest rates). Here’s why: a bond is a promise to repay a fixed amount of money in the future, plus interest (think of a bond as an IOU from a company or governmental entity). If the purchasing power of the money received in the future is going to be lower than when the bond was purchased (the definition of inflation), then the interest payments received must at least cover the loss of purchasing power. The interest payments then need to provide some positive investment return above the rate of interest paid to cover the inflation rate.

To put this idea into figures: if inflation is 2%, the interest you earn on your bonds needs to be greater than 2% to allow for some increase in purchasing power when the bond matures and the bond investment money comes back to you. And the longer the maturity of the bond, the higher the interest rate needs to be to compensate the investor for the current risk of future purchasing power. It is less risky to wait two years for the return of money from a bond investment than it is to wait for ten years, which is why interest rates on longer maturity bonds are higher than on short maturity bonds. And when dealing with money markets and other short-term, bond-like investments (e.g. bank CDs), whose interest rates often fall below the inflation rate, investors should be aware they are trading price stability of the investment for declining purchasing power over time.

In the current economic environment, central banks such as the US Federal Reserve (the “Fed”) set the overnight interest rates they control to accomplish a balancing act: keeping rates low enough to encourage economic growth, yet high enough to discourage too much growth, which in turn would give rise to inflation. In this context, inflation means rising prices (the same rising prices that translate into declining purchasing power). Accomplishing this balance is complex and delicate. The current Fed is trying to raise rates from the ultra-low rates in place since the 2008 recession, to more historically normal rates based on inflation of 2% (see Neil Irwin quote above). Every time the Fed raises rates by 25 bp (1/4 of 1%), the other outstanding bonds traded in the financial markets react, typically through declining prices, so that the lower interest rate associated with these outstanding bonds provides the same investment return at maturity as a newly-issued bond with a higher interest rate.  It is always unclear ahead of time how many rate changes the Fed needs to make to have the interest rate level at an appropriate place, neither too low nor too high.

The effect of inflation on stock prices is not nearly as direct as with bond prices. Higher prices often mean more profits for businesses, but higher interest rates increase their expenses. Higher interest rates also negatively impact purchasers who need to finance their large economic transactions, like buying a home or a car. Further, if inflation gets too high, many people are not able to afford the transactions at all, which has the effect of slowing down economic activity.  As Irwin writes in his NY Times article cited above, “If higher interest rates are caused by higher economic growth, that’s a dynamic stock investors would probably be fine with, in that more growth should translate into more corporate earnings. But if the higher rates are being driven by inflationary pressures, that’s a different story, and suddenly the assumptions behind sky high stock prices could fall into doubt…. In the short run, markets can be shaped by all kinds of things, whether algorithmic trading or a run of bad news for a major company or a presidential tweet. But in the longer run, economic fundamentals are powerful forces.”  What the article leaves unsaid, and what is always difficult to determine in advance of the event, is whether the higher rates are driven by good economic growth or not-so-good price inflation.

From an investment standpoint, higher rates make bonds more attractive, which could draw money away from the stock market. Irwin’s article also makes reference to this point: “After nine years of economic expansion and rising stock prices, the stock market is richly valued relative to earnings, making the earnings return on the stock market low. That low return might be tolerable when money invested in an ultra-safe Treasury bond or even in a savings account, generates very low returns,” but as those short-term rates rise, they become more attractive investments to some group of investors looking for safety of their capital, which has the potential of putting downward pressure on stock prices.

As stock and bond prices fluctuate more significantly, inflation will often be used as an explanation. An example is the recent NY Times article on jobs growth (front page, 5/5/18), discussing the low unemployment rate combined with a lack of rapid wage growth, which states that “Hourly earnings went up by 2.6% over the past year, not much faster than inflation.  The subdued wage gains eased the prospect that the Fed would accelerate its plans to raise interest rates.” In any case, inflation is and will remain an important factor in the movement of stock and bond prices.

There have been many days during the first quarter when stocks have fluctuated, either up or down, more than one percent. Some days, those fluctuations have exceeded two percent. The investment community and media refers to these kinds of large fluctuations as volatility.

We can use the major US stock indexes as illustrations:

• With the Dow Industrials at approximately 24,000, a 240 point price change is one percent, and a 480 point price change is two percent.
• With the S&P 500 at approximately 2,600, a 26 point change is one percent and a 52 point change is two percent.
• And for the NASDAQ Composite at 7,000, the figures are 70 and 140 points, respectively.

During the fourth quarter of 2017, a period of almost no volatility, there was one trading day out of approximately 65 in which prices changed more than one percent. During the first quarter of 2018, there were sixteen days with changes of more than one percent and eight days of more than two percent. (Note: these figures show changes from one day’s closing values to the next day’s closing values; they do not reflect days with large price swings intra-day that end up with modest day-to-day changes).

Even with all this increased daily volatility, for the first three months of 2018 the three indexes showed modest changes, at -2.5%, -1.2%, and +2.3%, respectively. These fairly benign quarterly results mask an approximately 11% decline for the S&P 500 from its Jan 26^th high to its February 8^th low (2,873 to 2,581). Other significant periods of decline on this index since 2000 include:

• First quarter 2000 to October 2002: 1,527 to 777; 49% decline;
• End of 2007 to March 2009: 1,468 to 677; 54% decline;
• April to September 2011: 1,363 to 1,131; 17% decline;
• May 2015 to end of January 2016: 2,131 to 1,940; 9% decline

The media provides daily reasons for these fluctuations (tariffs, budget deficits, rising interest rates, Trump’s problems), but as we wrote last month, most of the time the reasons are after-the-fact explanations for what is really unknown. The media and financial commentators make the current declines seem greater than they actually are, presenting a sense of urgency, if not emergency, to their audiences. Presumably, the more urgency, the more need to take some sort of action, which is what the media wants (keep tuning in), and the financial community wants (keep making transactions).

At Park Piedmont, we believe this incitement to action is the real downside to volatility. Briefly put, when prices fluctuate excessively, investors tend to want to react to the fluctuations, and to do something. These reactions are often detrimental to achieving their long-term investment goals.

One reaction could be to sell the stocks that are declining. History suggests this is not a good idea, because stocks tend to provide the best results compared to the other liquid investments (namely bonds and cash equivalents) over long time periods.

A significant problem investors face after selling stocks is that they do not know when to buy back into the market. Another problem is triggering capital gains taxes if selling is done in a taxable account. Note that some selling may be warranted as part of a well-developed rebalancing program, but rebalancing should not be occasioned by volatility, but should be established in advance of the periods of extreme price changes.

A second reaction is to buy more stocks at the lower prices, assuming the volatility is to the downside. This may or may not turn out to be a good idea based on what happens to stock prices going forward.  Noting the extent and length of time for some of the periods of decline shown above, this can be a nerve-racking strategy.

Finally, there is the decision to stay the course and rely on the allocation developed in more tranquil times, which allows investors to essentially ignore the short term volatility. This is of course our view, presented consistently over time. But the decision to stay with, or abandon, investments when they are experiencing sharp price declines involves more than objective factors, which is what makes the volatility so dangerous.

In terms of the causes of volatility, we do not believe the frantic daily buying and selling is being done by longer term investors. Rather, we think much of the volatility is the result of traders who use the stock market as a way to make short term bets. These bets have nothing to do with economics, or politics, or finance, but are simply guesses as to where the next price movement will occur. The volatility these traders generate can lead to inappropriate actions by those trying, instead, to use the stock market as a way to grow their money over time.

In our March 2016 Comments, we referenced an article in the “Your Money” section of the NY Times, written by University of Chicago Professor John List. His general point was that, because of loss aversion (defined in detail below), people underinvest in the stock market. They look at their investments too frequently, and when they see declines, they sell their stock positions to avoid further declines. This behavior occurs even though people are aware of the long-term outperformance of stocks.

As List notes, “[m]arket research shows that when your horizon is not today, not next week, but way in the future, the most profitable strategy is to invest more heavily in riskier assets – stocks – than people are prone to do. So why don’t people invest more in stocks? … Because people are loss averse… keenly more aware of losses than comparable gains… So what can be done? Not paying too much attention to your portfolio is a good first step…” More specifically, List’s advice – which he says he follows – is to look at one’s portfolio no more than once every three to six months. (We might ask the Professor: what is the point of checking even that often?)

We think Professor List’s main point is correct. We would add that extreme volatility leads to investors looking at their portfolios much more frequently than is beneficial to them. In the long term, economic growth rates and corporate earnings are the most important drivers of stock prices. They are not a day-to-day story, but play out over extended time frames, which aligns with the preferred, longer-term timeframe for most investment portfolios.

In sum: try to ignore the market’s volatility, as it is likely to lead to thoughts of making (typically unnecessary, often counterproductive) changes. These changes are unlikely to benefit your long-term investment results.

This month’s Comments provide current examples of an important point we have made regularly in the past: no one really knows the causes for stock prices and their sometimes dramatic changes.

Current case in point: from Friday, February 2^nd through Thursday, February 8^th, covering only five business days, US stock prices (S&P 500), declined by approximately 9% (2,832 to 2,581, a 251 point decline).  The reason given by the media, and other nominal experts, was that likely coming inflation and accompanying higher interest rates were bad news for stock prices (we know they are bad news in the short run for bond prices as well).

But then what happened from February 9^th to 14^th, over four business days? The S&P 500 regained approximately 4.5% (2,581 to 2,699, a gain of 118 points), even as the economic reports continued to show higher inflation and higher interest rates (along with continuing lower bond prices).

How can stock prices decline in one week, and gain in another week, with the same stated reason for the price changes?  Since that is not logically consistent, there must be some flaw in presenting the cause in the first instance. Our view at Park Piedmont is that causation of stock price changes is extremely difficult to pinpoint, and even when there is widespread agreement as to a reason, the conventional wisdom is often wrong.

A second, more recent example covered four business days between February 28^th and March 5^th. On the 28^th, President Trump announced, surprisingly, the imposition of tariffs, going against most conventional economists who typically oppose tariffs. Stocks proceeded to fall approximately 1.5% (2,714 to 2,678 on the S&P 500), and the media and other pundits were sure tariffs were to blame. Three days later, stock prices were higher (at 2,721) than the day before the decline, and tariffs were still to be imposed.  Then Trump’s economic adviser Gary Cohn resigned over the tariffs on March 6^th, and the pundits predicted serious declines due to that event. But there were no declines at all. Events that the media claim as causation for falling stock prices are often incorrect. And, at times, the predicted events do not even occur.

To show this is a common occurrence in media reporting, remember back to Trump’s most surprising election victory, and our Comments (October 2016) at that time:

An excellent example of the “herd mentality” related to the certainty of significant declines appeared in the NY Times on election day (11/8/16, page B1), in an article titled, “What the Election’s Results Will Mean for the Markets,” by highly respected financial columnist Neil Irwin. The article begins: “What will happen to financial markets after the election? More so than usual, we have a decent idea. That’s because there has been a clear and identifiable swing in a variety of asset prices – especially the stock market and currencies – at inflection points in the presidential race. A stock market rally on Monday is the latest evidence, and appears to be linked to the FBI announcement that an examination of newly discovered emails tied to Hillary Clinton revealed nothing warranting charges.”

And in a post-election NY Times article (11/11/16, page B1), James Stewart, another well-respected financial columnist, wrote: “To the long list of pundits who called the election all wrong – as well as its consequences – add Wall Street analysts.” He cites predictions of 11-13% declines, and 2,000 points on the Dow (approximately 11%), and observes that “with the benefit of hindsight, what’s extraordinary is how few professional investors saw it coming. Trump was derided as the candidate of uncertainty, which markets typically abhor…. But there was nothing uncertain about his overall pro-growth, pro-business and American-first tendencies, now backed by the firepower of a Republican House and Senate.”

To us at Park Piedmont, this simply reinforces the absolute futility of making predictions. This is not to pick on Mr. Irwin or the NY Times; it’s simply to illustrate, once again, the real problem that we as consumers of financial information face. We are unable to distinguish between what does and does not make sense, even in well-written articles by presumed experts.

Reviewing some of the key points we made in our March 2017 Comments, we reiterate the following:

• The factors that move stock prices are many and varied. In our view, there is no way to explain day-to-day stock price movements with any one or two explanation points (e.g., Trump’s economic legislation agenda under attack). If that’s the case, then why does the media find it necessary to report on the markets as though they were a single sporting event, providing an often incoherent narrative (e.g., a slow trading day suggests that portfolio managers acted earlier in the week)?
• There is no way a Times reporter – or any reporter, for that matter – can accurately “know” what “investors” are thinking, and what makes them act, and report as if the claim is accurate. The results of any day’s stock price movements are the results of the activity (and inactivity) of many thousands of market participants – professional and amateur, traders and long-term investors. Who could possibly know what ideas are moving each of them to do what they do each day, let alone report on the “market” as though it’s an independent entity with its own intentions?
• It’s also hard to understand how the media can report that one day such-and-such-a-factor caused the market to move in one direction, and the next day, when prices move in the opposite direction, report that investors ignored the factor so essential the day before.
• Bad news is almost always emphasized, which tends to make people nervous and more likely to change their investments, rather than act as long-term investors with a time horizon of years, not minutes. Bad news may sell more newspapers, but emphasizing bad news can lead to adverse results by suggesting to investors they should take action in light of the news, rather than taking the longer-term view. Much of the investment literature supports the view that the fewer changes made to a portfolio based on reacting to current news items, the better the long-term outcome.
• Market reporters feel the need to infuse an article about market activity with explanations. Humans like stories; we at PPA are no exceptions! But rather than report the reality, which is that prices change day-to-day for many reasons, none of which are clearly or independently verifiable, at least most of the time, a narrative develops as an after-the-fact explanation of events.
• In the long term, economic growth rates and corporate earnings are the most important drivers of stock prices (mentioned ever so briefly in some of the daily reporting above). They are not a day-to-day story, however, and are difficult to capture in daily reporting. Instead, they play out over extended time frames, which aligns with the preferred, longer-term timeframe for most investment portfolios.

In sum: try to ignore most of the media’s day-to-day reporting on market activity, as it is likely to lead to thoughts of making (typically unnecessary) changes, and therefore unlikely to benefit your long-term investment results.

As stock prices continue their recent sharp fluctuations, mostly to the downside, we are writing again with more information (research from Guggenheim Investments), to present a long term perspective.

From year-end 1945 to year-end 2017, covering 72 years and using the S&P 500 index (note: S&P 500 index and Dow Industrial average often have similar percentage price changes), there have been:

1. 77 declines (approximately once a year) of 5-10%, with an average decline of 6%, covering one month and taking one month for the declines to recover to the price level at the start of the decline;
2. 27 declines (approximately once every two to three years) of 10-20%, with an average of 14%, covering four months, with four months for the declines to be recovered;
3. 8 declines (approximately once every nine years) of 20-40%, with an average of 27%, covering eleven months, with fourteen months for the declines to be recovered;
4. 3 declines (approximately once every twenty four years) of more than 40%, with an average of 51%, covering twenty-two months, with fifty-seven months for the declines to be recovered.

The current decline on the S&P 500 (to 2,581 as of the close on February 8th) has now reached 10.2% from its January 26th all-time high of 2,873 (the Dow Industrials have gone from a January 26th high of 26,617 to a February 8th close of 23,860, a decline of 10.4%). Which of the above categories the current decline will eventually fall in is as yet unknown, and this represents the risk associated with stock investing.

The media and financial pundits try to attribute reasons for the declines, such as: (A) an economy that is doing so well that it may cause the Fed to raise interest rates to a level that negatively affects stock prices (see our January 2018 Comments for more on this subject), or (B) traders using highly leveraged products based on volatility, or (C) some other rationale designed to fit the event after the fact.

But perhaps the reason for these declines is simply that stock prices had gotten too high.

To elaborate, the last significant decline before this one (Jan-Feb 2016) reached 11%, and was followed by two years of extraordinary gains. At the January 26th, 2018 high, the S&P 500 index had advanced from 1,829 to 2,873, a gain of 57% (the Dow rose from 15,660 to 26,617, a gain of 70%).

Finally, note the impact of asset allocation: for younger clients not currently using their money, an allocation of 70% to stocks means 30% is not affected by the stock declines, and for older clients who might currently be using their money, a 35% stock allocation means 65% is not affected by the declines. An important part of our work at Park Piedmont Advisors is to develop and follow allocations designed specifically for each of our clients.

Last month in our discussion of interest rates, we stated that ”one major interest rate story for the year 2017 deserves additional comment:  the fact that while there were three one-quarter point increases in the short-term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%.”  One month later, we see the ten-year yield at 2.71%, a substantial 30 bp rise in one month, clearly indicating that the buyers and sellers of bonds believe interest rates are on the rise. The question now is how much further rates will rise, and the speed at which they do so. As discussed below, a long, drawn-out rate increase should have less negative impact on portfolios by reducing the short-term price declines and thereby allowing the higher rates to offset the lower prices more quickly.

More generally, when interest rates rise, bond prices fall, with more price impact on longer maturity bonds.  The tradeoff, as we wrote last month, is that investors owning longer maturity bonds typically earn additional income in return for their willingness to absorb larger price declines in the bond portion of their portfolios, compared to the smaller price declines that occur with shorter-term bonds that pay less interest.  These bond price declines, should they occur, are typically modest compared to the extent of potential stock price declines, and bond price declines are offset in part over time by the higher interest received.

This brings us to the discussion of how interest rates impact stock prices. Our first observation is that the connection between interest rates and stock prices is far less clear than the direct impact of interest rates on bond prices.  Stock prices are affected by a host of factors, such as the pace of economic growth, expectations of corporate profits, and investor psychology as to the likely future direction of market prices. Interest rates therefore are but one of a number of factors to consider in relation to stock prices.

When economic growth is strong, and corporate profits are increasing, it makes sense for stock prices to rise.  But if growth becomes too strong, the Federal Reserve typically raises interest rates in an effort to slow the growth down and avoid (or at least mitigate) the harmful effects of inflation. How does this work in practice? Higher interest rates can slow economic growth by raising the cost of borrowing, which in turn tends to slow spending and reduce corporate profits. In the financial markets, when rates rise, bond prices fall and interest rate payments increase, setting the stage for potential stock price declines, as bonds become a more attractive investment.

The key point to recognize is that in the liquid markets, stocks and bonds compete for an investor’s accumulated savings. Stocks represent an ownership stake in a company’s future profits and offer the potential for significantly higher appreciation (see the period from 2009 to the present), even with significantly more downside risk (see 2008 through March 2009).  Investment returns from stocks come from price appreciation (or depreciation) and dividends.  Bonds, on the other hand, are a promise to repay a set amount of money in the future, plus interest, and the investment return comes mostly from the interest, with modest price changes (depending on the maturity) until the bonds mature.

When interest rates rise in the marketplace, and bond prices decline, this creates an opportunity for a flow of more income from the higher interest payments, and some number of investors become more likely to reduce their riskier stock holdings and increase the steadier bonds now paying more interest.  This provides a rationale for stock price declines even in the face of strong economic growth and strong profits.  Of course, how much the prices decline and for how long are always unknowns.

This brings us to a recent “Opinion” article by Professor Burton Malkiel (author of the many editions of “A Random Walk Down Wall Street) on “How to Invest in an Overpriced World”. The article begins by stating that “all asset classes appear overpriced;” bonds because of their low yields and stocks because of their historically high price earnings (P/E) ratios. “Investors have reason to worry, but they need to be aware of two basic facts.  First, no valuation metric can dependably forecast the future…. A corollary is that no one can consistently time the market… which involves two decisions, when to get out and when to get back in.  Timing both correctly is virtually impossible.”

Malkiel continues by discussing two strategies that can control risk, namely broad diversification and rebalancing. “Broad diversification…. By holding a wide variety of asset classes, investors have historically enjoyed smoother gains during bull markets and gentler losses during bear markets. In a diversified portfolio, declines in stocks are often partially offset by stability in fixed income markets…. Real estate equities, available through REITs, have also tended to stabilize portfolio returns…. Internationally diversified portfolios, including emerging markets, also tend to see less volatile returns over time and better risk adjusted performance.” Additionally, “Rebalancing helps control risk by ensuring your asset allocation has not strayed far from your desired levels. If the strong US stock market has lifted the proportion of domestic stocks in your portfolio to levels that are riskier than desired, it would be appropriate to reduce your equity share…. In general, staying the course in a broadly diversified portfolio is the best strategy when all asset classes appear overpriced.” He then suggests REITs and higher-yielding preferred stocks as potential replacements for positions sold while rebalancing.

The article closes with the advice to keep costs low, and avoid paying one percent for the investments and an additional one percent for the advice. He “recommends passive index funds and exchange traded funds, now available at virtually zero expense ratios, as the best investment vehicles for all investors.”

At Park Piedmont, we are advocates of Professor Malkiel’s advice, and recommend a broadly diversified mix of short and intermediate maturity bonds, along with high yield investments, and a mix of US (including REITs) and international/emerging market stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds and ETFs. Periodic rebalancing, a fiduciary relationship with our clients, and advisory fees at the low end of the profession’s fee schedules have all been key aspects of our work on behalf of our clients since our founding some fifteen years ago.

Whenever stock prices experience large short-term declines, we make sure to check in with you to put the declines in perspective. The chart at the bottom of this memo provides figures that should help.

1. The media likes to present large numbers in its reporting, but the focus should always be on percentages. Using end of January 2018 price levels, a 1,000 point decline in the Dow is less than 4%. This is comparable to a stock you own going from 100 to 96, a change you might not notice that much.
2. Since the end of 2014, there have been two periods (August 2015 and Jan-Feb. 2016) of declines of 12%, which would be 3,000 points using the end of January 2018 price levels. Do you even remember those periods?
3. Stock prices have had very large gains since the 2016 election, up approximately 7,800 points to the end of January 2018, which was a 42% gain since the election. Even with the declines of the last two weeks, stock prices are close to year-end 2017 levels.
4. Some kind of stock price correction has been anticipated for many months now, as prices kept going higher. How much stock prices are likely to decline, and for how long, is of course in the realm of the unknown, although the media and the financial community will certainly provide their guesses.
5. Note that stock prices have gone up in periods of both increases and declines in 10-year Treasury yields. These yields have increased significantly since the end of 2017.

 Stock Index % Changes, and US Treasury % Changes

End 2014 to Feb 5, 2018 (Using end 2014 as base year)

Our general advice to firm clients is to stay the course, avoid attempts at market timing, and rely on asset allocation (specifically, the percentage of one’s portfolio not invested in stocks) to soften the extent of the declines.