What We’re Thinking

As stock prices continue their sharp October declines, we are writing to follow up on our October 10-11, 2018 Special Memo, which also discussed these declines. This memo uses the S&P 500 as a proxy for the US stock market, which closed today, October 24, at 2,656. We highlight a few price points for that index since Donald Trump’s surprise 2016 election.

These figures indicate that even with the October declines so far, the index remains substantially positive for the almost two years since the election; still higher than the February 2018 lows; and less than one percent below year-end 2017. Note also that interest rates (ten-year US Treasuries), an oft-cited reason for these declines, are actually lower now than when the serious declines started on October.

Some other observations, expressed regularly in our Monthly Comments:

• There are no guarantees stocks will consistently move higher. Instead, history tells us there can be periods of significant decline, for all sorts of reasons, and the real questions are how long the time period, and the amounts of the declines. History also suggests stocks provide better long-term results when compared to other liquid investments
• Trying to time when to be in and out of stocks cannot be done consistently over time.
• Allocations to bonds and cash equivalents provides a defense against stock price volatility. For example: A 50% allocation to stocks means whatever the percentage decline, your portfolio should be down only half that amount.

Please feel free to contact your us for additional conversation.

As is our practice when US stock prices experience significant declines, we write to comment on what we think is happening. The declines of October 10th were as follows:

S&P 500, down 95 or 3.3%; Dow Jones, down 832 or 3.1%; NASDAQ, down 316 or 4.1%.

We suggest putting the declines in the context of recent gains, in this case measured from 2018 highs and year-to-date (YTD) 2018 gains:

Much of the media commentary on the reasons for the declines centers on rising interest rates, but October 10th actually saw a small decline in the ten-year US Treasury benchmark. This makes us wonder why this particular day saw such a sharp stock selloff. That said, there has been a significant rise in the benchmark rate since year-end 2017, from 2.4% to the current 3.2%. During most of this period, stock prices have in fact been rising.

Further, stock returns so far this year continue to be better than bond returns, which are modestly negative because of the rising rates. However, bonds have a self-correcting mechanism when rates rise, as the additional interest earnings substantially offset the price declines over time.  The issue with stocks is that they have no such mechanism; stocks can suffer serious short-term declines that might not recover any time soon, and can therefore create doubt and unease in the plans of otherwise long-term investors. Which brings us to our constant refrain: Your asset allocation, i.e., the percentage mix of stocks and bonds, is the main defense against the unpredictability of stock price volatility.

Our advice, as usual, is to stay the course with your established allocation, designed to allow you to withstand unsettling short-term price declines.

While US stock prices have continued to rise, international and emerging stock markets have had a difficult year.  These markets are used by investors to provide global diversification for their portfolios. The results for the last few years, and 2018 year to date are as follows:

Some key characteristics of these market sectors are as follows:

Developed International (represented by Vanguard Developed Markets Index fund, VTMGX):

Regions: Europe 54%, Pacific 37%, North America 8%

Countries: Japan 22%, United Kingdom 14%, Canada 8%, Germany 8%, France 8%; Top 5 = 60%; Top 10 = 83%;

Companies: Nestle 1.3%, Samsung 0.9%, Novartis 0.9%, HSBC 0.9%, Roche 0.9%; Top 5 = 4.9%; Top 10 = 8.6%;

Sectors: Fincl. 19%, Industrial 16%, Cons. Discretionary 12%, Cons. Staples 10%, Healthcare 10%; Top 5 = 67%

Price/Earnings (PE) Ratio: 14; 3,900 stocks tracked

Emerging Markets (represented by Vanguard Emerging Markets Stock Index Fund, VEMAX)

Countries: China 35%, Taiwan 15%,  India 12%, South Africa 7%, Brazil 6%; Top 5 = 75%; Top 10 = 85;%

Companies: Tencent 5%, Alibaba 3.5%, Naspers 2%, Taiwan Semi. 2%, China Constr. 1.5%; Top 5 =13%

Sectors: Fincl. 22%, Technology 22%, Cons. Cyclical 12%, Basic Materials 8%, Energy 7%; Top 5 = 71%

Price/Earnings (PE) Ratio: 13; 4,500 stocks tracked

A number of recent articles discuss this situation.

The Economist Magazine (9/13/18) writes that “Emerging markets are suffering their worst slump since 2015. The MSCI Emerging Markets Index entered a bear market in early September after dropping 20 percent from its early 2018 peak.” The article mentions countries as diverse as Argentina, Turkey, India, and Indonesia, all having trouble supporting their currencies (note three of the four countries constitute less than 3% of the index). The article continues “while each country has its own challenges…the US Federal Reserve has played a key if unintentional role in triggering the stress…. With the American economy enjoying a strong upswing, the Fed has been raising interest rates (note, most recent rate increase on September 26), and also unwinding its bond buying policy….The Fed’s policy turn has left emerging nation borrowers scrambling to get more costly dollars to service their debt.” The remainder of the article presents various opinions on how much more serious these problems are likely to get going forward.

A second Economist article (9/22/18, page 65) discussed various countries, including China. The article begins by citing the falling currencies in India and Indonesia, and then states that “even where Asia’s currencies have remained steady, its stock markets have faltered, citing a 20% decline in Hong Kong’s index and a struggling stock market in Mainland China….The trade war with the US has soured the mood in China and Hong Kong….India and Indonesia report respectable economic growth…  and are largely insulated from the trade war thanks to their domestic demand, but are exposed to two other dangers, higher oil prices and America’s remorseless money tightening.”

The NY Times reported on this situation as follows (9/11/18, page B1): “Cratering currencies, rising inflation, jumpy investors: A financial panic is again gripping some of the world’s developing economies. The sharp selloff of emerging market currencies, stocks and bonds seems to stand in stark contrast to the US, where a nearly decade long bull market continues amid buoyant economic conditions. Higher interest rates in the US, and a stronger dollar, rebalance the risks and rewards for investors the world over and act as a kind of financial magnet, pulling them out of riskier investments. While we’ve seen this before….investors had to contend with spillover of trouble from one country to others, dragging down economic growth or causing market stress. So far in 2018 this kind of contagion has been limited. Economies as varied as Argentina, Russia, South Africa and Turkey are facing the maelstrom, but each has its own reasons for falling out of favor, and the turmoil has yet to raise anxiety about the world’s biggest economies and markets.”  The article then discussed the situation in each of the four countries and concludes that “Perhaps most important is a country’s credibility with financial markets. If investors believe a country will continue to pay its bondholders in a currency that retains its value, they will most likely put up with even the ugliest looking levels of debt. If that trust starts to fray, look out below.”

Another NY Times article (9/13/18, page B7) discussed the Developed Markets in Europe. Citing the negative impact of US tariffs, the article states that “the European Central Bank (ECB) has lowered its projections for economic growth across the 19 nation euro area, and warned that any potential escalation of the dispute could create further headaches.” The article also notes trade risks associated with emerging market problems, particularly in Turkey, along with issues related to striking a deal with Britain regarding “Brexit.”  The conclusion of the article however states that the ECB will continue with its plans to cut back on the stimulus programs that were put in place after 2008, in much the same way that the US has cut back these programs, albeit the US economy is much stronger than the EU at this time. The EU outlook currently appears to be much more mixed than that of Emerging Markets, which are wrestling with debt, interest rate, and growth issues.

Despite the current underperformance of Developed International and Emerging Market stocks, we at Park Piedmont continue to advocate some exposure to these sectors as part of a broadly diversified portfolio, particularly since their PE ratios are in the mid-teens, compared to much higher US stock PE ratios, which have climbed to the mid-20s. When PE ratios show this much divergence, it can be argued that the lower PE sector represents a comparative value when compared to the higher PE stocks. As always, only time will tell if this proves correct.

US stock prices have continued to rise, reaching historic new highs last attained in late January 2018, while bond prices have stabilized, resulting in positive returns. These currently favorable financial market results have occurred in the context of the following presumed negatives:

1. New tariffs (see July Comments) on China and other parts of the world;
2. Expectations that the Federal Reserve will continue raising short-term interest rates;
3. Problems in various countries, ranging from China, to Turkey and Greece, to Britain’s “Brexit” outcome;
4. President Trump’s new and ongoing legal and political problems;
5. Historically high Price Earnings Ratio (25, using trailing 12 month earnings; see article on the ongoing US bull market in stocks in The Economist, 8/25/18 print, page 62).

It is fair to ask how this combination of favorable current results in the US is taking place, even with all the negatives. As our regular readers know, we are highly skeptical of attempts to explain short-term movements in financial markets, but we think the current situation calls for some effort to explain.

While not answering the question directly, Jeff Sommer’s NY Times article (9/1/18, page BU3) sheds some light on the positives that might be supporting these market moves:

“While the stock market has been hot lately, warnings of trouble ahead have been multiplying….But what if the good times that are evident in important sectors of the markets and the economy just keep rolling, at least for a while? That bullish possibility has arguably been underplayed, given the strength of the current numbers… Consumer confidence has soared to levels unseen since October 2000, and the US economy’s annual growth rate, 4.2% in the second quarter, was the best in nearly four years, while the unemployment rate (3.9%) hovers near its lowest level in decades. That statistical snapshot depicts a stock market and an economy that are prospering.”

So perhaps this solid economic growth is one reason supporting the current favorable financial market results. Sommers’ article continues to discuss potential pitfalls to the favorable scenario, and also the political implications of the current apparently favorable economy. The article concludes with a quote from a well-known independent stock market analyst, Edward Yardeni, who describes himself as a “conservative-leaning fellow”: “On contentious issues, from tax cuts to trade disputes to deregulation, financial markets have been giving quite a bit of weight to the possibility that this will all lead to less protectionism and greater global prosperity.”

Two other articles appearing in the NY Times (9/8/18, Business Section), make different points regarding the strong US stock market. The more cautious view comes from another Jeff Sommer article (NYT 9/8/18, page BU4), which states that “there has been a disconnection between stock markets and economies around the world, with stock markets generally outperforming their economies…but the US stands out.  There’s a much greater degree of [stock] outperformance and disconnection from domestic economic growth.” The article observes that the US GDP grew 38% (unadjusted for inflation) from Dec 2007 through August 2018, while the S&P 500 index has nearly doubled, but “that does not mean the American stock market will necessarily fall soon. It is being supported by several macroeconomic factors, aside from cash inflows from foreigners. Corporate profits, supported in part by tax cuts, and relaxed regulations and low interest rates, have been rising more rapidly than GDP, while wage growth has been constrained.”

Our note: rising corporate earnings tend to support higher stock prices by essentially lowering the historically high Price Earnings (P/E) ratio closer to its long term average of approximately 15. On the website “Seeking Alpha,” projected S&P 500 earnings to year-end 2018 are $145, which would mean a P/E of 20 using the current S&P value of 2,900. The next twelve months showed a projection for earnings increasing to $155, suggesting further earnings support for current S&P levels. Of course, relying on projected earnings is a dangerous proposition, but is done regularly by Wall Street analysts and prognosticators.

The second article, written by Neil Irwin (NYT 9/8/18, page BU5), discusses the favorable possibility that the US economy may increase its productivity, “allowing for faster output growth and lower unemployment without serious inflation risks,” drawing a parallel to the mid-1990s, when a similar set of positive conditions converged.

Given all the countervailing factors impacting the financial markets, we stick by our usual advice to maintain your asset allocations, and consider re-balancing if one part of your allocation gets too high.

In a recent front page article on tariffs (6/20/18), the NY Times wrote in its lead paragraph,  “President Trump’s threat to impose tariffs on almost every Chinese product that comes into the US intensified the possibility of a damaging trade war, sending stock prices tumbling yesterday and drawing a rebuke from retailers, tech companies and manufacturers.”  For the record, the S&P 500 index closed June 19^th at 2,762, down from 2,773 (less than half of one percent for the day), and closed Friday, August 3^rd at 2,840, up almost 3% from its June 19^th close.

As regular readers of these Comments know, Park Piedmont is almost always skeptical of the media’s efforts to overstate market moves, and to attribute single causes to market changes driven by many factors. Nevertheless, it is worth having a basic understanding of tariffs, some of their effects on economies, and their potential impacts on financial markets.

Tariffs are a tax, mostly on goods, that are imported from another country. If the US puts a 25% tariff on steel coming into the US from China, it is making that steel more expensive. The expected impact is to raise the price of imported steel in the US, thereby reducing American demand for this steel and making steel manufactured in the US more competitively priced. At first blush, it is clear that the US manufacturer of steel is benefitted, and the Chinese manufacturer is hurt.  But it should also be clear that the higher price for steel should likely increase prices for US goods made with that steel, so some other business/businesses in the supply chain, and/or the end consumer in the US, is likely to pay more for the goods made from steel.

In a recent article on tariffs (NY Times, 6/16/18, page A8), Neil Irwin provided his insights on the current tariff situation, focusing on the US-China trade relationship. “The US moved forward Friday with a 25% tariff on $50 billion of Chinese imports, adding to tariffs imposed in previous weeks…. For many years, American companies have complained of being treated shabbily as they try to do business in China. They often must partner with Chinese companies to be allowed to do business in the country, and frequently complain that their most advanced technologies are being stolen, among other concerns. The Trump administration’s list of goods to be subjected to the tariffs is aimed at these high tech sectors…. In return, China said it will place tariffs on $50 billion worth of American imports.”

Irwin continues: “China views the development of its high-tech industries as core to its economic strategy of the future and won’t want to give up advantages in these sectors lightly. On the other hand, the substantial US trade deficit with China means America has more potential Chinese imports on which to slap punitive tariffs.” Irwin then explains that the US and China almost had an agreement on China buying more agriculture and energy products from the US, which would have reduced the trade deficit, but not helped with the longer term issues around technology.

Irwin’s article then turns to the current impact on the US economy by noting that “the US has a gross domestic product (GDP) of nearly $20 trillion, so a new tax on $50 billion (or eventually $150 billion or more) of Chinese imports is a rounding error…. As countries retaliate (with their own tariffs) they can certainly cause damage for individual American industries that export, but the reality is most economic activity in the US is for domestic consumption. Exports constitute about 12% of GDP.” Soybeans, a product heavily exported to China, is cited as an industry adversely affected, along with “some major industries that use steel and aluminum heavily [and] are complaining of sharply higher prices, which make them less competitive against global competitors.”

The article continues: “the risk comes if things spiral out of control in ways that crater the stock market or lead businesses to pull back significantly on their investment spending…. The initial tariffs on Chinese goods are not focused on consumer products, but on products mainly purchased by businesses … which could put upward pressure on inflation…. Even if the dispute spreads to consumer goods, the actual amount American consumers will pay depends on many factors, including the availability of domestic substitutes and the competitiveness of the industry. For any given product it is hard to predict how much of the tariff will be passed through to the consumer versus absorbed by producers and retailers.”

Other articles on tariffs discuss the impact on supply chains. An example from Bloomberg Businessweek (4/16/18, page 11): “It is well understood that tariffs on imported goods raise prices for domestic businesses and consumers…. What is less familiar is that tariffs are blunt instruments that strike every nation in a supply chain, not just the ones being targeted…. Globalization almost guarantees casualties from friendly fire. The US tariffs on steel and aluminum will have impacts on eight or nine mostly developing countries from which China buys iron ore for its steel production.”  Many other examples of the impact on countries in the supply chain of the products being subject to the tariffs are presented.

At Park Piedmont, we view the tariff issue as one of many factors that affect the economy and the financial markets, with highly uncertain impacts going forward. As always, we suggest maintaining previously established appropriate allocations of liquid investment portfolios, even when the media attempts to isolate particular issues as major negatives.

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.