What We’re Thinking

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.

As you may know, the Levinsons are pretty big baseball fans. Vic and Nick actually coached Tom’s little league teams (photos are available upon request), and Nick and Tom (and their sister Lynn) grew up going to Yankees games on the 4 train in the 70s and 80s.  So there was some excitement upon the announcement, made this past weekend, that the Yankees had traded for Giancarlo Stanton, the reigning Most Valuable Player in the National League.

In the article on espn.com breaking the news, an interesting detail popped out: when Stanton was drafted back in 2007, he was the 76^th player selected. Stanton is a towering slugger and four-time All Star. Yet, a decade ago, the teams of Major League Baseball selected 75 other players before him. Amazingly, of those 75, over twenty never played a single game in the Major Leagues.

How did so many teams, tasked with the most expertise and up-to-date information, get their predictions so wrong? Some players got injured, as you’d probably expect. Elbows wear down and knees give out. Some others just didn’t improve the way teams expected them to – in some cases the shortcomings were likely physical; in others, mental; in still others, both.

But the real answer is that fortune-telling is exceedingly hard.

At year’s end, forecasts for the year to come are everywhere. That’s especially the case in the financial markets. With various stock indices at or near all-time highs, analysts and pundits declare that it’s only a matter of time before a significant stock decline. “Whoa,” say other commentators, “why so gloomy?” With a growing economy both here and abroad, unemployment down, and significant tax legislation on the brink of passage, these observers exude confidence that there’s plenty of room for markets to rise.

Many – including many who are smart and sophisticated – attribute significance to the predictions. They base their actions on these predictions. They rely on them. Indeed, much of the investment advisory industry relies on the ostensible predictive ability of researchers and stock pickers, portfolio managers and quants. Are they reliably right?

No.

According to the S&P Dow Jones Indices Persistence Scorecard, very few funds consistently outperform their benchmarks. The 2016 Scorecard reports: “Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016. Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile.”

In other words, roughly 97 percent of the active managers who are paid (handsomely) to outsmart the future failed to, even over a 2-year period. Jeff Sommer’s March 2015 column in the New York Times memorably explored this same territory.

Researchers have found that in various fields, experts have a hard time forecasting what’s to come. In a September 2011 episode of the Freakonomics podcast called “The Folly of Prediction,” Philip Tetlock, a professor of psychology and management at Wharton, explained that a signature challenge for experts lies in “think[ing] they know more than they do.” They tend to be “systematically overconfident.” As much of the field of behavioral economics continues to reveal, humans are predisposed toward emphasizing data that supports our positions, our viewpoints, and our biases, and undervaluing data that challenges those positions.

Perhaps needless to say, the difficulties of prediction aren’t limited to experts! We mortals aren’t too hot at predicting outcomes, either.

Frequently in conversation, the question is asked: where do you think the markets (or interest rates, or the economy) are going? You likely know our answer by now: we don’t know.

Park Piedmont has a deep institutional humility about our ability to forecast what’s to come in a complex world. It’s why our Comments routinely feature Larry Swedroe’s observation that “the biggest mistake investors make is treating the highly unlikely as impossible (such as having a massive crisis), and the likely almost as if it is certain (such as the probability that stocks will outperform bonds over twenty years).” It’s why we emphasize customized, broadly diversified asset allocations for you, our clients, in a way that’s respectful of your risk tolerance and designed to help accomplish your long-term goals.

It’s also why you won’t see us placing a wager on the Yankees’ World Series chances in 2018 after their blockbuster trade – even if that’s what the experts are predicting.

Last month we changed our focus from the surprising, ongoing advance of stock prices since the 2016 election, to bonds, the other major asset class in most client portfolios.

During September there was a substantial increase in market interest rates, which brought the benchmark ten-year US Treasury yield to 2.34%, up 21 bps from August’s close of 2.13%. October’s increase was a much more modest 4 bps, to 2.38%, still below the year end 2016 rate of 2.45%, even as the Federal Reserve has made two 25 bps increases (in March and June) in the ultra-short term overnight rates it controls during 2017.

Ordinarily, an increase in rates by the Fed would result in a similar increase in longer-term rates set by bond market buying and selling. Surprisingly, this has not occurred so far in 2017.  A new Fed Chairman replacing Janet Yellen, and a likely additional 25 bps short term rate increase by the Fed in December, provide some additional context to this discussion.

We are going to use Jeff Sommer’s recent article on bonds (NY Times, 10/29/17 Sunday Business, page 3) as background for our Comments.

The article observes, as we often do, that “Stocks and bonds are complementary partners in standard portfolios. While stocks typically have a higher return potential, bonds are generally less risky and provide a hedge against a stock market plunge, as they did during the bear market that started in 2007.”

PPA’s addition: the extent of the stock decline (and subsequent recovery) are most noteworthy, and add important detail to the rather bland statement of a “bear market that started in 2007.” The S&P 500 index declined from its October 2007 high of 1,565 to a March 2009 low of 677, a decline of 57%. That same index closed October 2017 at 2,575, a gain from low to high of 280%. This is an annualized gain of approximately 17% over the 8.5-year period.

The article continues that “despite a rocky bond market over the last month, bond prices are still too high, and their yields so low, that bonds simply can’t provide much buffering.”

PPA’s addition: we respectfully disagree. If long term market history is any guide, when stock prices fall 20% (the definition of a bear market), or more, the declines in bond prices attributable to rising interest rates are likely to be much, much smaller, and that is the whole point of owning an appropriately allocated and diversified portfolio of bonds and stocks.

The article then continues with a discussion of the wonderful returns in stocks over the last eight plus years, and whether they are likely to continue.

PPA’s addition: surely no one knows the answer to this question.

The article then returns to another recent article by the author: “the standard practice after a big run up in stocks is to rebalance, meaning to take profits out of stocks and put them into bonds. The goal is to create a well-diversified portfolio … the problem is that this is not an ideal moment to be putting money into bonds.” Reasons for the continuing upward pressure in interest rates are presented, ranging from the Fed’s desire to raise rates gradually to ward off future inflation, to the Fed program of selling bonds it had purchased in the aftermath of the financial crisis, to the identity and likely policies of the new Fed chairman, to the potential inflationary impact of the larger budget deficits coming from the government, including from possible changes in the tax law.

Sommer continues that “the bond market turmoil leaves investors in a bit of a muddle. The central reason for holding bonds remains intact: Bonds will still buffer a portfolio and generate income. But in the near future, they aren’t likely to do so as effectively as in the past.”

PPA’s addition: if the point of bonds is to offer a buffer against serious stock market declines, investors should focus on this purpose, and be less concerned about whether this is or is not a good time to buy bonds based on their future return potential.

The Sommer article concludes with some observations from John Bogle, the founder of Vanguard, one of which is that “compared to stocks, bonds are a good value, better than they have been in years … and it still makes sense to hold stocks and bonds in a diversified portfolio.”

PPA’s addition: we take no position on the relative valuations of bonds and stocks, but certainly agree that a diversified portfolio of stocks and bonds, allocated to the investment goals and risk tolerance of each investor, is the best defense against the unexpected (refer to Larry Swedroe’s observations about asset allocation above).

A few other comments may prove useful:

1. Rebalancing (adding to bonds after large stock price advances) “is more a risk control measure than a return generator.” (This quote comes from Sommer’s article on rebalancing, and we agree. Note there is no mention in the quote of whether this is a good or bad time to own bonds, just that owning them is intended to provide risk control.)
2. Investors expect to receive higher interest rates on their bond investments when inflation rises, to offset the reduced purchasing power of the money they receive when their bond investments mature. So when rates do rise, and bond prices decline, one other result is that investors receive higher interest payments in the future.
3. The extent of price declines depends on maturities of the bonds, and on the amounts and time intervals of the interest rate increases.
4. We are always available to discuss these issues in more detail, including how to balance stock and bond allocations in each client’s portfolio.

A recent article by Wall Street Journal columnist Jason Zweig, entitled ‘Don’t Touch My Money, Just Hold My Hand’ (WSJ, June 9, 2017), touched on topics that reinforce the investment approach Park Piedmont has been conveying to clients since its founding in 2003.

First: many people look to investment advisers to boost their investment returns. If that’s your perspective, “you may be paying your adviser for the wrong thing,” according to Zweig. Just as investors tend to be their own worst enemy by “flinging money at whichever assets have gone up the most and then bailing out at the bottom, locking in losses” – typically during periods “when they are in the grip of greed or fear” – many advisers, driven by the perceived need or desire to outperform, act the same way. In their efforts to chase performance, advisers can lag significantly behind those who maintained a discipline in maintaining their long-term plan.

Second: investors often feel the urge to do something, when nothing may actually be a better investment decision. Zweig writes that investors tend to add and subtract money at inopportune times, leading to “what is often called the ‘behavior gap’ between the performance of an investment and its investors.” For instance, mutual fund investors earn average annual returns that are approximately 1 to 1.5 percentage points lower than the returns of the funds themselves. Zweig adds that investors in hedge funds “may lag those vehicles by up to 7 percentage points annually.” That’s what a financial adviser “should prevent,” writes Zweig.

Finally: Mr. Zweig closes his piece with the following quote, which further reinforces another of Park Piedmont’s consistent message to our clients. “You should hire an adviser not for his or her investing prowess, but to help organize your finances, prioritize your goals, minimize your taxes, and navigate the shoals of retirement and estate planning. Done right, those services can make you far richer – and happier – than the pipe dream of investment outperformance is likely to.”

There will always be events that affect the market in the short-term, in both positive and negative ways. But an adviser can give clients confidence and help them maintain their discipline, so that short-term events don’t undermine longer term goals.

Please contact us if you’d like more information about how Park Piedmont Advisors, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.

At Park Piedmont Advisors (PPA), we advise clients that trying to predict future events, and the financial market’s reactions to future events, can often lead to disappointing results.   Rather, we advocate ignoring most current events and focusing instead on long term financial goals and the cost efficient investments that help achieve those goals.

Here is an example of how even knowing future events can lead to disappointing results.

On Monday May 23, 2016, the US S&P 500 index was 2,048.

Since then, we have experienced the following events- some surprising- that, to most observers, would have been considered negative for financial markets:

•   England’s vote to leave European Union (“Brexit”, June 23-24);
•   Donald Trump elected US president (Nov 8);
•   two Federal Reserve quarter point interest rate increases (Dec 14 and Feb 15);
•   world wide hacking (mid-May);
•   North Korea weapons testing (ongoing);
•   Trump problems with FBI and Russia (ongoing).

Assuming you were able to predict the future and knew all this was going to happen, would you have thought the US stock market, as measured by the S&P 500 index, would be:

a)   closer to 1800 (approximately 12% lower than mid May 2016);

b)   2100 (approximately the same as mid May 2016); or

c)   2300 (approximately 12% higher than mid May 2016)?

Of course, we now know the answer is the 2300, but who would have thought that before the fact?

The moral of the story is to try and ignore the short term news, and focus instead on your long term goals. This is the ongoing message PPA provides its clients. Contact us to learn more about our investing approach.

We’re going to start commenting on investing/financial items we read or hear about in the media, in the hope that it’s interesting and informative for you. Please let us know if you have any comments or questions.

Our first post involves the 5/16/17 NYT article titled “Dream Paychecks.” It discusses the enormous 2016 earnings for hedge fund managers (ranging from $1.6 billion [not a typo] to about $100 million), many of whom significantly underperformed the broad stock and bond market indexes for the year. “The 25 best-paid hedge fund managers earned a collective $11 billion in 2016, according to an annual ranking published … by Institutional Investor’s Alpha magazine…. Nearly half of the top-25 earners made single-digit returns for their investors, a lackluster sum in a year when the S&P 500 stock index was up 12%, accounting for reinvested dividends.” To be fair, not all hedge funds invest exclusively in stocks, and so the S&P 500 might not be the best benchmark for all of the funds managed by the highest-paid managers. And as the article notes, “the original allure of a hedge fund was the promise of smoother returns during market upheavals along with risk-adjusted returns that would stand out.” But many of these funds and their managers have risen to prominence, and outsized pay, by taking enormous risks in search of market-beating returns, which have not occurred recently for several well-known managers. The article mentions John Paulson, “who is best known for reaping a windfall by betting on the collapse of the housing market in 2008, [and] has made $15.45 billion over the 16 years Institutional Investor has been compiling the list. But he was bumped off the list after double-digit losses in 2016…” Also mentioned is William Ackman of Pershing Square Capital Management, who “has had percentage losses in the double digits for two years in a row.”

The main points from PPA’s perspective are that active managers, whether of hedge funds, private equity funds, or simply actively-managed (as opposed to passively-managed or indexed) mutual funds, take big risks that might generate outsized returns over certain periods, but always have the possibility of significant declines in other periods. This lack of “persistence” in the returns of active managers is one of the main reasons PPA prefers index funds to implement client portfolios. And the cost of this significant risk, which is in turn “the key to these large paydays [at least for most hedge funds,] is the fee system known as 2-and-20. Hedge funds typically charge investors 2% of their investment annually, regardless of performance… In the event they make a profit, the funds take 20% of that as well.”

Please let us know if you’d like more information about how PPA, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.