What We’re Thinking

In the immediate aftermath of Donald Trump’s unexpected election as President of the United States, global stock prices are experiencing substantial short-term volatility.  As always, when events create this kind of volatility, we think it useful to step back and think more long-term with regard to your investment portfolio.  Here are some points worth considering:

• The meaning of “big” declines: While the media likes to present declines in large numbers, a 900 point decline in the Dow Jones Industrial Average (DJIA) is a 5% decline. That means a portfolio allocated with 50% in stocks and 50% away from stocks should show a decline of 2.5% — significant but not devastating. The value of an appropriate asset allocation – for mitigating risk and cushioning against volatility – is always most clear when stocks experience substantial declines.
• Your time horizon as an investor: It’s always important to understand how much of your money you’ll need to use, and when. The further away in time you need to use it, the more you can think of yourself as a long-term investor — measured in years, not days.
• Historical perspective: At the end of October 2008, just before Barack Obama was elected President, the DJIA was 9,325, in the midst of an historic decline from 13,265 at the end of 2007 caused by the financial crisis of that time. In those first few months of the Obama presidency, the DJIA fell to as low as 6,547 in March 2009, or 30% below October 2008.  Since March 2009, the DJIA has advanced to over 18,000, a gain of almost 200%.  An even more recent example of short-term volatility that didn’t last was the late-June “Brexit” event, where Britain voted to leave the European Union. Despite a nearly 5% decline in the days immediately after Brexit, stock prices are now higher than they were the day before the Brexit vote.

Beyond money

We recognize that, for many people, this election result is about much more than finances and stock prices.  We understand that initial reactions can be powerful and offset longer term thinking.  Uncertainty about what the future holds is always uncomfortable.  But planning thoughtfully for an uncertain future is an important part of our work together.  As investment advisors, we continue to advocate a long-term approach, built around appropriate asset allocations. We are, as always, available to speak with you if you’d like to talk further.

On Thursday, June 23, British voters, by a majority of 52% to 48%, voted to have their country leave the European Union (EU), an event dubbed “Brexit” by the media. Since the financial markets reacted sharply to this event (stock prices down, then quickly recovering; bond prices sharply higher, meaning continuing lower yields to investors), and the media proclaimed the event historic, this month’s Comments are devoted to this topic.

The print media’s immediate treatment of Brexit can be seen in the following headlines:

• June 25, NY Times front page: “Global Shocks After Upheaval in Britain.”
  • Sub Headline: “Investors Gripped by a Panic Last Seen in ‘08”
• June 28, NY Times, page B1: “Brexit Spreads Fear Far From Britain’s Shores.”
• June 25-26, Wall Street Journal: “UK Vote Sets Off Shockwaves”
• June 25-July 1, Economist Magazine cover:  “A Tragic Split”
• July 2- July 8, Economist Magazine cover: “Anarchy in the UK”

The media discussion of Brexit covered many consequences: political (resignation of British Prime Minister and other political leaders), societal (vote partly against immigration), economic, and financial.  Our focus will be on the economy and financial markets, using the July 2^nd-8^th issue of The Economist (a magazine based in London, with a decidedly liberal, global, and upscale point of view) as the basic source of information.

In describing the outcome, the first of many Economist articles (page 9) states: “Anger stirred up a winning turnout in the depressed, down-at-heel cities of England. Anger at immigration, globalization, social liberalism and even feminism, polling shows, translated into a vote to reject the EU…. Unless these voters believe that the global order works to their benefit, Brexit risks becoming just the start of an unravelling of globalization and the prosperity it has created…. Proponents of globalization, including this newspaper, must acknowledge that technocrats have made mistakes and ordinary people paid the price. The move to a flawed European currency led to stagnation and unemployment and is driving Europe apart.”

Elaborate financial instruments bamboozled regulators, crashed the world economy and ended up with taxpayer funded bailouts of banks, and later on, budget cuts…. Trade with China, which lifted hundreds of millions of people out of poverty and brought immense gains for Western consumers, also left many factory workers with lost jobs, and they have been unable to find a decently paid replacement…. While American GDP per person grew by 14% in 2001-15, median wages grew by only 2%…. As Brexit shows, when people feel they do not control their lives or share in the fruits of globalization, they strike out, and the distant, baffling, overbearing EU makes an irresistible target.”

The next article (page 10), rather than seeking causes, focuses on the future. “The country needs a new leader, a coherent approach to negotiating with the EU, and a fair settlement with those nations within its own union that voted Remain (in the EU)…. Brexit comes in many varieties, from an arrangement, like Norway’s, involving continuing access to Europe’s single market, in return for allowing free movement of people from EU countries and a contribution to the EU budget, and at the opposite extreme, cuts its ties entirely, meaning no more payments to EU and no more unlimited migration, but no special access to the market which buys nearly half of Britain’s exports…. Britain’s next leader must explain to 17 million voters that the illusion they were promised – all of the EU benefits with none of its obligations – does not exist.” [Our note: negotiations on the terms of the British exit from the EU have a two year deadline from a still-to-be determined start time).

The next article (pages 17-20) focuses on the EU, and what Britain has chosen to leave (terms of departure currently unknown). Recent EU issues range from the “debt crisis in the euro zone (our note: mostly Greece; Britain is not a member of the euro zone), and the mass influx of refugees and other migrants. But Brexit is qualitatively different, since it strikes at the very idea of a union…. The EU is the world’s biggest single market, counting some 500 million rich-world consumers. It stabilized new democracies in southern and eastern Europe…. Two big questions… will anyone else follow Britain out of the union, and what reforms are needed if the institution is to cohere and survive?  Eurosceptics across Europe have similar dissatisfactions as Britain’s ‘Leave’ voters: resentment of globalization, estrangement from elites, a sense the EU is distant and undemocratic, and above all, the EU has let in too many foreigners who take away jobs, benefits and national identity.”

The article focusing on the “economic fallout” begins on page 21. “Business and financial markets hate uncertainty. The vote for Brexit gives rise to a surfeit of it…. Forecasts for economic growth are being revised down – markedly for Britain, materially for Europe, and modestly for the world.  A lot depends on the kind of trade deal Britain can negotiate with the EU and how quickly its outline will emerge…. Three broad scenarios cover most of the possibilities; … the Norway arrangement, reached quickly, in which case the spillovers to Europe and the global economy would be small and transitory. In the second case, discussions are considerably longer drawn out, key issues of disagreement remain, and businesses in Britain, and to a lesser degree other countries with which it has close ties, defer whatever spending they can… The pound remain weak, pushing up the costs of imported goods. Hours and wage growth fall…. In this middling scenario, the combined effects of business uncertainty and a weaker pound would be likely to cut the economy’s growth rate by 1-2 percentage points in the next 12-18 months….”

“A decent rule of thumb is the reduction in GDP growth in Europe will be between a third and a half as big as the loss to Britain’s rate of growth…. The worse outcome (third scenario) would occur if trade talks stall, the politics of Europe sour, and agitation for referendums in other parts of the EU grow…. Broader anti-EU or anti-euro sentiment would likely cause worried business leaders across Europe to cut back on investment. Europe’s banks might be spooked by tumbling stock prices into choking credit for firms and households.”

The article continues that “many forecasters are treating Brexit as a regional economic event, rather than a global one. Britain accounts for a bit less than 4% of world GDP; it is not big enough to make the global economic weather as America or China can.  Even so, there are worries that Brexit might disturb some existing fault lines in the world economy in a way that amplifies its impact.”

The financial market reaction is discussed in the Buttonwood column (page 62). “Shock, followed by frantic recalculation, was how astonished financial markets reacted to the British vote to leave the EU. The initial phase saw a worldwide sell-off in riskier assets, such as equities, and a flight to safe ones, prompting further declines in government bond yields. After the sell-off, equities started to bounce again on June 28^th, in part because central banks may respond with easier monetary policy (or in the case of the Federal Reserve, slower tightening); in part because Brexit may not have much impact on the Chinese economy.”

The article continued that “the biggest casualty was the pound sterling, which went from $1.50 before the vote to $1.32, a 31-year low. A big drop in the pound, to make British assets more appealing to foreign investors and imports less appealing to Britons, is a necessary adjustment…. Now the initial shock has passed, investors need to work out what the economic impact will be…. One question is whether consumption will suffer because of the vote…. The bigger worry is investment, …many companies are waiting to see whether Britain decides to join the European Economic Area, alongside Norway, which would keep it in the single market…. In the meantime, uncertainty means few businesses will be inclined to invest in new projects…. For the rest of Europe the question is whether Brexit will encourage other anti EU movements.”

Given the extensive and fear-provoking media coverage of Brexit, we think it important to spotlight the actual price (and percentage) changes of some key stock indexes, starting with the day before the vote (June 23), and then over the next six business days (ending July 1)

               Dow Indus.      S&P 500      NASDAQ       FTSE 100

6/23      18,011                  2,113                4,910                6,338

6/27      17,140 (4.8%)    2,000 (5.3%)  4,594 (6.4%)   5,982 (5.6%)

7/1         17,949 (0.3%)    2,103 (0.5%)  4,863 (0.9%)   6,578 +3.8%

7/15       18,516 +2.8%     2,162 +2.3%   5,030 +2.4%   6,669 +5.2%

It is worth noting that this totally unexpected recovery of stock market prices in a few short days received much less prominent coverage than the initial declines. This again illustrates the point that much of the media coverage of financial events appears designed to frighten people, emphasizing the bad news, while addressing improving news in a far more muted tone. This suggests that the best course of action, far from hanging on the media’s breathless pronouncements, is to ignore the media’s play-by-play account of what’s happening, and instead focus on your longer term goals.

The fact is, had you missed all the news, you would have returned to stock prices that were almost unchanged, except for the Financial Times-London index (FTSE), which actually was 5.2% higher! As usual, after the fact, commentators fashion reasons for this totally unexpected price recovery. The focus now is on the idea that central banks are likely to continue to keep interest rates very low. (The low interest rates can be seen in the very high prices for high credit quality bonds in the US and certain other developed countries like Germany and Japan.) But since it will take two years from a still uncertain future date for Britain to negotiate its new status with the EU, it now appears that Brexit is likely to be a footnote in the history of stock price fluctuations.

Financial stock markets around the world have reacted negatively to the unexpected victory of the “Leave EU” campaign in Great Britain.  However, US Treasury bond prices are higher, which often occurs when stock markets decline sharply.

While the immediate impact on the markets seems clear, the longer term outcome based on England’s negotiations with the EU over the terms of its withdrawal are unclear to all.

Further uncertainty is likely to arise over whether other countries are likely to follow Britain’s example.

Given all the uncertainty surrounding the consequences of the vote, we at Park Piedmont are advising that clients retain their existing allocations, and make no changes based on this one event.  As we consistently advise, the financial markets are impacted by many, many events and factors, and while Brexit is today’s main event, there will be many others to take the stage as the uncertain future unfolds.

Since the financial crisis of 2008, and the resulting stock market declines (which reached 60% on the S&P 500 index, from October 2007 to the low of March 2009), interest rates have been maintained at extremely low levels by the US Federal Reserve (the “Fed”). While the Fed controls short term interest rates (overnight borrowing rates by financial institutions), it is the buying and selling in the bond market that establishes longer term rates, including the benchmark ten-year US Treasury rate. Since October 2007 that rate has fallen, with some interruptions, to the current extremely low level of 1.85%. The actual progression of fairly consistent declining rates is as follows (all month-ending figures):

Oct 2007:    4.47%          Dec 2010:   3.30%                      Dec 2013:   3.03%

Dec 2008:   2.25%          Dec 2011:   1.88%                       Dec 2014:   2.17%

Mar 2009:   2.69%         July 2012:   1.47% (the low)     Dec 2015:   2.27% *

Dec 2009:   3.83%          Dec 2012:   1.76%                       May 2016:   1.85%

* 0.25% Fed rate increase in December 2015, the first since 2008

To begin the discussion, we will focus first on interest rates and their impact on the real economy. Since interest rates are a cost of doing business, lower rates should encourage more borrowing and more economic activity. That is the underlying idea behind the Fed keeping interest rates as low as they are in the US. It should also be noted that in parts of Europe and in Japan, interest rates have turned negative (below zero), with central banks charging commercial banks for maintaining deposits. This would seem to be the ultimate incentive to lend out money, and yet these economies, and the US to a lesser extent, are stuck with extremely low economic growth rates, now into the eighth year following the financial crisis of 2008.

Borrowers obviously benefit from low interest rates. Borrowers include national as well as state and local governments, all manner of businesses, and consumers buying goods and services and homes that qualify for financing (that is, paying off the purchase price over time). It is interesting to note that, in a period when borrowing rates are so low, many governments are unwilling to borrow further to improve infrastructure and otherwise invest in their respective economies, which would in turn add to economic growth. Of course the other side of this point is that the borrowing ultimately needs to be paid for with either higher taxes, or with additional borrowing at possibly less favorable future rates.

On the other side are all the people and businesses that have excess savings to invest, and are punished by ultra-low interest rates because they can’t get a decent investment return on their money. Businesses that are adversely affected include insurance companies, which rely on interest income to keep their premiums lower, and banks, which benefit from the spread between their borrowing costs and the interest they charge customers on their loans. In a recent Economist article about low rates in Europe, the conflict between trying to stimulate economic growth with low rates, and the impact of those low rates on savers, is presented well: “The conflict over the European Central Bank (ECB) has brought back tensions between Europe’s north and south that emerged during the euro crisis (with Greece). With their large current account surpluses, Germany and the Netherlands (and their citizens) are net lenders; low interest rates hurt them and help southern European countries which borrow more… But the Germans and Dutch seldom mention why the ECB is setting such low rates.  The Eurozone economy is barely growing, and may be on the verge of deflation, so that raising rates… could send Europe into recession. The chairman of the ECB said that “low interest rates are a symptom of low growth and low inflation, not the cause” (Economist, 4/30.16, page 47).

In addition to being a cost of doing business and a source of investment return for savers, interest rates have a direct connection with inflation. Inflation is the idea that the purchasing power of a given amount of money declines over time because of increasing prices. Interest rates are paid to savers as a way of offsetting the negative effect of inflation on purchasing power. The higher the level of inflation, the higher interest rates need to be to offset the impact of inflation. By the same token, low inflation allows interest rates to remain low. If inflation begins to rise, there is a case to be made for raising interest rates, which would conflict with keeping rates low to stimulate the economy. To further complicate matters, the same low rates designed to increase economic growth could end up creating too much growth, which would trigger inflationary pressures on prices, leading to an increase in rates.

This is the dilemma currently affecting the US Fed. “The Fed has held interest rates at low levels since the Great Recession, to stimulate economic growth by encouraging borrowing and risk taking. It started raising rates in December, seeking to reduce those incentives. But it paused as the economy appeared to weaken. Now it seems ready to continue” (NY Times, 5/28/16, pages B1-2). A second article in the Times stated that “the American economy is picking up speed after a slow start this year,… but the overall gains are still likely to fall short of what many experts would hope to see as the recovery nears the end of its seventh year. These crosscurrents highlight the challenge facing the Fed as they weigh whether to raise interest rates in mid-June, or wait until July or later in the year… Buried in the details of the gross domestic product report were signs that inflation was picking up to more normal levels after years of dormancy, with core inflation of 2.1%, just above the Fed’s 2% target” (5/28/16, page B2).

A NY Times editorial urging the Fed not to raise rates cited slow economic growth, recent disappointing job numbers, and inflation below the Fed’s 2% target, observing that “[r]ate increases are called for when economic activity is speeding up to the point of overheating, as reflected in an upward spiral in wages and prices. At its best the economy in recent years has managed to grow at an annual rate of about two percent, a moderate pace that has resulted in considerable slack in the job market. Raising rates in June would apply the brakes to a recovery that has never hit full speed and that now appears to be slowing.” The editorial also commented on the lack of government spending needed to “offset feeble spending and investment in the private sector” (NYT, Sunday Review section, 5/29/16, page 8).

Impact on Financial Markets

Turning to the impact of interest rates on financial markets, there are a few key points to establish (this subject is likely to be discussed frequently in future months):

• When interest rates rise, the prices of existing bonds decline; the more gradual the time frame over which rates are increased, the less prices are impacted negatively.

• Another significant factor on the extent of the price declines is how long it takes for the bonds to mature, at which time new bonds can be purchased paying the higher rates.

• The impact of rising rates on stocks is far less clear. It may be positive, indicating stronger economic growth; but rising rates increase costs to businesses, and provide a more attractive investment alternative (bonds), which would then be paying higher interest rates.

• The relationship between bond returns and inflation can be sobering: If savers earn 2% interest, and inflation is 2%, then purchasing power has not increased at all. If the interest is taxable, an apparent positive result can be negative, after accounting for inflation and taxation. Even so, bonds continue to provide a useful buffer in portfolios against the much more extreme price volatility of stocks.

photo: https://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg

From time to time since Park Piedmont Advisors was founded in 2003, we have quoted extensively from various authors whose books we have embraced.  These authors and their books include Burton Malkiel’s A Random Walk Down Wall Street;  John Bogle’s Common Sense on Mutual Funds;  David Swensen’s Unconventional Success; Charles Ellis’ Investment Policy; and Nassim Nicholas Taleb’s The Black Swan and Fooled by Randomness.

To this list we would like to add John Kay’s Other People’s Money, newly published in 2015.

http://www.amazon.com/Other-Peoples-Money-Business-Finance/dp/1610396030.

The author finds much to criticize in the current highly complex world of finance. He maintains that those engaged in finance have gone from providing traditional functions useful to society, to now engaging in activities profitable mostly to themselves and their own financial businesses. He uses the term “financialisation” to describe the two main components of these unfavorable changes: “the substitution of trading and transactions for relationships,” and the “restructuring of finance businesses.” (Pgs. 15-16)

In the upcoming months we will present selected portions of the book, which we highly recommend. The following excerpt discusses the likelihood of most investors successfully timing or outperforming the market:

“Many financial promotions exploit the control illusion and the excessive confidence people have in their own judgment. The most common means of chasing the dream is to believe that savers can successfully identify market highs or lows or select stocks or managers that will outperform the market. The overwhelming evidence is that they can’t. Few investors or managers have any sustained capacity for outperformance. Actively managed funds, taken as a whole, do worse than the market averages by the amount of fees charged.  Retail investors do even worse than the average of investment funds by mistiming their purchases and sales. As with games involving mixtures of skill and chance, such as poker, there are few people with genuinely outstanding abilities who profit at the expense of the general run of players, and many more who persuade themselves, and perhaps others, that recent runs of good fortune are the result of their exceptional skill.” (Pgs. 62-63)

With a volatile third quarter now ended, it may be helpful to offer some historical context for the recent market declines. Since the financial crisis in 2008, stock prices have had only one substantial period of decline (approximately 20%), in 2011. Since this has been a long period of generally steady stock price increases, it is perhaps reasonable to point out that stock prices are “due” for some declines. Interesting historical statistics were presented in a recent article in Investment News magazine (9/14/15, page 3), which advocated a buy and hold approach to price drops, rather than trying to time the markets in an attempt to be out while prices are falling and in when they are rising.  The article notes that since 1945 there have been: (a) 59 periods of declines between 5% and 10%; (b) 20 periods of declines between 10% and 20%; and (c) 12 periods of declines of more than 20%. In all of these periods, there have been recoveries from the declines, in varying time frames dependent on the severity of the decline. The article observes that “the majority of market returns occur in a small minority of days and that the big return days tend to be unpredictable and hot on the heels of awful news. ” It also states that “buy and hold is a relative concept that needs a certain amount of flexibility to allow for liquidity, rebalancing and various life events such as retirement.”

At Park Piedmont Advisors, these are core components of our investing philosophy. And this is why we focus so much on appropriate asset allocations specific to each clients’ circumstances, which we then expect our clients to be able to maintain during periods of declining stock prices.

The much awaited decision by the U.S. Federal Reserve as to whether to start raising interest rates was answered in the negative yesterday, while still leaving open the possibility of an increase before year end. “Heightened uncertainty abroad” and “prospects of low inflation,” both of which are reasons not to raise rates, were deemed more important at this time than “improving labor markets” and “reducing slack in the economy,” which would have been reasons to start raising rates

Financial markets had little reaction. Stock prices rose initially but ended the day modestly lower, and bond prices gained, but only back to last week’s levels.

While low interest rates are designed to benefit economic growth, they have a negative effect on investors looking for safe ways to earn interest on their money. This adverse impact on conservative investors has not been sufficiently highlighted in the Fed’s ongoing decisions to keep rates at close to zero starting in 2008. Conservative investors have had to add riskier investments to their portfolios to try and earn even modest investment returns. While taking on this added risk has worked well since 2008, it still has its unsettling moments (as recently as August), and carries no certainty that the results will continue to be  favorable.

As the world’s stock markets continue to capture our attention with their extreme fluctuations, we think it’s important to present our view that most of this volatility is actually being created by traders, as opposed to long-term investors. (Note: this is our third memo in the last several days addressing current stock price declines.)

What’s the difference between trading and investing? Traders look to profit from price changes that occur in the short term, typically measured in days, frequently even shorter. The wider the price range, the more opportunity for gains or losses. Trading is a form of gambling, in that the result of the trade is known quickly and is often unrelated to any underlying, long-term economic rationale.

In contrast, investing presumes a lengthy time period, a set of goals to be achieved over that time period, and a view that there’s likely to be sustainable economic growth in the world’s economies over that time period. The investor’s relevant time period is measured in years, not days. We believe investors should not transform into traders when the markets experience periods of extreme market volatility.

A thoughtful article in The New York Times (August 22, 2015, pg B2, written by Ron Lieber), headlined “Take Some Deep Breaths, and Don’t Do a Thing,” makes the same point. Mr. Lieber observes, “Stocks are most useful for long-term goals. So unless these goals have changed in the last few days, it probably doesn’t make much sense to overhaul an investment strategy based on a blip of market activity.”

At Park Piedmont Advisors, we have long advocated that the U.S. stock market not be used as a basis for trading activity because trading can give rise to unsettling price changes from time to time. These changes can lead investors to take ill-advised actions that could undermine their long-term goals. Simply put, the financial well-being of long-term investors is threatened when trading activity turns the stock market into a casino.

Given the continued sharp stock price declines on Friday, August 21^st, and thus far on Monday, August 24^th, we’re sending this follow-up memo to discuss the pitfalls of alternatives to our customary advice of maintaining your current stock allocation. Our advice presumes that stocks are a necessary part of your investment portfolio to meet your long-term financial goals. The following is a list of the main alternatives, and the key issues associated with each:

1) Sell stocks and buy back at lower prices. This is referred to as “market timing”, and is very hard to implement successfully. In addition to deciding the right time to sell, you also need to make the right decision about buying back into the stock market. If you wait too long, you miss the upside that has historically come from the stock portion of your portfolio.

2) Sell stocks and hold as cash. Short-term cash/money markets pay virtually no interest in the current low interest rate environment, and are guaranteed to lose purchasing power to inflation.

3) Sell stocks and buy high credit bonds. Since interest rates are very low (with the 10-year US Treasury benchmark rate close to 2%), these bond prices are very high, and remain vulnerable to the anticipated rise in US interest rates (although issues in the world economy may delay the Fed’s raising rates).

4) Sell stocks and buy high yield income investments, from US and international issuers. When stock prices are declining because of fears of worldwide economic slowdown, these investments also tend to decline as credit risks increase.

5) Sell stocks and buy alternative investments that provide hedging opportunities. This is another form of market timing, because while hedges may help during stock price declines, they will also hold back the extent of the gains during stock price recoveries. Issues of timing include when to buy these hedges and when to sell them; if held for the long term, the hedging costs might result in a lower return than simply maintaining the initial allocation without the hedges.

6) Sell stocks and buy commodity investments like gold, oil, and industrial metals. Commodity prices have been declining in recent years, and continue to be adversely affected by the same economic slowdown that the world’s stock markets appear to be reacting to.

It’s no secret that both the Wall Street investment community and the media have an interest in convincing investors to increase their activity and market participation when prices turn down. At Park Piedmont, we’ve evaluated these various alternative strategies and concluded that your long-term financial well-being is better served by maintaining the allocations to the various markets that we developed with you in calmer times.  We’re available to discuss any of these topics in more detail at your convenience.