“If it’s not one thing it’s another…” Rosanne Rosanna Danna SNL circa 1970 something
In view of current economic growth in the U.S. and overseas, what stands to be the largest potential areas of impact over the next 12-24 months?
The month of October has a reputation for being the cruelest of months for markets. And this reputation is well earned. During October of 1929, 1987, 1989, 1997 and 2008, U.S. stock markets experienced elevated levels of volatility, often in response to political and economic events that had been building throughout the year. On average, the S&P 500 has over 60 days each year in which it rises or declines over 1%. In 2017 there were only 8 of these days. So far, as of October 26, 2018, there have been over 40 of these days.
This increased, yet historically normal, level of market volatility has been impacted by political and economic events such as the U.S. government’s fiscal deficit, mid-term elections in the U.S., concerns about fiscal and bank solvency in countries such as Argentina and Italy, and assorted other political events in the U.S. and abroad. While tax reform and a less burdensome regulatory regime have provided meaningful economic stimulus in the U.S., the challenges mentioned above are threatening to undo this positive momentum. Additional challenges facing financial markets include the most recent announcement that the US government’s fiscal deficit was higher than some analysts expected, a heightened degree of uncertainty and unrest politically, the threat and uncertainty around rising interest rates and the potential impacts of trade conflicts and/or tariffs that may inhibit cross border exchange and dampen global economic growth.
Of all of the challenges mentioned above, those that most directly affect the global economy are most likely to have a direct impact on financial markets. Recently International Monetary Fund economists have estimated world economic growth is slowing to 2-3% annually. In addition, short-term interest rates, which have been near zero since the great recession of 2008-09 in many countries, are starting to rise, increasing the cost of capital and potentially dimming investors’ enthusiasm for risk-taking. This decreased risk appetite may impact a wide range of investments, including equities, high-yield bonds, private equity, real estate and other assets classes with higher risk and return profiles relative to cash. The lower cost of borrowing has allowed federal and state governments, companies, municipalities and individuals to access financing at attractive rates. All of this has, in turn, increased economic activity, capital spending, hiring plans and helped drive economic growth rates higher. In the U.S., stronger GDP growth (over 3% annually in the most recent quarterly reports), low unemployment (under 4%) and low inflation (under 3% annually) are partly responsible for strong corporate earnings growth in the last several years.
This equity bull market has had a long run with few interim declines, so what can investors expect?
Since the beginning of this most recent bull-market almost ten years ago in the spring of 2009, passive investment strategies such as index funds have attracted an increasing share of investor dollars. These inflows to passive funds have begun to slow in 2018 compared to 2017. In the event of a significant market correction this could present a few challenges to investment markets. Passive funds provide daily liquidity even though no cash is retained in the mutual fund portfolio. Redemptions are met through stock sales, and in order to maintain the passive nature of the fund, securities are sold on a pro rata basis, regardless of their individual investment merit. Just like many of these strategies have seen large net inflows, if outflows begin, it could pressure stocks across the entire market causing potential price declines from selling to meet these redemptions.
Monetary policy may provide another source of market volatility. The Federal Reserve is decreasing their balance sheet, thus lessening demand for the securities for which they have been buyers over the last decade. The direct impact of this policy is that bond prices fall, and interest rates rise. The low-rate environment of recent years has allowed public companies to finance the repurchase of their own stock. These corporate buybacks have helped fuel the bull market. However, rising rates may make this a less attractive strategy. When coupled with slowing economic growth and the tough earnings comps that many companies will face in 2019, it is certainly fair to be wary of the challenges facing stocks in 2019. These may be some of the drivers that have led to increased October volatility in 2018.
Through Friday, October 26, 2018 the major U.S. stock market averages such as the S&P 500 have declined 10% from recent highs as have other stock indicators. While these types of market declines have been less frequent in recent years, more normal annual volatility often includes at least one of these 10% corrections. Whether it becomes more than 10% domestically, as we have experienced in international equity markets, remains to be seen.
Diversification provides the opportunity for a smoother ride, but is the destination clear?
Among the advantages of diversified portfolio construction is one which involves reasonable straight forward math. Through allocation to strategies which will outperform at various, but usually different, times, well diversified portfolios will, in the aggregate, not go up or down as much as the most volatile individual asset class. Diversification can not only make the investment “ride” smoother, it can also increase the ultimate value of the investment portfolio.
As a simple example, assume an investor starts with $100,000 and invests it in a strategy that produces annual returns of +10%, -5%, +10%, -5%, and repeating in this pattern for ten years. After ten years, the investor has slightly less than $125,000, ignoring any income tax effect. However, if the portfolio is invested 50% in the original strategy and 50% in another strategy which earns +5% during the down years and 0% during the up years, the portfolio will be worth over $126,000 at the end of 10 years. While the increase in return is very small, the risk-adjusted rate of return is much higher, due to significantly lower volatility. The result is more money for retirement, education or other purposes. The less extreme declines hopefully lead investors to better decision making along the way. While real life investing is more complex than this simple example, over time diversified portfolios tend to provide superior risk-adjusted returns as we have outlined here. See the 2018 RGT Investment Perspectives available from our office for more information on investor behaviors.
While some years like 2018 produce a wide disparity between the best and worst performing asset classes, we believe proper diversification is still the approach that is most likely to help investors reach their financial goals.
Please contact someone from RGT Wealth Advisors to discuss these topics further.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Charles Prince, Citigroup CEO. July 2007 interview with the Financial Times.
“History doesn’t repeat itself but it often rhymes.” Aphorism often attributed (probably incorrectly) to Mark Twain.
For investors in the U.S. stock market the music is playing and investors are dancing. While other asset classes have had sell-offs and corrections, the U.S. stock market just keeps on rolling. In the third quarter the S&P 500 was up 7.7%, bringing its year-to-date return to a robust 10.6%. This quarterly return was the largest quarterly gain for the S&P 500 since the fourth quarter of 2013. U.S. small cap stocks are not missing out on the party. The Russell 2000 was up 3.6% in the third quarter and is now up 11.5% for the year-to-date. Digging below the headline numbers, however, a different story begins to emerge. The Russell 1000 Growth Index, a commonly cited benchmark for large, growth-oriented companies, increased 16.3% through September, while the Russell 1000 Value Index, the benchmark for large value stocks, increased only 5.7%. This disparity with growth stocks, primarily technology and health care stocks, outperforming value stocks has been a hallmark of this bull market over the last several years. While the U.S. bull market has roared, it has been a much bleaker picture for foreign equity markets in 2018. The MSCI-EAFE Index is down 1.4% for the year in dollar terms. And emerging markets, represented by the MSCI-EM Index, have done even worse, down 7.7% thus far in 2018.
Fixed Income markets continued to muddle along in the third quarter. The Bloomberg Barclays U.S. Aggregate Bond Index, the most commonly used index for investment grade bonds in the U.S., gained a paltry 0.02% in the third quarter and has lost 1.6% for the year. The losses sustained by bond investors are due to the steady rise in interest rates throughout the year. The increase in interest rates has occurred across the yield curve. The 6-Month U.S. Treasury yield has moved from 1.53% at the end of 2017 to 2.19% at the end of the third quarter. Likewise, the 10-Year U.S. Treasury yield has increased from 2.40% to 3.05% and the 30-Year Treasury yield from 2.74% to 3.19%. This continued upward pressure on rates in the third quarter appeared to be due to several factors. First, the Federal Reserve raised rates for the third time this year and the market consensus seems to point to a fourth raise in rates near the end of the year. In addition, the economy continued to show signs of strength through rising wages, solid economic growth, and bullish consumers and investors. Finally, there was some thawing in trade negotiations, which resulted in a lessening of trade tensions with some of our largest trading partners.
Rising oil prices contributed to positive returns in the energy sector. West Texas Intermediate Crude Oil (WTI) has risen in price from $60.46 at the end of 2017 to $73.25 at the end of the third quarter. The 21.2% price increase is a result of a classical imbalance between supply and demand – constrained global supply due to sanctions on Iranian oil exports and production bottlenecks in the U.S., combined with rising global demand.
While some investors may be disappointed with the performance of a diversified portfolio, these investors may be inadvertently dancing to a tune that is closer to its end than its beginning. We can’t know for sure when markets will turn, or the exact manner in which a reversal will happen. But while we wait for the music to stop for U.S. stock markets, it seems prudent to utilize asset classes other than just U.S. stocks. This includes (almost) any asset class other than the S&P 500. Because sooner or later the music, and the dancing, will move on to a different venue.
Another common behavioral bias is the anchoring effect. Put simply, the anchoring effect describes the tendency to rely too heavily on a singular piece of data or information when making decisions. Often the anchor is an initial piece of information or something familiar to the decision maker. Taking the concept one step further, anchoring also describes how people consistently fail to appropriately adjust to new information because they are “anchored” to an initial reference point. Exploring how this behavior plays out in everyday life and when making investment decisions will help us better understand what it is as well as avoid some of its unpleasant consequences.
There are many examples of the anchoring effect at play. Two that most people regularly experience involve restaurants and gas stations. To illustrate how anchoring occurs at a restaurant, assume one dining party enters a crowded restaurant and is told the wait time is estimated to be 20 minutes while another party enters and is told the wait time is estimated to be 40 minutes. If both parties are seated after 30 minutes of waiting, it is very likely the party that waited a shorter amount than they were told will be in a much better mood than the other party, frustrated by having to wait ten more minutes than they were told. This is because we all subconsciously anchor ourselves to the initial data point, estimated wait time, and react according to how long we wait relative to that estimate. Thus, it is no surprise that some restaurants will intentionally overestimate actual wait times, creating a better dining experience for the customers.
Another real-world example of anchoring involves gas prices. The price of a gallon of gasoline is arguably the most recognizable of all prices. Each day, drivers see the price at the pump as they travel on America’s roads. What is less well known is how those daily data points affect their psychology. A motorist having to pay $3.00 per gallon for gasoline two weeks after paying $2.50 per gallon feels very differently than a motorist paying $3.00 per gallon two weeks after paying $3.50 per gallon. The first motorist, anchored to $2.50 per gallon, feels as though he is overpaying or wasting money while the second motorist, anchored to a higher price per gallon, feels as though she is getting a bargain. Yet both motorists are paying the same price.
ANCHORING AND INVESTING
What does this have to do with investing? Anchoring can unfortunately have negative effects on one’s investment portfolio and financial life. Three examples of investment- or financial-related anchors include becoming fixated on purchase price, targeting a random level in the market before investing, and using local housing prices to gauge the value on homes in other geographies. Briefly examining each of these examples can help investors overcome the urge to be overly influenced by these anchors when making important decisions.
When an investor purchases an investment, the purchase price, known as cost basis, is often crystallized in the investor’s mind. This becomes a natural anchor on subsequent decisions related to the investment. Cost basis can become a hurdle to overcome for any investment that has declined in value but needs to be sold. Sometimes there are fundamental or market forces that change the merits of holding the investment. Even though an investment declines in value, the projected forward returns on another opportunity may be much more attractive than waiting for the original investment to recoup its value. It is very difficult for investors to take a loss and move on or use the sale proceeds to purchase a more attractive investment. This same dynamic occurs with successful investments that are sold too early because an investor is similarly anchored to her cost basis and struggles to adjust to a potential new reality. The investor may fail to see how the investment can continue to provide attractive rates of return even when a positive inflection point occurs that changes the trajectory of the investment.
Another example of anchoring occurs when investors come into new money, such as an inheritance or sale of a business, and articulate a desire to “wait for a correction” before investing. This could refer to waiting for a 10% or 20% pullback in the stock market or simply be a round number they recall from the past, such as the Dow Jones Industrial Average falling to 20,000. The market may have recently increased, and there is a tendency to anchor one’s strategy to a lower market level that, at present, seems like a bargain. History reveals this line of thinking often results in sub-optimal outcomes as it is foolhardy to predict the market will inevitably return to previous levels. The last several years of strong market performance, when many were skeptical of stock valuations, is a great example of this. If investors are always waiting for the perfect time to invest, they might miss out on receiving dividends on stocks or interest income on bonds, a significant component of total return. Investors’ long time horizons tend to dramatically dampen the effects of bad timing. Finally, if individuals invest in a balanced, diversified portfolio that exhibits much less risk than stock markets, they are much less directly exposed to a correction than they may believe.
ANCHORING AND HOME OWNERSHIP
Outside of one’s marketable investment portfolio, market participants tend to view the nation’s housing landscape through the lens of their local market. It is easy to use familiar, local home values as an anchor when looking at second homes or house hunting during a relocation. The result can be sticker shock for someone moving to more expensive housing markets, such as the West Coast or Northeast. On the other hand, someone moving from a coast to the Midwest might have a hard time passing up a much bigger house with lots of land. Using your local knowledge of one area to decide what is a reasonable price to pay for a home in another market can result in a significant financial mistake. Homes are not easily tradeable, demographic trends vary greatly, local economies grow at different rates, income levels may be wildly different, and location matters. These dynamics make viewing housing prices through a narrow lens and anchored to one’s local market potentially costly.
The anchoring effect occurs daily for almost all of us. Most of the time, the subconscious tendency to rely too heavily on an initial piece of information simply results in fleeting elation, regret, or frustration. However, the anchoring effect can lead to material differences in future outcomes when it comes to one’s portfolio and financial life. Acknowledging its existence and examining how it may influence one’s decision making are key to avoiding anchoring’s negatives. One can seek to counteract the potential negative consequences of this behavioral bias by partnering with a strong team experienced in navigating these tendencies.