Mar
13
Just ten weeks ago, investors were coming off one of the best years in a decade for a broad swath of financial assets. The S&P 500 rose by 31.5% and bonds, as measured by the Bloomberg Barclays U.S. Aggregate Index, increased by a dramatic 8.7%. Almost everything good that could happen for investors did happen. What a difference a couple of months makes. With each passing week, markets now seem to be confronted with yet another unexpected piece of news or negative turn of events. The list over the last three weeks alone would be enough to fill an entire year:
- The rapid spread of COVID-19 outside of China not only led to volatility in stock and bond markets, the likes of which we have not seen since the Global Financial Crisis, it has also severely disrupted daily life and travel plans for many around the globe.
- The tenor of the U.S. presidential election shifted substantially as a more moderate candidate emerged to challenge progressive frontrunners at the same time the economic outlook darkens.
- Instead of bolstering confidence, an unexpected emergency interest rate cut from the Federal Reserve confirmed investor concerns of an underlying shift in corporate and economic fundamentals and signaled a potential return to zero interest rate policy.
- Over this past weekend, an alliance of oil producing countries known as OPEC+ fractured, leading oil prices to decline almost 25% in a single day and causing significant declines in the prices of stocks and bonds issued by many well-known energy companies.
Collectively, these events have had a significant impact on the equity positions within investor portfolios and driven long-term interest rates to record lows in the U.S. Uncertainty and worry have turned the market upside down in short order. The speed of the transition suggests the market has gone from pricing assets as if nothing negative would ever happen again to pricing them as if the worst possible outcome is now unavoidable. As risk gets re-priced and sentiment turns negative, government bonds are trading at levels more consistent with a recession environment and stocks are trading slightly above levels that would mark the first official bear market in over 12 years.
It’s important to remember that RGT has been in business for 35 years and has the requisite experience to manage through market disruptions such as this. While each disruption is different, experience is valuable when navigating turbulent market environments.
RGT is preparing for a longer grind than many market pundits are indicating today and one with more frequent bouts of volatility. A technical recession, defined as two quarters of negative GDP growth, or even something more protracted are real possibilities. While we view many of today’s events such as COVID-19 as transitory, economic damage has been inflicted. Corporate investment is slowing, and consumer spending is shifting while risk aversion increases. While the ultimate length of time required for markets to find a bottom, and the ultimate level of that market bottom is unknowable, there are a few silver linings in play.
RGT client portfolios came into this environment balanced and well-positioned. Not only have bonds helped mitigate losses and reduce volatility during this market turmoil, high-quality bonds have performed very well. Our investment philosophy is guided by thoughtful asset allocation and diversification, two pillars that we have stood by when many abandoned them during this period of low interest rates and an uninterrupted bull market. Consequently, we have what we believe is a solid foundation from which we can manage portfolios through this environment as there are no dramatic, rash decisions to be made. Like sailing through choppy waters, marginal adjustments are much better (and easier to make) than wholesale portfolio changes.
We utilize a platform of experienced investment managers continuously focused on improving their portfolio’s risk and return profile. We regularly speak with these managers and are currently deep in the process of speaking to them about the present landscape. These conversations, which are already bearing fruit and informing our views, have reminded us of the value our managers bring in helping us make more informed, marginal changes to portfolios during volatile periods. We believe utilizing managers as a resource to stay current on how the economy and specific companies are performing is an advantage. We loathe the thought of having to look at a portfolio made up entirely of ETFs, quantitative strategies, and index funds that don’t say a word, and make no changes to their portfolios, when times are tough.
Given the significant performance differential over the last month between bonds and stocks, we are now actively looking for rebalancing opportunities between asset classes and other strategies where performance has diverged. We expect a series of smaller changes to be made over the course of months, not days. While this process can be tedious and is often dependent on individual client or family circumstances, it is a disciplined and unemotional act of strategically working to buy low and sell high. Rebalancing also allows us the opportunity to reset portfolio exposures back to longer-term targets.
Finally, it is worth noting that as riskier assets, such as stocks, decline in value they inherently become cheaper. This ultimately improves future returns, perhaps dramatically if the decline is steep or growth ends up surprising to the upside. The ultimate length and depth of economic disruption is anyone’s guess, but stocks have improved return prospects on both an absolute basis and relative to bonds, especially as interest rates plumb record lows. An investor with a long-term time horizon and no need for immediate liquidity will thus be more appropriately compensated for owning risk assets going forward.
As markets continue to fluctuate, sometimes wildly and unpredictably, it is important to remind yourself that these types of environments often give rise to significant opportunities. Current losses aren’t permanent when markets decline despite how uncomfortable it can be along the way. Maintaining a disciplined and deliberate approach centered around a long-term strategic asset allocation increases the probability of participating more fully in higher-returning environments. Responding from a balanced position also makes it easier to identify and invest in compelling opportunities when they arise.
Please let your RGT advisor know if you would like to discuss these ideas.
Mar
6
Despite all the concerns surrounding COVID-19 (see RGT’s thoughts here) and yesterday’s surprise 50bps reduction in the Fed Funds rate, it’s hard to forget that this year is an election year. We all know what that means: incessant media coverage of candidate personalities and their policy proposals – caricatures and unrealistic talking points, mainly. Many policy proposals, regardless of which side of the aisle they come from, would likely have a direct impact on your investment portfolios: higher capital gains taxes, financial transaction taxes, taxation on unrealized gains, or various regulatory changes. Other policy proposals may have a more indirect, though no less impactful, effect as they consider broader issues that could spur or hinder both domestic and global economic growth.
Feb
28
“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” U.S. Secretary of Defense Donald Rumsfeld, February 12, 2002.
We began the year 126 months into the longest economic expansion in U.S. history. On February 19, 2020 the S&P 500 closed at an all-time high of 3,386.15 (as a point of comparison, the S&P 500 reached its nadir following the Great Financial Crisis on March 9, 2009 at a closing level of 676.53). Most market concerns at the beginning of 2020 centered around volatility due to contentious U.S. elections, continued tensions around trade, somewhat stretched valuations for financial assets, and the simple fact that the expansion, and the bull market, were getting somewhat long in the tooth.
Typically, though, it’s not the things that the market worries about, the “known unknowns,” that bring about violent downturns in financial markets. A great example of a “known unknown” is the Y2K crisis. We were warned about Y2K years in advance. It received large amounts of media attention, but because it was known and years had been spent addressing the problem the impact of Y2K was negligible. Instead it’s the event that no one sees coming, the “unknown unknown,” that is potentially the most problematic for markets. The Coronavirus, now known as COVID-19, is a perfect example of the kind of shock that the “unknown unknown” can have on markets.
When an “unknown unknown” shock occurs markets often react in dramatic fashion. That’s because mar
kets are forward-looking, and they now must add a variable that they had heretofore not considered. But beyond that, the simplest explanation is that most humans fear the unknown. And fear has a way of creating quick and extreme reactions, which often turn into overreactions.
Financial markets are a perfect environment in which to see this sort of human behavior on display.
- Since the market close last Friday, February 21, the S&P 500 has dropped 11.4% through the close of trading on Friday, February 28. Foreign stocks, as represented by the MSCI-EAFE fell 6.7% over that same time frame.
- The last week has been the worst week in the U.S. stock market since the 2008 Financial Crisis.
- The 10-year Treasury is at all-time lows dropping from 1.46% on Friday, February 21 to 1.17% on Friday, February 28.
- Oil prices have fallen over $8/Bbl, or more than 15%, in a week’s time.
The last week has been a prime example of a reaction driven by the fear of the unknown. Let us stress as strongly as possible, almost everything about COVID-19 and its ultimate impact on financial markets is unknown. Another point worth noting is that reacting to unknown threats is not illogical. In fact, it’s an important human survival trait. However, it is not necessarily the best way to respond in your investment portfolio.
If indeed COVID-19 turns into a pandemic, it will not be the first pandemic of this sort with which markets have had to deal. The 2009 Swine Flu Pandemic (H1N1/09), which lasted from early 2009 to 2010, is the most recent example. Somewhere between 10 million to 200 million people are estimated to have contracted H1N1/09[i]. The exact number of deaths are not known, though one estimate puts the estimated number of deaths worldwide at somewhere between 105,700-395,600[ii].
Negative views make for great media fodder and feed into the market sell-off frenzy. But the latest news out of China, which has been the nation hardest hit by COVID-19, is beginning to seem more positive. While there will no doubt be an adverse impact on Chinese demand and output, it appears that the containment efforts by the Chinese government are starting to make an impact on the rate of transmission of the disease, which should be encouraging. Nonetheless, there is no visibility into the duration of the health crisis or to what extent this disease will ultimately spread.
What can we learn from history?
- These types of events are transitory. The key question becomes how the event lasts.
- Currently investors view the risks as to the downside, thus the violent sell-off of stocks and other “risky” assets and the rise in prices for U.S. Treasuries and other safe-haven assets. And as often happens, once markets begin to sell-off, pressure for other investors to sell rises.
- The long-term risks faced by investors are more about how the economy (and thus revenues and earnings) is impacted and for how long. If this follows the most recent global pandemics, then the economic impact should be temporary and it’s possible that markets rebound nearly as fast as they sold off.
Key Takeaways for Investors
- Right now, there is no visibility into the length of the health crisis. Thus, attempting to make a call on how this plays out from an economic and market perspective would be futile. Assuming the worst outcome is no more helpful than assuming the best outcome.
- Asset allocation is showing itself to be valuable during the latest market sell-off. Make sure your investment plan and asset allocation fit your circumstances. Well diversified portfolios are designed to lessen the impact of stock market losses, not to eliminate them entirely. The key is to be able to help mitigate your losses thereby easing your compulsion to feel the need to sell at market lows. If you can do this, you should you be better position to participate when markets recover.
- Cash for defense is just that, cash. But right now, you earn very little on cash. So, if you feel the need to get defensive in this way, you can’t concern yourself with return.
- Rebalancing and tax loss selling opportunities may present themselves. If you have a long-term outlook you should avail yourself of these opportunities, without an emphasis on trying to have perfect timing.
- Remember, you own stocks for a multi-year time horizon, not for what happens in a week, a month, or even a year. If you have cash to invest, market corrections like this can provide an opportunity to put it to work at lower valuations, thus potentially enhancing prospective long-term returns.
If you have any questions or concerns about these matters and how they impact your portfolio and your financial situation, please contact your RGT advisor.
[i] “Report of the Review Committee on the Functioning of the International Health Regulations (2005) in relation to Pandemic (H1N1) 2009” (PDF). 5 May 2011. Archived (PDF) from the original on 14 May 2015. Retrieved 1 March 2015.
[ii] Dawood FS, Iuliano AD, Reed C, et al. (September 2012). “Estimated global mortality associated with the first 12 months of 2009 pandemic influenza A H1N1 virus circulation: a modelling study”. The Lancet. Infectious Diseases. 12 (9): 687–95. doi:10.1016/S1473-3099(12)70121-4. PMID 22738893.
Oct
9
“We tolerate complexity by failing to understand it. That’s the illusion of understanding.” Steven Sloman and Philip Fernbach, The Knowledge Illusion, 2017.
“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time, perhaps for a long time.” John Maynard Keynes, The Great Slump of 1930, 1930.
If you’ve ever tried to explain something to a small child, then you’re familiar with their constant response of “Why?” to whatever answer you provide. As adults, we seem to believe that this is because children enjoy annoying adults. But maybe it’s because children see the world as a complex place and simple answers just won’t suffice. Eventually we all (or at least almost all of us) succumb to the realization that we are never going to be able to understand this complexity and we learn to rely on mental shortcuts, or heuristics, to give us “good enough” explanations for what’s going on in the world.
For the most part, these heuristics work well enough. But when we try to understand complex systems, like markets, monetary systems, or broad economies, these heuristics often break down. To make matters even worse, our reliance on heuristics to understand causality in complex systems leads us to seek the easy answer, not the complex answer, and feeds into an overconfidence that we understand that which is quite often not understandable.
Performance in the financial markets in the third quarter was a bit of a jumbled mess. The S&P 500 ended the quarter up 1.70% and is up 20.55% for the year. But there was a four-week period running from late July to late August when the S&P 500 lost 5.9% before recovering over the last month of the quarter. Other equity markets, such as U.S. small-cap stocks (Russell 2000), foreign developed markets (MSCI-EAFE), and emerging markets (MSIC EM), were all down for the quarter.
Fixed income markets were no less volatile, with the bellwether 10-year U.S. Treasury yield dropping from 2.00% at the beginning of the quarter to an intra-quarter low of 1.47% on September 3 before rates backed up. The 10-year Treasury ended the quarter at a yield of 1.68%. The falling rate environment was a strong tailwind for bond returns with the Bloomberg Barclays U.S. Aggregate Index up 2.27% for the quarter and up 8.52% for the year.
What led to this intra-quarter volatility? Those seeking the quick answer had a plethora of choices from which to choose – trade wars, slowing economies, tweets, election uncertainty, falling earnings growth, more tweets, and on, and on. It’s tempting to latch on to one or two of these explanations, especially if they conform to our view of the world as we try to seek order in chaos. But the very real danger is that oversimplified explanations can imbue us with a false sense of confidence. Believing that we understand the causal relationships in these complex systems, we in turn are in danger of poor decision making based on our overconfidence. To avoid this trap when we manage portfolios, we try to develop a sound, long-term investment plan, we engage in thoughtful and deliberate decision-making processes, and we seek to build portfolios in such a way as to diversify our risk exposures and our opportunities for return.
Aug
8
“We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one that we are unwilling to postpone, and one which we intend to win.” John F. Kennedy, September 12, 1962.
If you’re like me, you’ve spent more than a few evenings this summer watching the trove of documentaries that have been airing on PBS and other outlets about the Apollo program in celebration of the fiftieth anniversary of the first lunar landing on July 20, 1969. I find that watching the story of Project Apollo unfold and witnessing the genius, ingenuity, determination, and bravery of the men and women of NASA making the seemingly impossible become a reality to be both fascinating and inspiring.
Revisiting these events has also been an opportunity to see and hear the speech President Kennedy delivered on September 12, 1962 at Rice Stadium in Houston. The quote above, pulled from that speech, has long been one of my favorite presidential quotes. The speech was intended to rally support for the space program, but the rhetoric used to sell the audacious goal of landing astronauts on the moon and bringing them home safely seems to have a much broader application. Just because a task is hard doesn’t mean that it isn’t worth doing. Shirking difficult challenges and opting for the easy way out is not something that can be counted on to produce long-term success.
Our task at hand, managing investments, is certainly a much easier task, by many orders of magnitude, than the challenges faced by NASA and the Apollo program. While the NASA engineers had to solve problems related to the laws of physics and the nature of human biology, the most difficult challenges facing investors are often internal rather external. Being disciplined investors that make good decisions focused on cogent, long-term strategic plans is our ‘hard’ task at hand. The difficulty comes in battling cognitive biases, such as Recency Bias, Hindsight Bias, or Bandwagon Bias (also known as Herding), that are constantly pulling investors in the wrong direction. We are all subject to falling victim to these biases. They are constantly pushing us towards the seemingly easier path and are the most difficult challenges facing most investors.
Recent market performance is providing a plethora of cognitive bias challenges for investors. As has been the case for much of the last 10 years, the S&P 500 was the best performing market index in the second quarter, up 4.30%. This despite some significant intra-quarter volatility. That brought the S&P 500’s year-to-date performance up to 18.54%. This is where our cognitive biases kick in. Recency Bias will lead investors to extrapolate this performance into the future leading them to overweight large-cap US stocks. Hindsight Bias will whisper in the investor’s ear that everyone knew that the S&P 500 was the best place to be – it was obvious. And the Bandwagon Bias will urge investors to jump on board the US large-cap stock train; everyone else has and they are all doing better than you. This is the time that doing the hard thing, maintaining a disciplined long-term approach grounded in fundamental investment principals, becomes most difficult. And it is why investors should be prepared, as Lady Macbeth said, to “screw their courage to the sticking place,” and prepare to do that which is hard, not that which seems easy.
Aug
1
The Tax Cuts and Jobs Act passed in late 2017 provided for tax incentives designed to encourage capital investment in local “zones” in an effort to spur economic development and job creation in distressed areas. The Opportunity Zone, or O-Zone, program encompasses over 8,000 census tracts and more than 30 million residents across the U.S. Texas has approximately 600 Opportunity Zones, with nearly 30 in the DFW area. It is estimated that these new tax incentives will provide over $100 billion of investment in qualifying O-Zones. For investors, income taxes levied on future expected gains can be significantly reduced if the qualifying investment is held for at least 5 years. In addition, if an O-Zone investment is held for longer than 10 years, the gain, which would otherwise be taxable, will be tax-free. Other elements of this new tax law include the chance to reinvest gains incurred from other sales into O-Zone investments and the deferral of any tax that would have been paid for up to seven years. For example, if a business is sold in early 2019 and a taxable gain of $250,000 is recorded, the $250,000 gain can be reinvested in an O-Zone qualified investment fund thereby deferring the taxes due on this $250,000 until a later date. So, there is immediate income tax savings and potential future additional tax savings or elimination of taxable gain, depending on how long the O-Zone investment is held. To provide further guidance, the IRS issued Proposed Regulations in October 2018 as well as April 2019.
Who should consider O-Zone investments? Anyone who has already incurred a taxable gain from sale of any type of investment (no more than 180 days prior to making a qualified Opportunity Zone investment) or who anticipates having a taxable gain in the next 180 days could be a good candidate. Taxpayers can benefit by reinvesting a portion of or the entire gain incurred into a qualified O-Zone fund within the 180-day time requirements. The gain can be from marketable securities, real estate, private investments, sale of a closely held business, gains received through partnership investments, etc. Only the portion of the gain that is reinvested would be eligible for future tax deferral, depending on the holding period of the qualified O-Zone fund investment.
What are the potential rewards? Current year income tax is deferred for any qualified gain invested in an O-Zone fund. For example, if taxes of 20% on $500,000 of gain ($100,000 of income taxes otherwise due) are expected, the taxpayer/investor could choose to invest this $500,000 (or any portion of this gain) in a qualified O-Zone fund. As such, the $100,000 of capital gains taxes would be deferred to a later date and the $500,000 invested would escape taxation if the O-Zone investment is held for a minimum of 10 years. Thus, the tax deferral is immediate as well as the potential savings in the future if the O-Zone requirements are met. Another benefit of the new tax law is the broad range of qualifying O-Zone investment types that qualify (e.g. real estate, equity, loans or other types of legal structures). More IRS guidance is expected to further clarify these criteria.
What are the risks? General investment risk is inherent in any O-Zone fund. While the tax benefits are nice to have, if the O-Zone fund is not successful, any deferral or elimination of taxes would be offset by an unsuccessful investment. It is important to evaluate the investment fund without the tax incentive program benefits being included. If the diligence suggests an investment, the tax savings should be viewed as an added incentive. In addition to general investment risk, there is the risk of a tax law change in the next 10 years that could make this program less beneficial for all taxpayers or select taxpayers above a certain income threshold. Thus, there is the possibility of law revisions which could potentially remove some of the benefits. This needs to be considered before investing.
How do you get more information? Individual circumstances are important to consider when determining whether an Opportunity Zone Investment is appropriate. RGT Wealth Advisors is actively researching the new O-Zone rules and regulations and can provide more analysis and assistance in determining whether these investment funds may be appropriate for an investor. So far, RGT has seen qualifying O-Zone investment funds in NY, CA, TN and AZ. Please contact us for additional discussion on Opportunity Zone investing.
Jun
25
“The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.”
Sir John Templeton, Investment Success, 1933.
Sometimes investment market trends are so strong, and extend over so many years, that even time-tested approaches, such as disciplined, diversified asset allocation strategies, can seem “out of touch”. Oftentimes… Click here to view full article.
Jan
9
“I have two kinds of problems: the urgent and the important. The urgent are not important, and the important are never urgent.” Dwight D. Eisenhower in a 1954 speech to the World Council of Churches, quoting Dr. J. Roscoe Miller, the President of Northwestern University.
December’s market swoon came as a shock for many investors. After finishing the previous nine years with a positive return, December’s market selloff resulted in the first negative annual total return for the S&P 500 since 2008. The fourth quarter of 2018 also marked the fourth time in the last decade that the S&P 500 declined more than 10% over the course of a quarter. The other three times occurred in Q1 2009 (-10.9%), Q2 2010 (-11.4%), and Q3 2011 (-13.8%). There were numerous factors that seemed to contribute to investors’ fear. Among them were increasing concerns about a slowing global economy, the ongoing trade war between the U.S. and China, the Federal Reserve disappointing markets by raising rates 25 basis points in December and signaling an additional two rate hikes in 2019, uncertainty surrounding the impact of falling oil prices, and fears that corporate earnings may have peaked. Adding “agita” to the markets were comments by current Chair of the Federal Reserve Jerome Powell that the Fed’s ongoing unwinding of its balance sheet would continue on “automatic pilot.” Throw in selling pressure from investors engaged in year-end tax-loss selling and a lack of buyers over the holidays and you have the perfect recipe for a significant market correction. By Christmas Eve, the S&P 500 was less than one-half percentage point from entering a bear market (traditionally defined as a drop of 20% or more). However, equities rallied back following a Christmas break to narrowly avert an official bear market. U.S. small-cap stocks fared the worst of the major equity asset classes, losing 20.2% during the fourth quarter and bringing their year-to-date losses to 11.0%. Losses were wide spread across all equity asset classes and market sectors with virtually all equity asset classes finishing both the quarter and the year in the red.
As investors fled volatility in equity markets, many sought to allocate their capital to the relative safety of bonds. This flight to safety helped push interest rates lower in December, driving the benchmark 10-Year Treasury down to 2.69%, 55 basis points below its peak of 3.24% on November 8, and only 29 basis points above where it ended 2017. Despite interest rates mostly rising throughout the year, the December rate plunge moved broad fixed income indices back to the breakeven point or slightly into positive territory for the year. The Bloomberg Barclays U.S. Aggregate Bond Index, the broad benchmark used by many fixed income investors, finished the year with a return of 0.01%, which would be about as low as you can go and still claim a positive return. Shorter/intermediate-term municipal bonds, measured by the Bloomberg Barclays Municipal Bond 5-Year Index, finished the year up 1.7% after a strong fourth quarter rally.
Despite the pervasive pessimism that seemed to overcome markets in the fourth quarter, there are more than a few bright spots to consider as we look forward to a new year. The U.S. economy grew at an annualized rate of 3.4% in the third quarter of 2018, and growth in China is expected to be in the neighborhood of 6% in 2018. Inflation continues to be benign, with the latest report showing the CPI (Consumer Price Index) rising 2.2% year-over-year through the end of November. The unemployment rate is also low, coming in at 3.9% as of the latest report from the Bureau of Labor Statistics on January 4. Low levels of inflation combined with a strong and apparently stable labor market should continue to provide a counter to some of the worst market fears. And it seems fair to posit that investors are pricing in some fairly negative outcomes related to tariffs, trade wars, and other geopolitical concerns. Given these positive underlying economic indicators, any upward surprise in the areas with which the market has expressed so much concern could significantly improve investor psychology.
As we move into a new year, investors should continue to focus on what is important, their long-term investment plan. The investment plan should include contingencies for changing market conditions, such as portfolio rebalancing, tax-loss selling, and reassessing the asset allocation of the plan as conditions change. But we should all beware of devoting too much time to the tyranny of the urgent, never letting it distract us from that which is truly important.