Saturday, September 12, 2015

Your Weekly Update AND Essential Unpleasantries AND Too Much of a Good Thing

I must say, my greatest---and most important---vocational challenge is the convincing our clients that what they know to be true with regard to virtually every other aspect of their lives is true for their portfolios as well. They've heard me preach both privately and publicly that market downturns---like winters, like diets, like sore muscles following a workout---are the unpleasantries that are essential to a healthy functioning system.

All that preaching notwithstanding, when they open that August statement, and/or when we're meeting and I describe the potential for a market selloff upon the first Fed rate hike in nine years, our clients (well. some of them) tend to cringe. With regard to the Fed, "Let's pray they don't!" or "Surely they won't while the market's so volatile, will they?" are common retorts. Again, all my ramblings on confusing volatility with loss, on why now is the best time for the inevitable and why hanging onto emerging markets and commodities stocks---perhaps even adding a little---amid their pummeling may, as we look back, turn out to be our smartest decisions of 2015 seem to carry little weight against the possibility of a near-term selloff in stocks. Oh well, I remain undeterred!

If, for the moment, you're in need of a little reassurance, please take a few minutes and take in this commentary from a tumultuous moment in 2012, and this one from last month.

As you'll read in the excerpt from my 2007 book Making Lemonade below (yes, a most shameless plug!), the fall of 1997 saw some unexpected volatility that, like today, was blamed on struggles befalling certain Asian nations. But before we go there, I'd like to share an observation that comes from the past three decades of doing what I do: It's that Mark Twain was mostly right, "history may not repeat itself, but it does rhyme". And that policymakers, as they come and go, are every bit as human as the rest of us: At the end of the day, they pursue their own objectives. In fact, if in this context, being human means they suffer the frailties of the ego, I must say that they are yet more human than the rest of us---which will be my segue into the next section:


The dollar has been very strong of late, and while that in many ways is a good thing, it's not viewed that way by many politically-influential leaders of the U.S. manufacturing industry. Here's from L. Ashraf's excellent 2008 book Currency Trading and Intermarket Analysis: How to Profit from the Shifting Currents in Global Markets:
It was no coincidence that the dollar’s peak of spring 2002 coincided with President Bush’s trade war action of slapping foreign steel producers with tariffs in order to secure the Republican Party victory in key states ahead of the Congressional elections later that year. Escalating protests by U.S. manufacturers calling the administration to weaken the strong dollar were heeded by Washington. The message was also loud enough for currency traders to begin selling the dollar against all major currencies, including the euro, which had become an obligatory legal tender in the Eurozone that year.

Make no mistake folks, while the coming Fed rate hike may indeed---as so many predict---spark more upward momentum in the dollar, too much of a good thing is too much of a good thing. A truism that, with regard to a strong U.S. dollar, the powers that be are keenly aware of. I can't help but wonder (and not just for political purposes) how much life the dollar has left and, therefore, how utterly attractive commodities and emerging markets may be at current levels. Check out the inverse relationship (the blue is the dollar index, the yellow is the MSCI Emerging Mkt Equity Index and the red line is the CRB Commodities Index):     click to enlarge


Also take a look at a time when the global powers-that-be formally agreed that too much of a good thing was too much of a good thing. I added text to describe the wheres and whens of the globally coordinated efforts to manipulate the dollar back in the 1980s.     click to enlarge


And, to bring it forward, here's an excerpt from the final communiqué released by the G20 finance ministers and central bankers after their meeting in Ankara just two weeks ago (emphasis mine):
We reiterate our commitment to move toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments. We will refrain from competitive devaluations, and resist all forms of protectionism.  

I.e., they'll be careful while manipulating their currencies to not further exacerbate the knock on effects of a strong U.S. dollar (or a weak Chinese Remnimbi).


In Making Lemonade: A Bright View on Investing, on Financial Market, and on the Economy, I took the reader---by way of my newsletter articles---back through the bull and bear markets of my career to that point. Here's a featured essay from November 1997 that speaks to our connection to emerging economies, the inevitability of falling markets, and of recency bias. The latter being the tendency to frame the current market environment within the context of the most emotionally impacting experience of the recent past. In that the internal manifestations of (the emotional reactions to) market declines are measurably more intense than market advances for most people, the current "correction" is surely provoking 2008, and/or 2000 to 2003-style nausea for your everyday individual investor. Particularly those who reacted, and sold, during a previous market downturn. Oh, and by the way, that 554 Dow-point decline on 10/27/97 that I reference in the following would equate to a 1,200 point decline today:
A Dose of Reality,  November 1997  

It’s the end of the day, October 27, 1997, and the Dow Jones Industrial Average just plunged 554 points, the second biggest one-day point drop and the twelfth biggest percentage drop in the history of the stock market. How did this happen? The market was moving along just fine. We had low interest rates, low inflation, good corporate earnings, lots of cash going to stock funds every month—all the makings of a great outlook for the U.S. stock market. Then “Bloody Monday”! We all thought that, with such a favorable economic backdrop, stocks would just keep moving up indefinitely; after all, it’s different this time, right? Well, those who really believed that have just received a dose of some much-needed reality.

You’ve read here before that I subscribe to the notion that it’s next to impossible for anyone to successfully time the market on a consistent basis. Therefore, I expose my own portfolio, and suggest my clients do the same, to the stock markets of the world when a long-term position in equities fits our overall objectives and tolerance for risk, rather than when the “timing” seems right. As a result, at times we feel like geniuses and at other times like nincompoops.

I’m tempted to provide a chart illustrating past down years in the market and the subsequent up years, but you’ve seen those before. Besides, at this time the Dow is already above where it was before the big sell-off. So can we call this a non-event? Certainly not for that portion of a diversified portfolio allocated to non-U.S. stocks, which are still well below the values seen just a couple of months ago (see Q and A for info on Asian markets). As for our U.S. market, it’s easy to blame the October 27 drop on events in Asia (it’s widely believed that the massive Asian market sell-off is the primary cause for the recent turmoil in our market). Regardless of where the blame resides, you might say that a Wall Street correction was overdue. Valuations were high relative to historic norms, and next year’s corporate earnings outlook isn’t as rosy as the past couple of years, particularly if Asia’s woes play havoc with U.S. multinationals. So maybe a correction such as the one that occurred on October 27 was meant to be. If so, my concern now is that we may be shrugging it off a little too quickly.

The day after the big 554-point drop, we received lots of calls from clients, as we did the day after the October 1987 crash, the biggest point drop in history. However, this year’s calls had a very different tone than the 1987 calls. In ’87, clients were very nervous and were asking if they shouldn’t “jump ship” and take their losses. Very few, if any, wanted to rush in and buy at those much lower levels. This year the calls were almost entirely from clients asking what to buy and wanting to place a trade that very day. My initial thought was that folks are certainly more educated than they used to be; they understand the long-term nature of stock market investing, and instead of panicking about their current holdings going down, they want to put even more money to work at these now lower prices. Then I had a different thought: if our clients had really been listening to my advice, any money they had in reserves that wasn’t intended for emergencies or other short-term needs would have already been in their long-term portfolios. They were actually calling to get into this downward-trending market to make some quick bucks and were willing to risk their cash reserves to do it. After all, we’ve learned that stocks just don’t stay down very long, right? Who could blame these investors for such assumptions? Even if they were in the market when it tanked in ’87, their portfolio probably did fine if they just held on. However, what we can never forget is that once in a while the market takes a dip that turns into a “bear market” that can leave scars on a portfolio—scars that, believe it or not, last longer than a week or two, or even a year. Recall this summer’s newsletter article “Why Buy Bonds,” which recounted the market decline of 1973 and 1974.

So what’s my point? Am I predicting a bear market in the foreseeable future? Certainly not. I don’t make near-term market predictions. In fact, I believe the stock markets of the world will continue to offer patient investors great potential for long-term returns. I also believe, however, that the old law “the higher the potential return, the higher the near-term risk” will never be repealed.

History suggests that sticking to a long-term, balanced approach—mixing the stocks of U.S. companies, non-U.S. companies, large companies, small companies, etc.—and riding through the inevitable ups and downs is how we stand the greatest chance of beating inflation and reaching our long-term financial goals.

The Stock Market:

Non-US developed markets (EFA and FEZ below)—even after their recent pummeling—have outperformed the U.S. major averages (save for the NASDAQ Composite Index) year-to-date. Given many foreign markets’ cheaper valuations, early-stage recoveries and, yes, accommodative central banks, I remain constructive on non-U.S.. That said, there are a number of potential international hot buttons (as we've recently experienced) that could easily delay the narrowing of the gap between the valuations of U.S. and non-U.S. securities (particularly emerging markets [VWO below]). That’s why we think long-term and stay diversified!

Here’s a look at the year-to-date price changes (according to CNBC) for the major U.S. indices---and for non-U.S. indices and U.S. sectors---using index ETFs as our non-U.S. and sector proxies:

Dow Jones Industrials:  -7.80%

S&P 500:  -4.75%

NASDAQ Comp:  +1.27

EFA (Europe, Australia and Far East):  -2.30%

FEZ (Eurozone):  -3.61%

VWO (Emerging Markets):  -14.87%

Sector ETFs:

Here’s a look at the year-to-date results for a number of U.S. sector ETFs:


IYH (HEATHCARE):  +4.74%


XLK (TECH):  -2.15%




IYT (TRANSP):  -11.65%

XLB (MATERIALS):  -11.88%

XLU (UTILITIES):  -12.01%

XLE (ENERGY):  -19.95%

The Bond Market:

As I type, the yield on the 10-year treasury bond sits at 2.19%. Which is 6 basis points higher than where it was when I penned last week's update.

TLT, an ETF that tracks an index of long-dated U.S. treasury bonds, saw  its share price decline a 1.05%  over the past 5 trading days (down 3.60 year-to-date).  As I keep repeating, I see bonds in general sporting a risk/return trade-off that makes going out on the yield curve not worth the risk.

On Volatility and Timing:

Each week I share with you the very short-term (year-to-date) results for major indexes and sectors. I do this with a bit of hesitation, as I in no way want to give the impression that you, nor I for that matter, should base our long-term investment decisions on short-term movements in markets or their sectors. It can, however, serve as a reference point for how the markets are, or are not, responding to the data (which is why I, as a professional, track the short-term). While my beginning of the year optimism over non-US (developed markets that is) and the housing sector, and my pessimism over utilities, appears to be justified by recent results, I need to strongly (very strongly!) emphasize that I was not predicting what we’ve experienced thus far in 2015. Plus, while we maintained our healthcare exposure I in no way expected the gains that sector has experienced this year. Same goes for energy and materials, only in the other direction.

My optimism or concerns over a given sector or region are based on factors such as valuations, trends, supply and demand, monetary policy and cyclicality—and my comfort in making allocation recommendations rests on the view that our clients are not short-minded investors (it can take awhile, if at all, for the market to reward what I believe to be good fundamental logic) who mistakenly believe that any human being possesses a capacity for market timing. Some people get lucky from time to time, but without exception, market timers are wrong far more often than they are right. The path to long-term investment success is fraught with bumps and potholes. The ones who successfully make the journey take it slow and never over-compensate when steering through and around the inevitable obstacles along  the way.

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