President Mayor?

March 1st, 2020

by Steve Stofka

Among the Democratic candidates for President are two mayors. Mike Bloomberg was mayor of New York City for the twelve years following 9-11. Pete Buttigieg just completed an eight year stint as mayor of South Bend, Indiana. Americans have never elected a recent mayor to the presidency (Badger, 2019). Will this year be different?

Mayors are responsible for everything that happens in their city – from policing practices to snow removal. John Lindsay, a former mayor of New York City, almost lost his job because of a snowstorm (Marton, 2019). Too many homeless people in Los Angeles? Mayor Eric Garcetti takes full responsibility (City News Service, 2019). Few residents write to the mayor to say that they are so happy that their streetlights are working. The lack of complaints tells a mayor that he or she is doing a good job. Mayors are a tough bunch with strong shoulders.

Do we take the same responsibility for our savings portfolios? If interest rates are too low, do we keep all the money in a savings account and blame the system? When the market goes down, do we rethink our risk appetite, or do we blame those invisible market forces?

 At nearly 11 years, this bull market is the longest running in the past one hundred years. The 400% gain since the March 2009 low beats both the gains of the 1920s and 1990s bull markets. Just a month ago, the investment firm Goldman Sachs estimated that there was still room for more price appreciation this year (Winck, 2020).

This week’s downturn was made sharper by several practical factors. In any abrupt downturn that last a few days or longer, margin calls prompt more selling. What is a margin call? Let’s say I borrow $50 from my broker to buy a $100 stock. If the price goes down to $90, my broker wants me to pony up another $5. If I don’t have the cash, the broker will sell some of my holdings to raise the cash.

The Coronavirus prompted investors to reassess projected earnings for this year and to assign a greater risk to their stock exposure. A lot of investors bought bonds with the proceeds from their stock sales. Worst time to buy long term bonds? Probably. An ETF of 30-year Treasury bonds (TLT) hit its highest price ever this week.

President Trump regards stock market performance as an important indicator of his success. What will he do if market prices decline another 10%? Will he attack Fed chairman Jerome Powell as he did in 2018? Has Mr. Trump become the most wearisome President in modern history?

Joe Biden took almost half the votes in the S. Carolina primary this week, but Bernie Sanders is still leading the roster of candidates with 54 delegates (Leatherby and Almukhtar, 2020). It’s a long road to the goal of 1991 delegates to secure the nomination. The delegates captured in the first four primaries are dwarfed by the 1344 delegates in play this week on Super Tuesday. 643 of those delegates are in California and Texas. It’s a reminder of the power of a few states in the selection of a President.

What about the mayors in the race? Pete Buttigieg is 3rd in delegate count. Because Mike Bloomberg entered the race late, he set his sights on Super Tuesday and currently has 0 delegates. Elizabeth Warren and Amy Klobuchar have both worked long and hard, have enthusiastic supporters but have earned few delegates. Running for the top office is a hard job.

Will this week bring more downturns in the market? There was a big surge of investors willing to buy late Friday afternoon. It’s a good sign when large investors are willing to take a position before the weekend.  

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Notes:

Badger, E. (2019, November 18). Pete Buttigieg Tests 230 Years of History: Why Can’t a Mayor Be President? N.Y. Times. Retrieved from https://www.nytimes.com/2019/11/18/upshot/Buttigieg-2020-race-mayors.html

City News Service. (2019, August 26). Mayor of LA Promises More Help to Solve Homelessness Problem. Retrieved from https://www.nbclosangeles.com/news/local/streets-of-shame/mayor-garcetti-homeless-los-angeles-crisis-response/129407/

Leatherby, L., & Almukhtar, S. (2020, February 3). Democratic Primary Election Results 2020. Retrieved from https://www.nytimes.com/interactive/2020/us/elections/delegate-count-primary-results.html

Marton, J. (2019, January 28). Today in NYC History: John Lindsay’s No Good, Very Bad Snowstorm of 1969. Retrieved from https://untappedcities.com/2015/02/09/today-in-nyc-history-john-lindsays-no-good-very-bad-snowstorm-of-1969/

Photo by Mateus Campos Felipe on Unsplash

Winck, B. (2020, January 23). GOLDMAN SACHS: Lagging fund inflows can drive the stock market even higher | Markets Insider. Retrieved from https://markets.businessinsider.com/news/stocks/stock-market-higher-forecast-inflows-safe-asset-crowding-goldman-sachs-2020-1-1028840905

Price Plateaus

October 20, 2019

by Steve Stofka

Occasionally the stock market plateaus for six to nine months. The competing market sentiments – positive and negative – that cause a price plateau usually turn in one direction or another. Rarely does this leveling period last for twelve months or more. When those indecisive conditions don’t resolve for a year, what happens next?

Let’s begin by looking at shorter duration plateaus which occur more frequently. The market gets a bit too exuberant or conflicting economic signals make it more difficult to predict the future. Some investors read the data and reach for risk; others read the same tea leaves and opt for safety.

In 1999, near the peak of the dot-com fever, prices plateaued for seven months before going onto new highs in 2000 . Again, the market paused for much of the year.  It was the end of the huge bull market of the 1990s.

In the beginning of 2004, investor indecision caused a leveling of price action after market sentiment had turned positive in 2003. The dot-com bust, the 2001 recession, the 9-11 tragedy, and the Enron and accounting scandals had combined to cut stock values in half by the spring of 2003. Investor optimism following the tax cut package of 2003 suffered when employment gains in late 2003 turned erratic. Investors were wary. Would this be a double-dip recession like the early 1980s? 

A relaxation of financial regulations helped spur more residential investment and the market continued upward. The erratic gains in employment were attributed to seasonal volatility in the construction industry. Many factors contributed to the complex international financial environment that spurred a boom in housing. In 2007, investors began to question market evaluations and prices plateaued for six months.

Two recent price stalls lasting more than twelve months seem to buck the trend of shorter-term plateaus. That there have been two in less than five years is concerning. In mid-2014, oil prices began a steep decline. Lower commodity input prices helped the profits of the broad market but by early 2015, investors grew worried that this decline was a reaction to a broad economic downturn. For 18 months, prices leveled. As voters went to the polls in early November 2016, prices were the same as in February 2015. Some voters chose an inexperienced Donald Trump as an alternative to Clinton 3.0 or Obama 3.0.

Shortly after the passage of tax reform in December 2017, investor optimism hit a peak and it has barely surpassed that high since then. The optimism of this year’s gains has only balanced the pessimism and losses of last year’s final quarter. What will happen after this? I don’t know. Investors need to think like fighters who stay balanced on their feet because they don’t know where the next punch is coming from.


Portfolio Performance & Presidents

October 6, 2019

by Steve Stofka

The employment report released Friday was a Goldilocks gain of 136,000 jobs for the month of September. Why Goldilocks? Not as weak as some feared following news this week that manufacturing was getting hit hard in the trade war with China (Note #1). Not so strong that it ruled out the possibility of another rate cut from the Fed this year. Just weak enough to speculate on another rate cut by year’s end. After several days of big losses, the market rallied on Friday.

Although manufacturing has been contracting, a report on the rest of the economy was more encouraging, although a bit lackluster (Note #2). Service businesses are continuing to hire but the pace has slowed. New export orders have accelerated but new orders in total slowed significantly from August. Something to like, something not to like.

Billions of dollars around the world are traded as soon as the employment report is released each month. During Mr. Obama’s tenure private citizen Donald Trump accused Obama of fudging the employment numbers. Larry Kudlow, now Mr. Trump’s economic advisor, took him to task for that. Mr. Kudlow worked in the Reagan administration and knew well how sacrosanct the employment numbers were. The BLS is an independent agency working in the Department of Labor and its 2400 employees try to collect and publish the most accurate data it can accomplish. The agency’s Commissioner is the only political appointee in the BLS and once confirmed by the Senate, serves four years, the same as the head of the Federal Reserve (Note #3). According to Mr. Kudlow, the White House gets the number the night before only to prepare a press release when the report is released.

Mr. Trump’s reckless behavior helped him take out 16 other Republican presidential candidates in the 2016 election. He acts quickly and aggressively. That lack of caution has led to several bankruptcies, and because of that, no bank in the world will loan him money (Note #4). What if, on an impulse, Mr. Trump tweeted out the employment number shortly before its official release time? Some traders pay a lot of money so that the news will hit their trading desk a split second faster than a conventional news release. It’s that important. An early leak of the employment numbers would cost a lot of influential people big money around the world and would prompt a national if not a global crisis. Forget about the phone calls to foreign leaders to discredit Joe Biden. That would be an act of treason for sure – against the global financial community. Can’t happen? Won’t happen?

Mr. Trump knows no rules. His father protected him when his rash behavior got him into trouble as a child. The elder Trump sheltered Donald from his own mistakes in the real estate industry and his foolish foray into the Atlantic City gambling business. Now that Mr. Trump’s father is no longer there, he depends on others to protect him. He has enlisted a long line of people in that effort. They have come in the revolving door to the White House and left. The list is longer than I imagined (Note #5). John Bolton, the third National Security Advisor under Mr. Trump’s tenure, was the last high-profile team member to leave.

Mr. Trump has said that Americans would get tired of winning so much while he was President. To use a baseball analogy, when he takes the mound, the team doesn’t win very often. People who lose a lot either give up or blame everyone and everything else for their losses. They need to have an ideal environment or get lucky to win. Mr. Trump berates the independent Fed because he wants them to protect him. He needs every crutch he can get. He couldn’t succeed in a war or in the financial crisis because he is not disciplined or organized.

What does this mean for the average investor? Take a cautious approach and keep a balanced portfolio. Betting that Mr. Trump will pitch a good game is a poor bet.

Or is it? At an event on Friday, he claimed that the stock market has gone up 50% since he was elected. Not quite but it is up 42% since the day after he was elected (Note #6). It’s been about 35 months. That’s pretty good. A 60-40 stock-bond portfolio has gone up 30% in that time. Under Obama’s tenure the market only went up 27%. A balanced portfolio went up almost 40% and he had to deal with the worst recession since the Great Depression. The budget battles with Republicans put a big dampener on investor enthusiasm during Obama’s first term.

35 months after the Supreme Court awarded the presidency to George Bush, the market was down 25% but a balanced portfolio was up 21%. Even Mr. Clinton could not best Mr. Trump, although he comes close. 35 months after the 1992 election the market was up 38%. A balanced portfolio was up 40%. The winner? A balanced portfolio.

What might an investor expect? At today’s low interest rates and inflation, a break-even return might be 5% a year, for a total gain of 22% in four years. Will Mr. Trump’s first four years be one of his few wins? Check back in a year. It’s bound to be a tumultuous year.

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Notes:

  1. Institute for Supply Management (ISM). (2019, October 3). September 2019 Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm
  2. Institute for Supply Management (ISM). (2019, October 3). September 2019 Non-Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/NonMfgROB.cfm?navItemNumber=28857&SSO=1
  3. Bureau of Labor Statistics. (n.d.). About the U.S. Bureau of Labor Statistics. [Web page]. Retrieved from https://www.bls.gov/bls/infohome.htm
  4. Business Insider. (2019, August 28). The world is talking about Trump’s relationship with Deutsche Bank. [Web page]. Retrieved from https://markets.businessinsider.com/news/stocks/trump-tax-returns-deutsche-bank-relationship-drawing-intense-scrutiny-2019-8-1028482268#why-it-matters2
  5. Wikipedia. (n.d.). List of Trump administration dismissals and resignations. [Web page]. Retrieved from https://en.wikipedia.org/wiki/List_of_Trump_administration_dismissals_and_resignations
  6. Prices are SPY, the leading ETF that tracks the SP500. Clinton: 42 to 58 (approximately) – up 38%. Bush: 138 to 103 – down 25%. Obama: 91 to 116 – up 27%. Trump: 208 to 295 – up 42%. Balanced portfolio returns from Portfolio Visualizer calculated using a mix of 60% U.S. stock market, and 40% of an evenly balanced mix of intermediate term government and corporate bonds. Dividends were reinvested and the portfolio re-balanced annually.

Follow the Leaders

January 27, 2019

by Steve Stofka

This week the investment community mourned the death of John Bogle, the founder of Vanguard, the mutual fund giant. He had the crazy idea that mom-and-pop investors should buy a basket of stocks and not attempt to beat the market (Note #1). In 1976, he launched the first SP500 index fund, VFINX, a low-cost “no-brainer” or passive fund. Because people did not want to invest in the idea of earning just average stock returns, the initial launch raised very little money. “Bogle’s folly” now has more than fifty imitators (Note #2).

Vanguard has over $5 trillion under management. Let’s turn to them to answer the age-old question – what percent of my retirement portfolio should be invested in bonds? Bond prices are much less volatile than stocks and stabilize a portfolio’s value. Several decades ago, people retired at 65 and expected to live ten years in retirement. An old rule was that the percentage of bonds and cash should match your age. A 50-year old, for example, should have 50% of their portfolio in bonds and cash. Few advisors today would be so conservative. Many 65-year-olds can expect to live another twenty years or more.

Vanguard, Schwab, Fidelity and Blackrock offer various life cycle funds that have target dates. The most common dates are retirement; i.e. Target 2020, or 2030 or 2040. These funds are composed of shifting portions of stock and bond index funds offered by each investment company. The funds adjust their stock and bond allocations based on those dates. For example, if a 55-year old person bought the Vanguard Retirement Target Date 2020 Fund VTWNX in 2005, it might have been invested 75% stocks and 25% bonds when she bought it. As the date 2020 nears, the stock allocation has decreased to 53% and the bond portion increased to 47%. The greater portion of bonds helps stabilize the value of the portfolio.

In the chart below, I’ve compared the stock and bond allocations of various retirement funds offered by Vanguard (Note #3). Notice that the stock portion of each fund increases as the dates get further away from the present.

vantargetfundscomp

A 46-year old who intends to retire in 2040 when they are 67 might buy a Target 2040 fund which is 84% invested in stocks. The bond allocation is only 16%. Using the old rule, the bond portion would have been 46%.

What happens after that target date is met? The fund continues to adjust its stock/bond allocation towards safety. Over five years, Vanguard adjusts its mix to that of an income portfolio – 30% stocks and 70% bonds (Note #4).

These strategies can guide our own portfolio allocation. I have not checked the allocations of Schwab, Fidelity and others in the industry but I would guess that they have similar allocations for their life cycle funds.

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Notes:

1. History of Vanguard Group
2. More than fifty funds invest in the SP500 index according to Consumer Reports
3. Vanguard’s Target 2020 fund VTWNX , 2025 Fund VTTVX , 2030 Fund VTHRX, 2035 Fund VTTHX, and 2040 Fund VFORX
4. Vanguard’s Income Portfolio VTINX 

Place Your Bets

January 6, 2019

by Steve Stofka

This will be my tenth year writing on the financial markets. As I’ve written in earlier posts, we’ve been sailing in choppy waters this past quarter. In 2018, a portfolio composed of 60% stocks, 30% bonds and 10% cash lost 3%. In 2008, that asset allocation had a negative return of 20% (Note #1). We can expect continued rough weather.

If China’s economy continues to slow, the trade war between the U.S. and China will stall because a slowing global economy will give neither nation enough leverage. Will the Fed stop raising interest rates in response? If there is further confirmation of an economic slowdown, could the Fed start lowering interest rates by mid-2019? Ladies and gentlemen, place your bets.

Thanks to good weather and a strong shopping season, December’s employment reports from both ADP and the BLS were far above expectations (Note #2). Wages grew by more than 3%. Will stronger wage gains cut into corporate profits? Will the Fed continue to raise rates in response to the strong employment numbers and wage gains? Ladies and gentlemen, place your bets.

The global economy has been slowing for some time. After a 37% gain in 2017, a basket of emerging market stocks lost 15% last year. Although China’s service sector is still growing, it’s manufacturing production edged into the contraction zone this past month (Note #3). Home and auto sales have slowed in the U.S. What is the prospect that the U.S. could enter a recession in the next year? Ladies and gentlemen, place your bets.

The partial government showdown continues. The IRS is not processing refunds or answering phones. If it lasts one more week, it will break the record set during the Clinton administration. Trump has said it could go on for a year and he does like to be the best in everything, the best of all time. Could the House Democrats vote for impeachment, then persuade 21 Republican Senators (Note #4) to vote for a conviction and a Mike Pence Presidency? Ladies and gentlemen, place your bets.

When the winds alternate directions, the weather vane gets erratic. This week, the stock market whipsawed down 3% one day and up 3% the next as traders digested the day’s news and changed their bets. Interest rates (the yield) on a 10-year Treasury bond have fallen by a half percent since November 9th. When yields fell by a similar amount in January 2015 and January 2016, stock prices corrected 8% or so before moving higher. Since early December, the stock market has corrected by a similar percentage. Will this time be different? Ladies and gentlemen, place your bets.

Staying 100% in cash as a long-term investment (more than five years) is not betting at all. From a stock market peak in 2007 till now, an all cash “strategy” earned less than 1% annually. A balanced portfolio like the one at the beginning of this article earned a bit less than 6% annually. Older investors may remember the 1990s, when a person could safely earn 6% on a CD. Wave goodbye to those days for now and place your bets.

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Notes:

  1. Portfolio Visualizer results of a portfolio of 60% VTSMX, 30% VBMFX and 10% Cash
  2. Automatic Data Processing (ADP) showed 271,000 private job gains. The Bureau of Labor Standards (BLS) tallied over 300,000 job gains.
  3. China’s manufacturing output in slight contraction
  4. The Constitution requires two-thirds majority in Senate to convict an impeached President. Currently, there are 46 Democratic Senators and Independents who caucus with Democrats. They would need to convince 21 Republican Senators to vote for conviction to get a 67 Senator super-majority. 22 Republican Senators are up for re-election in 2020 and might be sensitive to public sentiment in their states.

Stormy Seas

December 23, 2018

by Steve Stofka

For the past two months, the stock market’s volatility has doubled from late summer levels. The Fed announced its intent to continue raising interest rates in 2019 at least two times, and the market nosedived in response. It had been expecting a more dovish policy outlook from Chair Jerome Powell.

What does it mean when someone says the Fed is dovish, or hawkish? Congress has given the Fed two mandates: to manage interest rates and the availability of credit to achieve low unemployment and low inflation. That goal should be unattainable. In an economic model called the Phillips curve, unemployment and inflation ride an economic see-saw. One goes up and the other goes down. To rephrase that mandate: the Fed’s job is to keep unemployment as low as possible without causing inflation to rise above a target level, which the Fed has set at 2%.

There are periods when the relationship modeled by the Phillips curve breaks down. During the 1970s, the country experienced both high unemployment and high inflation, a phenomenon called stagflation. During the 2010s, we have experienced the opposite – low inflation and low unemployment, the unattainable goal.

Convinced that low unemployment will inevitably spark higher inflation, the Fed has been raising interest rates for the past two years. The base rate has increased from ¼% to 2-1/2%. The thirty-year average is 3.15%. Using a model called the Taylor Rule, the interest rate should be 4.12% (Note #1).  After being bottle fed low interest rates by the Fed for the past decade, the stock market threw a temper tantrum this past week when the Fed indicated that it might raise interest rates to average over the next year. Average has become unacceptable.

FedFundVsTaylorRule

In weighing the two factors, unemployment and inflation, the Fed is dovish when they give greater importance to unemployment in setting interest rates. They are hawkish when they are more concerned with inflation. The Fed predicts that unemployment will gradually decrease to 3.5% this coming year. Unemployment directly affects a small percentage of the population. Inflation affects everyone. The Fed’s current policy stance is warily watching for rising inflation.

The stock market is a prediction machine that not only guesses future profits, but also other people’s guesses of future profits. As the market twists and turns through this tangle of predictions, should the casual investor hide their savings in their mattress?

These past five years may be the last of a bull market in stocks; 2008 – 2012 was the five-year period that marked the end of the last bull period that began in 2003 and ran through most of 2007. Here are some comparisons:

From 2014-2018, a mix of stocks returned 7.7% per year (Note #2). A mix of bonds and cash returned 1.96%. A blend of those two mixes returned 4.91% per year.

From 2008-2012, that same stock mix returned just 2.66% per year. The bond and cash mix returned 5.5%, despite very low interest rates. A blend of the stock and bond mixes returned 5.26%.

For the ten-year period 2008 thru 2017, the stock mix earned 7.7%. The bond and cash mix returned 3.54% and the blend of the two gained 6.35% annually. On a $100 invested in 2008, the stock mix returned $13.5 more than the blend of stocks and bonds. However, the maximum draw down was wrenching – more than 50%. The $100 invested in January 2008 was worth only $49 a year later. Whether they needed the money or not, some people could not sleep well with those kinds of paper losses and sold their stock holdings near the lows.

The blend of stock and bond mixes lost only a quarter of its value in that fourteen-month period from the beginning of 2008 to the market low in the beginning of March 2009. The trade-off between risk and reward is an individual decision that weighs a person’s temperament, their outlook, and the need for to tap their savings in the next few years.

A rough ride in stormy seas tests our mettle. During the market’s rise the past eight years, we might have told ourselves that our stock allocation was fine because we didn’t need the money for at least five years.  If we are not sleeping because we worry what the market will do tomorrow, then we might want to lower our stock allocation. Sleeping well is a test of our portfolio balance.

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Notes:
1. The Atlanta Fed’s Taylor Rule calculator
2. Calculations from Portfolio Visualizer: 30% SP500, 30% small-cap, 20% mid-cap, 20% emerging markets. Bond mix: 70% intermediate term investment grade bonds, 30% cash. The blend of the two was half of each percentage: 15% SP500, 15% small-cap, 10% mid-cap, 10% emerging markets, 35% bonds, 15% cash.

Not Trading

“It takes a lot of time to be a genius. You have to sit around so much, doing nothing, really doing nothing.”― Gertrude Stein

September 16, 2018

by Steve Stofka

As the U.S. market grinds higher, emerging markets are in bear territory, off 20% from their highs at the beginning of the year and selling at 2007 prices. After nine years of recovery, the U.S. economy is in the late stages of the cycle. Warnings of an impending market fall will come true at some point. If the market falls in 2020, those who called for a fall in 2014 will say, “See, I called it. Buy my book.” This year, hedge funds, the smart money, have underperformed index funds, the dumb money. For several years, passive index funds have outperformed active fund managers, a phenomenon that some warn will lead to a catastrophic meltdown when it happens.

For the average retail investor, it is difficult to beat buy and hold. An investor who bought the SP500 index 25 years ago would have earned 9% per year in price appreciation alone. Adding in dividends would have raised the annual gain to 9.58%. That is what is called a “Buy and Hold” (BnH) strategy. It’s not a strategy. It’s a strategy of no strategy, and yet it is surprisingly difficult to consistently beat a no-brainer no-strategy like BnH over several decades. The stock market earned this while riding through two downturns that erased half of the market’s value. Even a middle of the road strategy of 60% stocks and 40% bonds earned 8.3% annually during the same period.

Traders develop rules that work in one decade, but don’t work in the next. A strategy that worked well in the years 1998-2007 didn’t work well in the period 2008-2017. Why? Because they were two different time periods, with different events and circumstances (Note #1).

Here’s a rule that could have earned an investor twenty – yes, twenty – times BnH in the period from 1960-1993. The rule did not work in any timing frame other than daily. Each morning at the open, buy the SP500 index if the previous day was up, sell if it was down. Huge profits even after trading costs (Note #2). 1993 – 2018? It was a losing strategy. It would have been better to do exactly the opposite – sell after an up day and buy after a down day.

Every year thousands of people will shell out good money for a winning strategy that promises to best the market. Most strategies don’t beat the market consistently. Those that do are guarded like the nation’s gold at Fort Knox and are not shared. For the rest of us, the winning strategy is a few rules: save money and invest in a balanced portfolio that is appropriate for our age and needs in the next five years.

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Notes:

  1. From 1998-2007, an emerging market index fund (VEIEX) earned 15.08% annually. From 2008-2017, that same fund earned 1.13% annually. For the combined twenty-year period, the annual gain was 7.87%.
  2. Until the SPY exchange traded product was created in 1993, there was no product that enabled a retail investor to trade daily and frequently. Mutual funds that mimicked the index restricted the frequency of trades. I used the daily SP500 index numbers as though there had been such a product created in 1960.

Spring Cleanup

March 11, 2018

by Steve Stofka

Today time springs forward. Tufts of grass turned green, and some trees are beginning to bud. It was still light after 6 P.M. even before the time change. Great flocks of cranes fly north. In the springtime evening we can hear the siren call of the booby headed tax deadline.  2017 IRA contributions are due by April 15th.

This is a good time to check our game plans. Are we saving enough? In the accumulation, or pre-retirement, phase, 10% or more of our income is a good savings goal. 5% is an absolute minimum. Savings should be used to pay down any debt that has an interest rate more than 5%. High interest rate loans are a weight we must drag around with us. Consider working part time for a while and using that money to pay down high interest rate debt.

New car loans now average over $30K with an average maturity (length of payment period) of 67 months. The average interest rate is 4.21% but anyone with less than a FICO score of 690 is paying 5% or more. This article has breakdowns by credit score, lending institution, length of loan, and other factors.

Of the money we have saved – any annual portfolio realignments to be done? This is a good time to not only think about it but to do it.

In the distribution phase of a portfolio, we begin to withdraw funds from the portfolio that we have accumulated through a lifetime of saving.  Using Portfolio Visualizer, I’ve compared two portfolios with a 60/40 mix – 60% stocks, 40% bonds and cash.  These backtests include an annual rebalancing that may be more difficult for funds in a taxable account because buying and selling may generate taxable capital gains.

Let’s pretend a person retired in May of 1998 at the age of 68 and just died last year. During this twenty years, there were two times when the stock market fell 50%. The beginning year 1998 is near a high point in the stock market. The ending year 2017 was the 8th year of the current bull market. The test begins and ends at strong points in the market cycle, a key feature of a test like this.  Beginning a backtest with a trough in the market cycle and ending with a peak only distorts the results.

Portfolio

At the time of retirement, our retiree had a $1 million portfolio, although the amount could have been $100,000 or $10 million.

Portfolio6040

Although the stock allocation is the same for both portfolios, Portfolio 2 is totally simple. Put all the money in Vanguard’s Total Stock Market fund and forget about it. Portfolio 1 manually diversifies the 60% stock portion of the portfolio among four classes: Large capitalization, mid cap, small cap value stocks in the U.S., and European large cap stocks. Think of Goldilocks sitting down to a table with four bowls of soup – big, medium, small and European.  If that person retired today, a diverse stock portfolio would include an emerging markets index fund like Vanguard’s VEIEX.  In 1998,  emerging markets were not part of a core portfolio as they are today.  For this test, I left out emerging markets.

The bond portion of the portfolio is an index fund of the total bond market. Both portfolios hold 10% in cash for emergencies and living expenses.

Income

A portfolio is like snow in the Rocky Mountains that melts and flows toward the Pacific Ocean. Will the water make it to the ocean? Each year this retiree withdrew 4% of their portfolio balance for expenses. That percentage is considered safe during most twenty-year retirement periods. Note that some advisors are using a thirty-year retirement period to test a portfolio mix. As the years go by and the purchasing power of a $1 erodes, will 4% be enough to meet a retiree’s income needs? The more diverse portfolio allowed the retiree to withdraw a larger amount every year, and the annual withdrawal did keep up with inflation.  Secondly, the ending balance was about the same as the beginning balance after adjusting for inflation.

PortfolioWithdrawal6040

Return

The more diverse Portfolio 1 (marked complex in graphic below) has a better return over this twenty-year period. See the Internal Rate of Return (IRR) column, which adjusts for the withdrawal amounts each year.

PortfolioReturns6040
The drawdown, or greatest decline in value, in the time series is a critical test of a portfolio mix. The retiree needs that portfolio to generate a certain amount of income every year. If the portfolio falls to zero, the income stream has dried up. In the chart below, look at the dip in the portfolio value during the 2008 Financial Crisis. The more diverse Portfolio 1 (blue line) dipped below the starting $1 million figure, but not by much. The investor who was 100% invested in the stock market, the 500 Index portfolio (yellow line), fared the worst during most of the twenty-year period.  In a sign that the bull market has matured, the 500 Index has overtaken the simple 60/40 mix (red line) and is about to overtake the diversified 60/40 mix (blue line).

PortfolioGrowth6040
The diverse portfolio is not complex. There are no gold or commodity assets, no energy or natural resource funds, and no real estate REITs to manage.  If emerging markets were added to the Goldilocks mix, there would now be five equal bowls of soup, each of them taking 12% of the portfolio. This portfolio would have earned 4/10% better each year.

PortfolioEM6040

We could add a Pacific stock index like Vanguard’s VPACX to the mix, but when do we stop adding indexes? In this time period, that index had a slight negative effect on returns. As the number of indexes grow, we are less likely to adjust our allocation.

Our portfolios can get cluttered and too complicated to be effective and easily managed.  Can we simplify?  It’s worth a look see. In taxable accounts, de-cluttering and re-balancing can generate taxable capital gains, so it might not be advisable to make any changes.

Stress Test

February 11, 2018

by Steve Stofka

The recent market correction, defined as a 10% decline, has been a real time stress test for our portfolios. There hasn’t been a stock market correction since the 11% drop in December 2015 to January 2016. Because the end of January was near the height of the stock market, you can more easily find out how much your portfolio declined relative to the market. As of the close Friday, the SP500 had fallen 7.2% since the end of January. That is your benchmark. Later in this blog, I’ll review a few reasons for the decline.

You can now compare the decline in your portfolio to that of the market.  If you use a personal finance program like Quicken, this is an easy task. If you don’t, then follow these steps:
1) Write down your January ending balances at your financial institutions, including any savings accounts or CDs that you own.
2) Write down the current balances and calculate the difference in value since the end of January.
3) Divide that difference by the balance at the end of January to get a percentage decline.

For instance, let’s say your balances at the end of January added up to $100K and your current balance is $95K (Step 1). The difference is $5K (Step 2). Your portfolio has declined 5% (Step 3) compared to the market’s 7.2%, or about 70% of the market. If the market were to fall 50% as it did from 2000-2002 and 2007-2009, you could expect that your portfolio would fall about 35%. Are you emotionally and financially comfortable with that? A safety rule of investing is that any money you might need for the next five years should not be invested in the stock market.

The next step is to compare the gains of your portfolio in 2017 to the market’s gain, about 24%. The gain should be approximately the same as the loss percentage you calculated above. If the gain is slightly more than the losses, you have a good mix.

The chart below compares two portfolios over the past ten years: 1) 100% U.S. stock market and 2) 60% stocks/ 40% bonds (60/40 allocation). Notice that the best and worst years of the 60/40 portfolio are nearly the same while the best year of the 100% stocks is 10% less than the worst year.

StressTest2008-2017
The 60/40 portfolio captured 80% of the profits of the 100% stock portfolio ($101,532 / $128,105) but had only 60% of the drawdown, or decline in the portfolio. Compare that with the chart below, which spans only nine years and leaves out most of the meltdown of value during the Financial Crisis. There is no worst year! La-di-da! Investors who are relatively new to the stock market may underestimate the degree of risk.

StressTest2009-2017
The 60/40 portfolio captured 58% of the profits of the 100% stock portfolio ($152,551 / $262,289) but the drawdown was 63% (11.15% / 17.84%).  If the drawdown is more than the profits, that doesn’t look like a very good deal for the 60/40 portfolio, does it?  That is how bull markets entice investors to take more risk than might be appropriate for their circumstances.  Come on in, the water’s fine!  An investor might not see the crocodiles. Markets can be volatile. This has been a good reminder to check our portfolio allocation.

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Why?

So, why did the market sell off? Let me count the ways. It began on Friday, February 2nd, when the monthly labor report showed an annual gain of 2.9% in hourly wages. For much of this recovery, economists have been asking why wage growth was sluggish as unemployment fell. Economists who like their idealized mathematical models don’t like it when reality disagrees with those models. Finally, wage growth showed some healthy gains and the market got spooked. Why?

As wages take more of the economic pie, profits decline. Companies respond by raising prices, i.e. higher inflation. As interest rates rise, there are several negative consequences. Companies must pay more to borrow money. Fewer consumers can afford mortgages.  Homebuilders and home improvement centers like Home Depot and Lowe’s may see a decline in sales. Car loans become more expensive which can cause a decline in auto sales. There is one caveat: even though hourly wages increased, weekly earnings remained stable because weekly hours declined slightly.  Next month’s reports may show that inflation concerns were overestimated.

This past Monday, ISM released their monthly survey of  Non-Manufacturing businesses and it was a whopper. 8% growth in new orders in one month. Over 5% growth in employment. These are two key indicators of strong economic growth, and confirmed  the fears stirred up the previous day’s labor report. Inflation was a go and traders began to sell, sell, sell.

For the past year, market volatility was near historic lows. Volatility is a measure of the predictability of the pricing of SP500 options. A profitable tactic of traders was to “short” volatility, i.e. to bet that it would go lower. There were two exchange traded funds devoted to this: XIV and SVXY. Traders who bought XIV at the beginning of 2017 had almost tripled their money by the end of the year. When volatility tripled this past week, the whole trade blew up. People who had borrowed to make these bets found that their brokers were selling assets to meet margin calls.  Within days, XIV was closed and investors were given 4 cents on the dollar. SVXY may soon follow. Investors had been warned that these products could blow up. Here’s one from 2014.

The stock market is both a prediction of future profits and a prediction of other investor’s predictions of future profits! The prospect of stronger interest rate growth caused traders to reprice risks and returns. Much of the impact of the selling this past week was in the last hour on Monday and Thursday, when machine algorithms traded furiously with each other. The last hour of trading on Monday saw an 800 point, or 3% , price swing in just a few minutes. In the closing ten minutes of that hour, Vanguard’s servers had difficulty keeping up with the flow of orders.

Contributing to the decline were worries over the government’s debt.  The new budget deal signed into law this week will likely increase the yearly deficit to more than $1  trillion.  There was soft demand for government debt at this week’s Treasury bill auction.  Even without a recession in the next ten years, the accumulation of deficits will increase the total debt level to about $33 trillion.

This correction is an opportunity for the casual investor to make some 2017 or 2018 contributions to their IRA. Profit growth is projected to be strong for the coming year. The correction in prices this week has probably brought the forward P/E ratio of the SP500 to just below 20, a more affordable level that we haven’t seen in few years.

 

Ten Year Review

January 14, 2018

by Steve Stofka

To ward off any illusions that I am an investing genius, I keep a spreadsheet summarizing the investments and cash flows of all my accounts, including savings and checking. Each year I compare my ten year returns to a simple allocation model using the free tool at Portfolio Visualizer. Below is a screen capture showing the ten-year returns for various balanced allocations during the past several years.

10YrReturn20180112
The two asset baskets are the total U.S. stock market and the total U.S. bond market. A person could closely replicate these index results with two ETFs from Vanguard: VTI and BND. Note that there is no exposure to global stocks because Portfolio Visualizer does not offer a Total World Stock Asset choice in this free tool. An investor who had invested in a world stock index (Vanguard’s VT, for example) could have increased their annual return about 1.3% using the 60/40 stock/bond mix.

I include my cash accounts to get a realistic baseline for later in life when my income needs will require that I keep a more conservative asset allocation. An asset allocation that includes 10% cash looks like this.

10YrReturnStkBondCash20180112
In the trade-off between return and risk, a balanced portfolio including cash earns a bit less. In 2017, the twenty-year return was not that different from the ten-year return. From 2009 through 2011, ten-year returns were impacted by two severe downturns in the stock market.

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The Hurt

Falling agricultural prices for seven years have put the hurt on many farmers. This decade may turn out to be as bad as the 1980s when many smaller farms went belly up because of declining prices. Remember the Farm Aid concerts?

The Bloomberg Agriculture Index has fallen about 40% over the past five years. While farmers get paid less for their produce, the companies who supply farmers with the tools and products to grow that produce are doing reasonably well. A comparison of two ETFs shows the divergence.

DBA is a basket of agricultural commodity contracts. It is down 33% over the past five years.
MOO is a basket of the stocks of leading agricultural suppliers. The five-year total return is 31%.

The large growers can afford to hedge falling prices. For family farmers, the decline in agricultural prices is a cut in pay. Imagine you were making $25 per hour at the beginning of 2017 and your employer started cutting your pay bit by bit as the year progressed? That’s what its like for many smaller farmers. They work just as hard and get paid less each year.