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.

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.

Historical Portfolio Returns

December 25, 2016

Merry Christmas Everyone!

This week I will look at the historical performance of different portfolio allocations.  Also, a comparison of this year’s performance to long term averages.  There are a few surprises.

In the weeks since the election, there has been a strong demand for risk, lifting the broad SP500 index by 8%. So how goes it over on the safety side of the ledger? Holders of an index of the total bond market, VBMFX or BND, have seen a price drop of a bit more than 3% since the election, but a net gain of 2-1/4% in the past twelve months.  Almost all of that gain is the yield, or interest earned on the bonds.  Inflation eats up most of that net gain, leaving the bond investor with little net gain for the year, but no loss.

 Morningstar provides a comparison table of various investments.  The AGG broad bond index in their table has an average total return of 2.18% over the past five years.  Yes, this year’s rather low return of 2.25% is better than the five year average.

Vanguard provides a 90 year comparison of various portfolio allocations and it is the first one on the page that I’ll turn to.  Over 90 years, the average total return of interest and price appreciation on a 100% fixed income, i.e. bond, portfolio is 5-1/4%, or 3% more than this year’s total return.

In today’s low yield universe, there is little difference, or spread between today’s yield on a broad bond index and that on a broad stock index.  Over that 90 year period, stocks have averaged 10% per year total return.  The difference between the average total return on bonds and stocks is almost 5% and is called the risk premia.  It means that, on average, a bond investor sacrifices 5% annual return for the income and the relative price stability of bonds. That’s the 90 year average.  The 5 year average tells quite a different story: a 15% per year total return for the SP500 vs 2.18% for a broad bond index.  That risk premia is 2-1/2 times the 90 average.   Seniors and others needing safety have paid a high price.

OR…let’s look at this from a different perspective.  In the long run, the law of averages is like gravity. What price would the SP500 be if its total return were more in line with the 90 year average of 10%?  The answer is a price that we last saw during February of this year – about $1840.  That is an 18% drop from today’s current price of $2264.

As the generation of boomers continues to draw down savings to supplement their income, we can expect that price stability will become more valued.  That should balance some of the downside price risk of owning bonds in an environment of rising interest rates.  There are some countervailing forces.  Oil states may derive more than half of their revenue from profits based on the price of oil.  When oil prices were high, the sovereign funds of these states bought U.S. Treasuries and other assets with the excess profits.  As prices declined since mid-2014, the lower revenues have produced budget deficits in those countries dependent on oil.  They have already sold some assets and will continue to do so if prices remain below $60 a barrel.

Comfortability Ratio

The Vanguard table of returns for various allocations (see above) shows that a 60% stocks/ 40% bond portfolio allocation (60/40) produces the best total returns of the choices for a balanced portfolio.  Let’s look at a comfortability ratio – the average return divided by the percent of years with a loss, or %AR / %YL.  This can be an important psychological ratio for those approaching and in retirement.

As many studies have shown, we give more weight to losses than gains.  We are naturally risk averse, and especially so as we near the end of our working years.  Higher comfort ratios are safer.  A 40/60 and 50/50 allocation have comfort ratios of .44.  Their average return is 44% of the percent of years that an investor suffers a loss.

Ranked by this comfort ratio, the surprise is that a 60/40 allocation acts more like a growth, not a balanced, allocation.  70/30 and 80/20 growth allocations have the same .37 comfort ratios as the 60/40.  On a more surprising note, a strongly agressive 90/10 allocation with a .38 ratio  has a better comfort ratio than any of these growth allocations.  Here’s a table:

Allocation Avg % Years Comfort Ratio
                   Return    With Loss
40/60 7.8 17.7 .44
50/50 8.3 18.8 .44
60/40 8.7 23.3 .373
70/30 9.1 24.4 .373
80/20 9.5 25.5 .373
90/10 9.8 25.5 .384
100/0 10.1 27.8 .364

Allocation based on income needs

As an alternative to conventional allocation models using percentages, an investor might keep five years of income needs in bonds and cash and devote the rest to equities. An important caveat: income needs do not include emergency cash. Using this model, an investor who needed $20K from their portfolio each year, would keep $100K in bonds and cash, and put the rest in stocks.  A 35 year old with no income needs would have 100% in equities.  This model naturally becomes more conservative as the portfolio is drawn down.

For two years the stock and bond market have seen little net change.  Investors might have become complacent.  Since the election, the shift in sentiment has been strong and investors should check their year end statements and make adjustments based on their needs and targets.

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In a country far, far away….

Cue the Star Wars theme. Dah, dummm, dah, dah, dah, dummmmm.  In 2008, China overtook Japan to become the country that holds the largest amount of U.S. Treasuries. Since this summer, China has been selling Treasury bonds to support its currency, the yuan, and is now again in 2nd place.  As long as the dollar continues to rise, China is likely to continue this practice which will maintain a slight downward pressure on bond prices.

Election Volatility

November 13, 2016

Sometimes the hardest thing an investor can do is nothing.  That’s pretty much what a casual investor with a balanced portfolio should do in response to the election results.  With a portfolio of 57% stocks and 43% bonds and cash, my total portfolio has risen 1/2% this week, or much ado about nothing.  Let’s dig into this week’s election results and the market’s reaction.

Donald Trump, the President-elect, has long maintained that his campaign was a movement and was proved right this past Tuesday.  White voters from rural districts around the country rallied in strong numbers to Trump’s promise to straighten up Washington.

Voters generally want a change of direction after one party has occupied the White House for two terms and this election proved to be no different. In the modern era of politics, only H.W. Bush was able to gain a 3rd Presidential term for the Republican party in 1988 after two terms of Ronald Reagan.  Countering the emotion and momentum of the Trump movement on the right were the voters on the left who passionately turned out for Bernie Sanders in the Democratic primaries.  Voters and superdelegates chose the establisment candidate, Hillary Clinton.  Some say that the process and the rules favored Clinton over Sanders.  His supporters are convinced that Sanders could have beat Trump.  Movement against movement.

In the past decade, voters have expressed a preference for rallying cries, for mantras of momentum like “Si se puede!” (Obama), “Build the wall!” (Trump) and “Medicare for all!” (Sanders).  Candidates must learn to condense their message into a short slogan that can be easily waved.  McCain, Romney and Clinton never found a verbal cadence that would act as a catalyst for voters to enthusiastically join the parade.  Sarah Palin, McCain’s Vice-Presidential candidate in 2008, understood the need for slogans.

 Note to future Presidential candidates who would like to actually win:  criticize the candidate, not that candidate’s supporters.  Hillary Clinton made the same mistake that Romney made in the 2012 election – disparaging their opponent’s voters.

Election night.  As a Trump victory became increasingly probable, global markets began to sell risk (stocks) and buy safety (bonds).  In the early morning hours after the polls closed, the networks called the state of Wisconsin for Donald Trump and put him over the threshold of 270 votes in the Electoral College.  Several  minutes later, about 2:45 AM on Nov. 9th, we learned that Hillary Clinton  had called Donald Trump to concede and wish him luck.  Dow Futures were down about 4% at that point.  Japan’s stock market was down 5.5%.  The yield on the 10 year Treasury note was down 7.22%, meaning that the price was up about 8% as investors in world markets were seeking the safety of U.S. debt.  Emerging markets fell in anticipation of protectionist trade policies under a Trump administration.

About 3 A.M.  President-elect Trump began to give a sedate and rational acceptance speech that began with a gracious nod to Hillary Clinton’s fight.  He spoke of unity, healing and more importantly, infrastructure spending and tax cuts.  With control of the Congress and Presidency in Republican hands, there was real hope that Washington could end the years of stalemate and finally implement fiscal policy to rescue a economy that had been kept afloat by an exhausted monetary policy for six years.

The overseas markets began to turn around.  By the time U.S. markets opened more than six hours later, stocks and Treasuries had reversed.  Stocks were now off less than 1/2% and Treasury prices were down severely.  TLT, a popular ETF for long term Treasuries, opened about 2% lower, a price swing of 10%.  EEM, a composite of Emerging Market stocks, opened up almost 3% down and lost ground during the trading session.  By week’s end the SP500 had risen 3.8% for the week, and EEM had fallen by that same percentage.

This week’s action in the bond market was a good example of the mechanics of bond pricing so let’s look at the price action and what it says about the future guesses of the direction and extent of interest rates.  First, bond prices move inversely to interest rates.   The extent that these prices move is measured by a bond’s duration.  Here is a link to the iShares page for the TLT ETF on long term Treasuries.  I have captured a section of the page with the duration highlighted.

If you have a bond fund, the mutual fund company will state the bond duration as well.  What does this tell you?  Leverage.  Duration tells you the approximate change in price for a 1% change in interest rates.  In this case, a 1% increase in interest rates will generate about a 17% decrease in price.  Because TLT is a composite of long term Treasuries, its price is more sensitive to changes in interest rates, or the consensus on interest rates six months to a year in the future.  The price of TLT fell 7.4% this week as traders repriced future interest rates.  With some grade school math, we can calculate what traders are guessing interest rates will be a half year to a year from now.

The Fed last raised rates at the end of 2015, putting them at approximately 1/4% – 1/2%.  In July, the price of this ETF was about $142.  It closed this week at $122, a decline of 14% from the summer high. Now we divide the 14% by the bond’s duration of 17.41% to get a ratio of .80.  This is the new guess of how much interest rates are likely to rise – approximately 3/4% – 1%.  By the fall of 2017, traders are betting that the benchmark Fed interest rate will be about 1.25% to 1.5%.

Let’s look at a more balanced composite bond ETF that financial advisors might recommend for casual investors.  Vanguard has a more conservative composite ETF whose ticker symbol is BND, with a duration of 5.8, about a third of the TLT ETF. (Spec Sheet here)  This week BND lost almost 2% and is down almost 4% from its summer high.  When we divide 4% by 5.8% (the duration in percentage terms) we get a guess of about a .7% raise in interest rates.  Because BND contains shorter term bonds, this guess is slightly below that of TLT.

Why are traders betting on more aggressive interest rate increases after Donald Trump was elected?  He has spoken about infrastructure spending and tax cuts, two fiscal stimulus programs that will likely spur inflation upward.  With a Republican party that has control of the Presidency and both houses of Congress, these measures are likely to be passed in some form.  Some sectors of the economy will likely benefit from more infrastructure spending so they rose this week.  Shares in technology giants like Apple and Google fell as traders switched money among sectors but are still up by healthy margins since February lows.

Let’s say that next March comes and the Trump White House and the House Budget Committee can not come to terms on either of these programs.  Investors would likely reprice interest rate expectations and lower them, causing the price of bond ETFs or mutual funds to rise.

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Miscellaneous Election Notes

I’ll share a distinction that NPR’s David Folkenflik made this week.  Those on the left took Donald Trump literally, but not seriously.  Those who voted for him took him seriously, but not literally.

During Thursday’s trading the Mexican peso fell to 15.83 per dollar, the lowest since 1993 when Mexico reset their currency. Why the big drop?  Trump has repeatedly said that he would cancel the NAFTA agreement that binds Mexico, Canada and the U.S.  The NAFTA agreeement requires only a 6 month notification before termination.  There is some disagreement whether the White House would need Congressional approval to cancel NAFTA which might delay the action.  Some in the Republican party like free trade agreements and are likely to put up a fight.  Some analysts think that the devaluation of the peso could lead to a recession in Mexico, which was already under economic pressure due to falling oil prices.

131 out of 231 million registered voters cast their vote in this election, slightly below the voter total in the 2008 election. (538)  Trump and Clinton each took 26% of registered voters.

The Trump White House can reverse Obama’s executive action on the Keystone pipeline and re-initiate construction.  It will likely amend or repeal tentative proposals to mitigate climate change.

Why did pre-election polls get it so wrong?  According to Pew Research, more than a third of households would respond to a survey a few decades ago.  Now it is only 9%.  Statisticians must tweak this rather small sample to make it more representative of the population as a whole.  A particular demographic constituent in the sample – say white working class men – might be underrepresented in the survey.  Survey methodology then gives the opinion of relatively few sample respondents more weight than it actually has in the general voter population.

Some statisticians recommend using economic and demographic algorithms to gauge future election results based on actual past voting records.

Of the 700 counties that voted for Obama in 2012, a third of those voted for Trump in 2016.  Polls indicated that Hillary Clinton would capture the majority of the white college-educated vote for the first time in decades but she failed to do so.  More white voters voted for Obama than Hillary.

A third of Democrats in the House come from just three states:  California, New York and Massachusetts.  This concentration may answer to the concerns of those states but indicates that the party has become out of touch with the voters in many states.

Each time a Democratic candidate is elected President, unfounded rumors circulate that the new President will take away people’s guns.  People rush out to buy guns.  Trump’s surprise win caused the stock of gun maker Smith and Wesson to decline 22% in a couple of days.

On the other hand, many women feared that Trump and a Republican Congress would restrict birth control and stocked up in the days after the election. Here is a map of abortion regulations in the states before the 1972 Supreme Court’s decision in Roe v. Wade.  Abortion was more permitted in the southern states than the northeast states.

Here‘s a state-by-state breakdown of the vote from NPR.

Portfolio Strategy

The conventional wisdom has been that, over any 20 year period, stock returns will beat bonds and other fixed income investments. For the past 80 years, returns on stocks have been greater than bonds. But, for the past 20 years, bonds have outperfomed stocks. If someone had retired 20 years ago, needing to live off the returns on a portfolio invested mostly in stocks, they would have had a difficult time.

SimpleStockInvesting has historical returns and charts, both actual and inflation adjusted, of the S&P500. A look at the chart of the inflation adjusted price of the S&P 500 (3rd chart) provides a sobering reminder that stock prices may just barely keep up with inflation. If an investor had bought the S&P 500 in 1965 and sold 27 years later in 1992, his inflation adjusted price would have been the same.

A 25 year old investor can use the 80 year history of the stock market as a guideline. The 50 or 60 year old investor doesn’t have that luxury and is more concerned with the volatility of an investment. Balancing both return and volatility is a difficult task.

Let’s look at another investment – gold. Gold prices have been rising this decade and the London fix price per ounce hit an all time high of $1060 this past week. So, is gold a good long term hold? In January 1985, gold had fallen to $300 an ounce. Let’s say an investor had bought at that price. Adjusting for inflation puts the cost at $750. In the past 25 years, you would have made 1.25% more than inflation. But what if you had needed the money in 2007? You would have broken even after 25 years.

You can solve the problem of volatility by keeping your savings in money market funds or short term Treasuries but the return often doesn’t keep up with inflation.

Several decades ago, Harry Browne and a few colleagues came up with a balanced strategy, the Permanent Portfolio, that they thought would give an investor returns that would beat inflation but would not be volatile. You can read about the history here and a 36 year history of returns using his strategy here.