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.

Changing Dance Partners

October 14, 2018

by Steve Stofka

This week’s stock market activity helps us remember some simple rules of investing. Many of us confuse mass and weight. Mass is the resistance of an object to a change in speed or direction. Weight is the force of gravity on that object. Using this model, let’s compare the masses of stocks and bonds. On Wednesday, when stocks fell over 3%, the price of a broad bond composite barely moved.

Bonds act like a big cruise ship, more resistant to changes in wind and wave than a sailboat. The cruise ship’s progress is ponderous but predictable. Stocks behave like a sailboat which moves in a zig-zag fashion, changing directions to cope with wind and wave. Sometimes, the sailboat makes a lot of progress in calm waves with a favorable wind. November 2016 through January 2018 was one such period when stocks made steady progress.

On the previous Wednesday, October 3rd, a “rout” – a half-percent drop – in the bond market indicated a global unease. A half-percent move in the stock market occurs weekly. The last half-percent drop in the bond market was on March 1st 2017, eighteen months ago. Let’s look at that incident to help us understand the pattern.

BondStockMoves201703

Post-election, the stock market rose for three months, then plateaued for two weeks following that bond rout. Bonds drifted slightly lower and then, on March 15, 2017, charged higher by .6%. Within a few days, stocks lost 2-1/2%. On May 17th, bonds again surged, and stocks fell 2%.

The gigantic size of the bond market dwarfs the stock market. An infrequent daily shift in the pricing of the bond market signals a long-term recalculation of future risks and profits in both the bond and stock markets. When large shifts in the bond market happen frequently, stock investors should pay attention. Between Thanksgiving 2007 and the end of that year, the bond market experienced ten days of greater than 1/2% price swings! It signaled confusion and was a warning to stock investors that rough times were coming.

The bond market’s YTD price loss of 4% marks the probable end of a multi-decade bull market in bonds. The bond market is so stable that a small loss of 4% can mark the largest loss in decades.

We are seeing a change in dance partners. As an example, the stocks of high growth companies rose 20% from February lows. That was almost twice the gains of the SP500 broader market. Many of these are small and medium size companies whose growth is hampered by the greater cost of borrowing money in an environment of rising interest rates. The owners of growth stocks wanted to take some profits this past week but could not find buyers at those high prices. In the past week, prices of those stocks fell 8%. Cushioning the fall of some stocks is the large stockpile of cash – $350 billion – that U.S. companies have stockpiled for buybacks of their own stock. Some of that money was put to work in Friday’s recovery.

The U.S. stock market has been the one of the few bright spots in a global marketplace that has turned down this year. This week begins the reporting for the 3rd quarter earnings season so we may see more price swings in the days to come.

Optimism Reigns

Dec. 11, 2016

For the second week since the election the SP500 index rose more than 3%, reversing a slight loss the previous week.  The SP500 has added 160 points, or 7.6%, in total since the election.  Barring some surprise, the market looks like it will end the year with a 10+% annual gain, all of it in the 6 – 7 weeks after the election. Small cap stocks have risen 17% in the past five weeks.  Buoyed by hopes of looser domestic regulations, and that international capital requirements will be relaxed, financial stocks are up a whopping 20% in the same time.

Having held their Senate majority, Republicans now control both branches of Congress and the Presidency but lack a filibuster proof dominance in the Senate.  They are expected to pass many measures in the Senate using a budget reconciliation process that requires only a simple majority. The promise of tax cuts and fewer regulations has led investment giants Goldman Sachs and Morgan Stanley to increase their estimate of next year’s earnings by $8 – $10.  Multiply that increase in profits by 16x and voila!  – the 160 points that the SP500 has risen since the election.  The forward Price Earnings ratio is now 16-17x.

Speculation is about what will happen.   History is about what has happened. The Shiller CAPE10 PE ratio is calculated by pricing the past ten years of earnings in current year’s dollars, then dividing the average of those inflation adjusted earnings into today’s SP500 index.  The current ratio is 26x, a historically optimistic value.  The Federal Reserve is expected to raise interest rates at their December meeting this coming week.

As buyers have rotated from defensive stocks and bonds to growth equities, prices have declined.  A broad bond index ETF, BND, has lost 3% of its value since the election.  A composite of long term Treasury bonds, TLT, has lost 10% in 5 weeks.  For several years advisors have recommended that investors lighten up on longer dated bonds in anticipation of rising interest rates which cause the price of bond funds to decline.  For 6 years fiscal policy remedies have been thwarted by a lack of cooperation between a Democratic President and a Republican House that must answer to a Tea Party coalition that makes up about a third of Republican House members.  The Federal Reserve has had to carry the load with monetary policy alone.  Both former Chairman Bernanke and curent Chairwoman Yellen have expressed their frustration to Congress.  If Congress can enact some policy changes that stimulate the economy, the Federal Reserve will have room to raise interest rates to a more normal range.

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Purchasing Manager’s Index

The latest Purchasing Manager’s Index (PMI) was very upbeat, particularly the service sectors, where employment expanded by 5 points, or 10%, in November.  There hasn’t been a large jump like this since July and February of 2015.  For several months, the combined index of the manufacturing and service sector surveys has languished, still growing but at a lackluster level.  For the first time this year, the Constant Weighted Purchasing Index of both surveys has broken above 60, indicating strong expansion.

The surge upward is welcome, especially after October’s survey of small businesses showed a historically high level of uncertainty among business owners.  This coming Tuesday the National Federation of Independent Businesses (NFIB) will release the results of November’s survey.  How much uncertainty was attributable to the coming (at the time of the October survey) election?  Small businesses account for the majority of new hiring in the U.S. so analysts will be watching the November survey for clues to small business owner sentiment.  Unless there is some improvement in small business sentiment in the coming months, employment gains will be under pressure.

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Productivity

Occasionally productivity growth, or the output per worker, falters and falls negative for a quarter.  Once every ten or twenty years, growth turns negative for two consecutive quarters as it has this year. Let’s look at the causes.  Productivity may fall briefly if businesses hire additional workers in anticipation of future growth.   Or employers may think that weak sales growth is a temporary situtation and keep employees on the payroll.  In either case, there is a mismatch between output and the number of workers.

During the Great Recession productivity growth did NOT turn negative for two quarters because employers quickly shed workers in response to falling sales.  The last time this double negative occurred was in 1994, when employment struggled to recover from a rather weak recession a few years earlier.  For most of 1994, the market remained flat.  In Congressional elections in November of that year, Republicans took control of the House after 40 years of Democratic majorities.  The market began to rise on the hopes of a Congress more friendly to business.  Previous occurrences were in the midst of the two severe recessions of 1974 and 1982.   As I said, these double negatives are infrequent.



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The Next Crisis?

The economies of the United States and China are so large that each country naturally exports its problems to the rest of the world.  The causes of the 2008 Financial Crisis were many but one cause was the extremely high capital leverage used by U.S. Banks.  A prudent ratio of reserves to loans is 1-8 or about 12% reserves for the amount of outstanding loans.  Large banks that ran into trouble in 2008 had reserve ratios of 1-30, or about 3%.

Now it is China’s turn.  Many Chinese banks have reported far less loans outstanding to avoid capital reserve requirements.  How did they do this?  By calling loans “investment receivables.”  It sounds absurd, doesn’t it?  Like something that kids would do, as though calling something by another name changes the substance of the thing.  70 years ago George Orwell warned us of this “doublespeak,” as he called it.  Reluctant to toughen up banking standards for fear of creating an economic crisis, the Chinese central bank is planning a gradual move to more prudent standards that will take several years.  However, it is a crisis waiting for a spark.  Here’s a Wall St. Journal article on the topic for those who have access.

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The Talk

November 23, 2014

A strong wind from the southwest blew into town, chasing the cold weather out onto the great plains east of Denver.  Most of the trees had given up their leaves as the days grew shorter but the elm trees had stubbornly held onto their leaves, still green far into November.  The turning of color began during the cold snap of the previous week and now the great gnarly giants began to release their leaves to the winds.  Busy at work for many years, George had hired out the autumn cleanup.  Now that he was retired, he was becoming more attuned to the daily and seasonal rhythms of the plants and animals in the neighborhood.

“Leave me a small bag of leaves, dear,” Mabel asked.  She would dry them out, then arrange them into an autumn harvest theme.  George knew he needed to bring up the renewal of the CD with Mabel before her attention became entirely focused on the holidays.  She would set up the card table in the dining room and the season’s decorating would begin.

George had spent a lifetime assessing risk for the insurance of commercial buildings, which are dependent on the municipal services available to them – the fire, police, utilities, transportation, communications, and medical facilities that reduce either the risk or cost of damage.  George had given too many presentations at city council meetings or at the city planning board, outlining the cost benefits of municipal improvements.  Unlike the federal government with its seemingly limitless ability to borrow money, state and local governments had to live with real budget constraints.

George categorized himself as a prudent judge of risk.  However, he knew that most people he had met in his line of work thought they were prudent.  If asked, “Do you think you are more or less prudent than average?” most would answer that they are above average.  It was the Lake Wobegon effect, where everyone’s child was above average.  We couldn’t all be above average.

Mabel’s experience as a school principal had given her a firm grounding in budgets and accounting, but she was reluctant to take much risk with their personal savings, preferring CDs and savings accounts. She was not alone. In a recent Wall St. Journal blog was a study showing that 1/3 of IRA accounts had no stock exposure.

Fifty-six percent of IRA owners had either all their IRA money in stocks or absolutely none of that money in stocks in both 2010 and 2012, according to a study by the Employee Benefit Research Institute of data on 25.3 million accounts. (It was 33.2% at the no-equity end of the spectrum and 22.5% at the all-equity end.)

 In today’s low interest environment these accounts paid little interest but their value was secure.  If the 2008 financial crisis had happened when he and Mabel were in their thirties and had little in savings and several decades of paychecks to come,  the emotional effect probably would have lessened with time.  Coming as it did right before their retirement, the crisis had shaken their faith in anything whose principal was not guaranteed.  Their losses during the crisis had been lessened simply because Mabel had been so insistent on selling what stocks and bonds they had in September of 2008.

She had blamed the crisis on Bush, whom she thought to be one of the worst presidents in U.S. history.  George, who followed the markets and financial news more closely, made several attempts to give Mabel a more balanced assessment but she was adamant.  “No rules!  No regulations!  This dummy for a president is finding out what happens when there are no rules or regulations!  It’s like high school with no one in charge!”  As stock prices continued to sink over that winter, George was thankful that they had avoided any additional losses.  On the other hand, they had avoided most of the subsequent gains in the past seven years.

He mentally rehearsed his presentation.  The $50,000 CD was coming up next week.  It had paid a paltry 1.1%.  He checked one year CD rates.  Chase was offering 1/100th of 1%, Wells Fargo 5/100ths.  Had George read that right?  He checked the decimal points.  Sure enough, .01% and .05%.  In short, “We don’t want your money!”  A savings deposit or CD was essentially a loan to the bank, so why would any bank want money from Ma and Pa Liscomb when they could get it for almost free from the U.S. government?  So, he would start off telling  Mabel about the low interest rates.

The next part of his presentation would be a cautionary tone of risk and reward.  He would tell Mabel that the stock market was like a wagon train.  Well, maybe that was too poetic.  She might give him her “gimme a break” look.  He would hold up his hand and ask for some patience.  Different wagon trains take different paths across the country. The bond wagon train takes the southern route.  The terrain is flatter but the distance is longer.  The stock wagon train takes the more direct route across the mountains and valleys.  He’d show her the chart of the SP500 as it went up and down the hills and valleys.

“Yeh,” she would say, “what I don’t like are the steep valleys.”  That’s when he would show her his zig-zag chart.  Do you see how bonds zig when stocks zag? he would say.  This way, bonds counterbalance some of the risks in the stock market.

“So what happened in 2008?” she would say with a healthy dose of skepticism in her voice.  “Well, that was unusual,” he would say.  “Everything fell.  Even it did happen again, it is unlikely to stay that way for more than a few months or at most a few years.  If a crisis like that happened again and stayed that way for several years, we’d be more worried about getting food and gas, not about paying for it,” he’d say.  Ok, maybe that would be an overstatement, but maybe not.

“But stocks have already gone up for the past few years,” she might say.  “Some people are saying that it’s a bubble.”  Then he’d mention all the good economic signs.  Manufacturing and services were both strong.  Industrial Production continued to rise and has been above 2007 levels for more than a year.

Sure, there were signs of weak consumer demand. The Consumer Price Index had risen only 1.7% over the past year.  Falling gas prices had helped keep a lid on raises in the CPI and was putting extra money in consumers’ pockets.  It was not only lifting airline profits but contributing to lower costs for a lot of companies.  The Homebuilders association was reporting strong confidence among their members and existing home sales were at a stable level.

George wouldn’t tell her one thing that concerned him.  It was a long term phenomenon, a growing caution that George attributed to the aging of the population.  People put money in safe money accounts like savings, CDs, money markets, and checking when they were less confident about the future or anticipated a short term need for  cash.  On the second point, it was true that as people got older, they prudently put more money in safe accounts.  Retired people in particular were encouraged to keep five years of anticipated withdrawals in a safe place, not the stock market.  The Federal Reserve tracked the amount of these safe money accounts, known as the M2 money supply.  Occasionally, George would look at this amount as a percent of GDP.  Over the past decade the percentage of M2 to GDP had been growing.

This could be a natural trend of an aging population but there was another metric that concerned George.  Over the past thirty years, people were keeping twice the amount of money in safe accounts.  In the early 1980s, it had been about $8000.  After accounting for inflation over the past thirty years, the per capita average was $15000.

George guessed that this cautious move to safety would contribute to slowing economic growth for years to come.  But he wouldn’t tell Mabel that.  He was also keeping a wary eye on small cap stocks.

If the index continued to break down below the neckline, George expected further weakness, perhaps another 10% drop as investors lost confidence in small cap stocks.  Falling oil prices and low gas prices helped small caps but the strong dollar and continued weakness in the European countries and Japan would curtail export growth.

Armed with a mental outline of his presentation, George sat down next to Mabel in the living room.  “Whatcha reading?” he asked.  If she was in the middle of a whodunit, this wouldn’t be a good time.  “It’s a series of papers, mostly statistical studies on student scores,” she said.  “Teaching models, and correlations with their socioeconomic backgrounds, their race.  Lorraine lent me her copy.  It’s very interesting but reminds me that I need to brush up on some terms.”

This was good, George thought.  Her brain was in analytical mode already.  “Hey, hon, I wanted to talk to you about that CD coming up next week,” he started.  “Oh, yeh,” Mabel responded.  “I was at the bank the other day and couldn’t believe how low the rates are now.  Why do they insult their customers by posting the rates?” she mused.

“I was thinking about that,” George stepped in.  God, she was making this easy, he thought.  “What do you think,” she continued, “maybe move that money into one of those bond index funds?” she asked.  “Uh, yeh,” George said, a bit befuddled. She was making it too easy after all the time he’d spent planning his presentation, her objections, and his persuasive responses.  “You had said you wanted to keep everything totally safe, so I thought…,” George’s voice trailed off.  “Well, I do, but this is ridiculous,” Mabel said.  “Obviously, we are going to have to take some risk.”  “And I’ve got the time to watch it,” George reassured her.  “I’ve noticed that,” she said. “I don’t have the interest to watch it.  I guess I always thought that investing was a ‘set it and forget it’ proposition.  Maybe it was never that way.  But, after 2008, I’m…” and she gave a rock-the-boat gesture with her hand.  “Ok,” George said and stood up. “I’ll have the bank close out the CD, then transfer the money.”