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 

Fault Lines

January 20, 2019

by Steve Stofka

If your twin brother went away on a spaceship a month ago and looked at the current price level of the SP500, he wouldn’t see much change. What a month it has been! A 7% drop in stock price the week of December 17th, followed by a Christmas Eve when Santa left a lump of coal in investor’s stockings, followed by a government shutdown.

Let’s say your twin brother went off to the Romulan Galaxy on a spaceship flying near the speed of light on October 1, 2007. He has just come back and has aged a few weeks. You have aged a great deal. The financial crisis, the housing crisis, the job crisis, the crisis crisis. No wonder you look older. There are too many crises.

Your twin brother notes a similarity in the behavior of the stock market the past few months and the fall of 2007 when he took his starflight cruise. What similarity you ask? He hauls out his Romulan graphing tool and shows you a plot comparison of SP500 prices (SPY) in the fall of 2007 and the fall of 2018. Not only does your twin brother look younger but he also got a Romulan grapher on his journey. It is not fair.

spycomp20072018

“In both periods, prices fell about 15% in 15 weeks,” your brother says.

“They happened to fall the same percentage in the same amount of time,” you answer.  “That probably happens all the time and we just don’t notice.”

“15-20% drops in as many weeks doesn’t happen all the time,” your brother says. “It happens when there are fault lines forming. It happened in December 2000, January 2008, again in August 2011 during another government shutdown, and now.”

“Sure, there are some trade problems and the government shutdown,” you protest, “but the economy is good. Employment is at all- time highs, wage gains were over 3% last month, and inflation is relatively tame.”

“Everything was still pretty good in December 2000 and January 2008,” your brother responds. “‘A healthy correction after a price boom,’ some said. ‘The market is blowing off the excess froth before going higher,’ others said. At both times, there was something far more serious going on. We just didn’t know it.”

“You got pretty smart in the time you were gone,” you tell your brother. “Can I get one of those Romulan graphers?”

“Yes, I bought one for your Christmas present 11 years ago,” your brother says and hands you a grapher from his spacesack. “Tell me, what are these picture phones that people are carrying around now? I don’t remember them from when I left. And what’s Facebook?”

Decline of Income Growth

January 13, 2019

by Steve Stofka

On the week before Christmas, the stock market fell more than 7%. I wrote about the historical trends following previous falls of that magnitude. The week opened on Dec. 17th with the SP500 index. Two months was the shortest recovery period after 7% falls in 1986 and 1989. In a previous budget showdown in 2011, the market recovered after five months, but shutdowns are just one component of a complex economic environment. If the outlook for corporate profits looks positive, the market will pause during a long showdown, as it did in October 2013.

Investors wanting to contribute to their retirement plans can do so in a measured manner. The uncertainties that produce tumultuous markets take some time to resolve. Although the market rose for five straight days in a row this week, it was not able to reach that opening level of 2600 three weeks ago.

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Let’s turn to a persistent problem: the lack of income growth. Beginning in the early 1970s, the annual growth rate in real personal income began to decline (Note #1). I calculated ten-year averages of annual growth to get the chart below. 5% annual inflation-adjusted growth during the 1960s became 3% growth during the 1980s and early 1990s. The dot-com and housing booms of the late 1990s and early 2000s kicked growth higher to 3.5%. In 2008, annual growth (not averaged over ten years) went negative and reached as low as -4.9% in May 2009. Following the Financial Crisis, the ten year average is stuck at 2% growth.

rpigrowth

The Bureau of Labor Statistics (BLS) tracks total employee compensation costs, including benefits and government mandated taxes (Note #2). I compared ten-year averages of both series, income with (blue line) and without (orange line) benefits. The trend over five decades is down, as before. When the labor market is tight, employers have to offer better benefit packages and the growth in total compensation is higher than income without benefits. When there is slack in the market, employees will accept what they can get, and the growth of total compensation is less.

incgrowthcomp

Beginning in early 2008, we see the dramatic effect of the last recession and the financial crisis. Income growth went negative, but income with benefits plunged 19% by January 2009. With unemployment stubbornly high, employers could attract employees with rather skimpy benefit packages. The ten-year average growth of income with benefits (blue line) sank to 1%, a full percent below income without benefits. In the last two years, the two series are starting to converge but the trend is below 2% growth.

The data contradicts those who claim that income growth is low because employers are spending more in benefits.

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Notes:
1. Real personal income series at Federal Reserve. An explanation of various types of personal income at Federal Reserve
2. Fed Reserve Series PRS85006062 Less PCEPI Chain Type Inflation Index.

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.

Hat Trick

December  9, 2018

by Steve Stofka

For the third time in six weeks, the SP500 fell below its 200-day moving average. This ten-month average of trading activity is a benchmark that indicates mid to long-term sentiment. It is a tug of war between the bulls and the bears, the buyers and sellers, over the developing trade war between the U.S. and China.

Technical market watchers call a crossing below the 200-day a Death Cross, a too dramatic name for something that may occur once or twice a year. Less frequently does it happen twice in a two-month period – a Double (Note #1). Rarely does it occur three times in such a short period of time – a Hat Trick (Note #2).

Hat Tricks signal strong investor worry about one or more structural conditions that will impact future earnings. The situation may resolve, and the market regain its upward trend. If the situation does not resolve, expect further price declines.

What does this mean for the casual investor? Contributions to an IRA at current prices will be priced as though you had dollar-cost averaged (DCA) each month of this year. As I showed in 2011 (Note #3), the DCA strategy has produced the highest long-term returns on the SP500. Look at the monthly bar on the chart below.

5de57-iracontribspy1993-2010sharesmonthly
History is the only guide we have to investor behavior. Previous Doubles occurred in 2015 and 2012. Previous Hat Tricks developed in 2011 and 2010, producing strong price corrections (Note #4) in response to budget duels between Republicans and President Obama (2011), and debt crises in the Eurozone (2010).

In hindsight, the Hat Trick that occurred during four weeks in August 2007 signaled that this was more than a well-deserved correction in the housing market. Don’t we wish we had the clarity of a rearview mirror? Another Hat Trick a few months later in November and December 2007 coincided with the beginning of the recession that lasted 20 months and chopped 60% off the price of the SP500. Another Hat Trick in May and June 2008 came just months before the onset of the Financial Crisis in September 2008.

A Hat Trick accompanied the peak of the housing market in 2006, and the peak of the dot-com market in 2000. It signaled the start and end of the 1990 recession.

Lesson: be cautious.

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Notes:
1. In technical analysis, this double bottom forms a ‘W’ and indicates a possible exhaustion of selling before a reversal to the upside.
2. Hat Trick is a name I made up for 3 dips below the 200-day in a two-month period.
3. I compared various IRA investing strategies in May 2011
4. Price declines in 2010 and 2011 barely escaped being classified as bear market corrections, defined as a closing price 20% below a previous closing high price.

A Real Minimum Wage

November 18, 2018

by Steve Stofka

Near the top of the Democratic agenda in the new Congress is a minimum wage of $15. The bill is unlikely to pass the Senate, but it will signal to the voters that the Democratic House is meeting campaign promises. The states with the most solid Democratic support are those on the west coast and northeast coast where the cost of living is much higher. A single minimum wage for the entire country is not appropriate. Republicans control the Senate and they are from states with much lower costs of living. They will reject an ambitious minimum wage that is one-size fits all.

Housing is the largest monthly expense for most families. Below is a graph of home prices in several western metropolitan areas (MSAs) and the national average of twenty large MSAs. Home prices in Dallas and Phoenix are a 1/3 less than Los Angeles and San Francisco. Housing costs in many smaller cities will be below Dallas and Phoenix.

CaseShillerComps

Why isn’t the minimum wage indexed to inflation? Because politicians of both parties, but particularly Democrats, have used it as a wedge issue to gain voter support. If the House Democrats wanted to pass bi-partisan legislation on a minimum wage, they could use a flexible minimum wage that is indexed to the average wages for each region within the country. These are published regularly by the Bureau of Labor Statistics, the same agency that publishes the monthly report of job gains and the unemployment rate. I’ve charted the annual figures for those same cities.

HourlyEarnComp

A $15 minimum wage is 40% of the average wage in San Francisco, and a bit more than half of the average wage in Los Angeles. It is almost 60% of the national average. The current minimum of $7.25 is 28% of the national average.

If the House passed a minimum wage bill that set the wage to 40% of the average wage for each region, Senate Republicans might at least consider it. In Denver and L.A., the minimum wage would be about $11.50. In Dallas and Phoenix, it would be about $10.60. Democrats could show that they are in Washington to pass legislation for working families, not pound some ideological stump as Republicans did for eight years with the repeal of Obamacare.

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Stocks and Taxes

There is a close correlation between stock prices and corporate tax collections. The tax bill passed last December lowered corporate tax revenues in the hope that businesses would invest more in the U.S. The divergence between prices and collections has to correct. Either tax collections increase because of greater profitability or stock prices come down.

StocksVTaxes
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Income Growth

The financial crisis severely undercut income growth. Real, or inflation-adjusted, per capita income after taxes decreased for three years from 2008 through 2010, and again in 2014. It is the longest period of negative growth since the 1930s Depression.

IncomeRealPerCapGrowth

To Buy Or Not To Buy

October 28, 2018

by Steve Stofka

In ten years, the number of households that own their homes has grown by only 2-1/2%. Renting households have grown by 20%.

Should you buy a home? Home prices are sky high in some cities. Mortgage rates are rising. Is 2018 a repeat of 2006? Many bought homes at high prices only to see the price fall by a third or half over the following years.

Time to discover your inner owner investor who is going to buy the house. You are going to rent the home from your owner investor. Let’s compare the annual Net Operating Income (NOI) to the purchase price of the home. To keep the math simple, let’s say the owner investor can charge the renter $2000 a month in rent for the home. Let’s say that you, the renter, are going to bear the monthly cost of utilities. You, the investor, must pay $2000 in property taxes and other city charges like garbage collection. Your annual net income from the property is $2000 x 12 = $24,000 – $2000 taxes and costs = $22,000. Let’s say that the all-in cost of the home is $360,000. $22,000/$360,000 = 6.1%. That is the cap rate of the property.

Home pricing, like many assets, behaves in a cyclic manner, as the graph below shows. In the past thirty years, the average annual growth of the Case-Shiller home price index in Los Angeles is 5.6%. The rate of the past three years is slightly above that thirty-year average, meaning that prices in the L.A. area have stabilized relative to the long-term growth average.

HPILA

Rents have risen almost 5% so the two growth rates are fairly close. Let’s subtract an inflation rate of 2.6% from that to get a real capital gains rate of 3%. Add the two rates together to get a combined rate of 9.1%. For an average home in the L.A. area, this is a pretty good total rate of return.

Let’s look at another area: Denver. The thirty-year average of annual growth in home prices is 4.9%. During the past five years, population growth in the Denver area has been robust. Home prices have risen more than 7.5% during each of the past five years, topping 10% in 2015. In 2017, rents rose an average of 5.33%, not enough to keep pace with the growth in prices. An investor would be buying at an above average price.

In a hot market like Denver, a family might think “I am saving 8% a year by buying now.” They assume that above average price growth will continue. The law of averages indicates the opposite – that price growth is more likely to fall below average, and even turn negative.

In making a decision, understand where current prices are in the cycle (Note #1).  Understand where current rental growth is in the cycle and compare the two (Note #2). Here is a graph comparing the two series in Denver. Note the large divergence between home prices and rents in the late 1980s, 1990s and again in the 2000s. Rental prices were much more stable.

HPIvsRentDenver

Imagine that the home purchase is a cash investment and estimate a total return on that investment, as I showed above. Some familes pick a home in a price range based on the leverage of their income and down payment. A real estate agent may present home buying choices based on the amount of house a family can qualify for. But – is the house a good deal? These rates of return are an important factor to consider in making a wise decision.

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Notes:

  1. You can search for “FRED home prices [large city name here]” to get the Case-Shiller Home Price Index for that city. Click Edit Graph button in upper right and change the units to “Percent Change From Year Ago”. To get an average, click the Download button above the Edit Graph button to download an Excel spreadsheet.
  2. You can search for “FRED cpi rent residence [large city name here]” to get the index of rental prices for that city. As above, click Edit Graph button and change units to “Percent Change From Year Ago

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Stocks

The recent downturn in the market was overdue. Since the election almost two years ago, the year over year total return of the SP500 has been above the 10% historical average.

SP500TRYOY

The longest above average streak under Obama’s Presidency was almost three years. In the dot-com boom under Clinton, the market had above average returns for almost 3-1/2 years. After a two-month stumble in 1998 due to the Asian Financial Crisis, the streak continued for another twenty months. Such a long period of exuberance was sure to fall hard. During the following three years, the market lost half its value. Reagan and Eisenhower enjoyed the next longest streaks of almost 2-1/2 years. The 1987 crash ended the streak under Reagan.

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.

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.