We talk a lot lately about how a diversified portfolio is hard to stick with when one single asset class like the S&P 500 seems to be destroying everything else in terms of returns over the past 5 years. The below snapshot is from the first link below. Long term thinking must be used when it comes to diversification.
In nearly every market commentary we mention how important diversification is to an investment portfolio. In 1952 Harry Markowitz introduced Modern Portfolio Theory which further expanded upon the benefits of diversification. The concept seems straightforward and logical yet time and time again many stray from it. The question is why? Why do investors give up on a strategy that "works".
Diversification shows its true benefit over the long run. The issue is there are periods of time where a single asset class’ performance dominates the others. Sometimes these periods can be several years long. For example, from 2004-2007 Emerging Markets returned an impressive ~132.9%. From 2009 to 2012 REITS (Real Estate Investments Trusts) returned ~84%. And more recently, from 2014-Present, the S&P 500 (Large Cap US Stocks) has returned ~60% (as of this writing). No other asset classes have come close to this same performance in those periods. This type of outperformance leads many to abandon diversification and overweight their portfolios with asset classes that have experienced the best returns. Many forget the years prior and after as to how significantly these same asset classes underperformed their peers. We do believe one should slightly overweight or underweight certain asset classes based on macro economic factors, but too much can wreck havoc on a portfolio's long term stability.
Over the past four years, excluding2017, diversification has not treated investors well as Bonds, International, REITS & Emerging Markets have lagged S&P 500 performance. The S&P 500 has shown extreme resiliency at every turn and recently has benefited from corporate tax reform, stock buybacks, and a growing U.S. economy. You may be asking yourself, why not just own this asset class as it's comprised of the 500 largest (or most "important") U.S. publicly traded companies and has been rock solid the past six years? The answer lies in the details. Owning solely the S&P 500 or any other asset class for that matter will most likely lead to a positive return over the long run. The challenge is you will have to deal with long stretches of underperformance that are difficult to endure if all of your money is in a declining or underperforming asset class. Take a look from 2004-2010; the S&P 500 was in the middle of the pack or lower for SIX straight years. While it did yield a positive return, it significantly trailed other asset classes. Both stock and bond markets are forward looking mechanisms so looking at past performance generally is not a recipe for success. Most people would look to jump ship into the better performers. This creates a loop that leads to chasing returns and market timing.
While 2018 really hasn't been kind to diversified portfolios, it is important to remember the goal of diversification is not outperformance. Rather, it is to minimize the fluctuations and earn an efficient risk adjusted return. There are periods in the short term where diversification may not seem effective, but the long-term results speak for themselves. The key to diversification is sticking to it over time and this will challenge you at times. A properly diversified asset allocation portfolio that is rebalanced regularly aims to smooth out the bumps and place your portfolio in the middle to upper middle of the pack most years.
The Fed raised rates again this week. It got lost in the media shuffle with the political coverage this week. Rates continue to climb up. The 10 year is above 3% again and the markets didn’t collapse so that is a win.
Marijuana stocks were in the news the past couple of weeks. These volatile stocks are the new bitcoin it seems. Speculators (not investors) are using the volatility to try and make a quick return. Don’t be fooled. You can’t out time the pros on this one.
Fidelity launched a zero fee index fund last month and turned the financial media on its head. Not because it was unexpected but because it wasn’t expected this soon. I assumed it would be either Vanguard or iShares to do it first. Fidelity figures it will make money from people using their other funds to more than offset the “cost” of the free funds. It is yet to be seen how this may affect their higher fee managed funds.
This is yet another win for investors. There could be a time in the not to distant future where the only fee investors pay is to their financial planners. It will be transparent and fully understood and the days of selling and commissions will be over. All “advisors” will be fiduciaries and fee-only. Humbly we can say we were ahead of this curve.
We talk a lot about how important technology is to our business. It’s our largest expense. I’d put our efficiency, processes and workflows up against any firm our size. This is mostly due to the way we use the technology we have. Since the very beginning (when we had very few clients) we built out our processes as if we had hundreds of clients. We were scaling before scaling was a thing. I thought a little more about it this week and I think if this were 1995 we would probably need at least 10 people to do what our technology does. That would mean higher costs to clients. Or, we’d have to cut our client base in half. Something would have to give. Luckily, its 2018 and financial technology is booming. Because of the competition the vendors we use are always improving.
Enjoy this week’s links…
Good synopsis in the first link about why the US stock market has been relatively immune to news. We have talked about the market’s resiliency for quite a while now. It’s hard to fathom that next week will mark the 10 year anniversary of Lehman Brother’s bankruptcy. The S&P proceeded to lose over 50% of its value over the next 18 months. It dropped to around 750 points and as I write this the S&P is at about 2900 points. Ten years can seem both like a long time frame and a short time frame. When the next sustained downturn occurs I’m sure we will use examples of the depths of the 2008/2009 plunge to show it could always be worse.
What is an Inverted Yield Curve and why is it in the financial news lately? In short, an inverted yield curve occurs when long-term debt (10 Year Treasury) has a lower yield than short-term debt (2 Year Treasury) of the same credit quality.
Typically, banks borrow short term and lend money out long term and the interest rate spread (difference) compensates banks for the risk assocaited with lending. When a bank generates less income on their assets (long duration loans) than their liabilities (short-term deposits), the incentive for new loans starts to dwindle and can cause a disruption in the money supply.
Add to the equation the Federal Reserve is attempting to unwind their balance sheet and tighten monetary policy after 7 years of near zero interest rates and the "conundrum" becomes more complicated. Since the low rates have directly inflated certain asset classes, the unwind is expected to be slow which won't help push up long term rates.
The slow down of interest rates on long term bonds indicates there is a concern for long term economic growth. That in itself isn't a cause for alarm but, as mentioned above, when this occurs at the same time the Federal Reserve is raising short-term rates, the gap between short term rates and long term rates continues to shrink. The closer it gets to inverting, the louder the alarm bells get.
The last seven recessions dating back to the 1960's have occurred when short-term rates have exceeded long term-rates. It is important to remember that recessions are not based off one data point and that each recession is unique in its own way but this is still something that should be monitored closely. The Federal Reserve has limited control over long term rates as because those are shaped by inflationary expectations. The Federal Resererve uses their power to influence short term/overnight lending rates. The yield curve inverts when the Federal Reserve believes inflation is headed higher but bond investors are expecting the opposite.
What is a bit different this time is the national debt is over $20 trillion and the Fed's balance sheet sits a tad over $4.5 trillion while, at the same time, interest rates still remain low. None of these existed when the Great Recession took hold in 2008 and left the Federal Reserve with plenty of ammunition to step in and help. That is no longer a luxury and has some worried as to what will happen in the next downturn when these mechanisms won't be available. The wild card here is economic growth. Obviously we don't know what it will be in the coming quarters but an economic slow down in the face of an inverting yield curve is not a desired outcome and could wreak havoc on financial markets. While GDP growth and productivity have been improving lately, we need to see this for a few more quarters before declaring any sort of victory.
After almost 16 years in the industry I find it hard to believe “sales contests” still exist. In an era where a standardized Fiduciary Rule is imminent it is still a common practice for companies to offer sales contests for certain products. Yes these conflicts of interests are disclosed somewhere in the paperwork their clients sign but this is still crazy. If the SEC fixes this then they should also stop the steak dinners wholesalers do for advisors on a regular basis. Free steak and free wine is a conflict of interest.
The S&P 500 hit an all-time high this week. It is also marking the longest bull market for the index in its history. This is an arguable “fact” however given the several major dips the index has recorded. In early 2016 and earlier this year the market was down well past correction territory. It flirted with what could be consider “bear market territory”. All of this has helped make this not only a very long bull market but also the most distrusted. The financial newsletter industry is a multi-million dollar industry. Most of these sell fear. They have been calling for the end of the bull market for 5+ years. They have been wrong almost every step of the way. Far more money has been lost in the last 5 years on the sidelines than will likely be lost in the next market down turn.
First link this week is about Elon Musk possibly taking Tesla private. Musk made news when he hinted at the possibility in a tweet. If you are musk there are a lot of positives to this line of thought. Plus he can spend less time arguing with analysts.
Bad Blood is the story of the Theranos scandal and it’s founder, Elizabeth Holmes. With a movie in the works starring Jennifer Lawrence I’m sure you will hear more about it in the future. The book is a must read for any investor. The entire time I was reading the great book I kept asking myself how could so many high profile people be fooled? The list is quite impressive. Henry Kissinger, the Obamas, the Clintons, the Walton (Wal-Mart) family, the Cox (cable) family, Robert Murdoch (News Corp), Bob Kraft (Patriots)…the list goes on and on. As the author points out, the fear of missing out drove most of these investors. They were duped and they let their fears and emotions drive their investment decision.
What you don’t see on the list is many professional investors. Where are the healthcare VCs? Where are the big Silicon Valley early investors? There were few. Why? Because they actually conduct due diligence on their investments. That’s not to say every investment they make works out but they are rarely deceived.
I highly suggest the book but the first link below is a podcast interview with the author.
I have to add commentary to the first link below and apologize for diverting away from finance in this one. First, I can’t believe how many people die from dogs. Second, who knew freshwater snails were so savage?
Tech stocks (specifically Facebook) got pummeled this week. The NASDAQ took quite a hit. This isn’t extremely alarming as long as you have a diversified portfolio.
No post next week so enjoy this week’s links. I hope to have the time over the next week to read Bad Blood: Secrets and Lies in a Silicon Valley Startup. The insanity and story behind Theranos still seems underrated. I don’t know why it didn’t catch on as an even bigger story. I’m sure a documentary or movie is in the works.
We have addressed the “trade war” enough in other posts so we are taking a much needed break from it. I guess you could call today the “start” of the trade war in a way. It isn’t going away anytime soon so we will have plenty of time in the weeks ahead.
Nonetheless, here are some good reads…
As expected, trade war talks have equity and bond markets on edge, especially European and Emerging Markets. Tensions continue to escalate as do the retaliatory threats coming from all sides, specifically between U.S. and China. Last month President Trump asked his administration to compose a list of $200 billion in China goods for levies and would add another $200 billion if China retaliates. This is in addition to the $50 billion already imposed. While these numbers are large, no one knows how much of this is posturing and how much will actually take effect. China has begun to retaliate and President Xi said the country will not back down from engaging in a trade war. The headlines sound frightening and all the dooms-dayers were definitely all over this latest fodder.
Many of the every day goods we use (cell phones, computers, TV's, clothes etc.) are imported from China and certain tariffs would increase prices which would be passed on to the U.S. consumer and in turn could lead to an economic slow down. Now the good news is as of this writing the updated list does not include cell phones or televisions, but if things continue to escalate, they could be added. Considering current deficit levels and rising rates, an unexpected economic slow down would be less than ideal. Unfortunately this "trade war" situation doesn't have a set timetable, so we may experience more anguish before obtaining any type of resolution. The markets hate uncertainty but even worse it hates uncertainty with no time table.
As an industry, manufacturing makes up 11.6% of U.S. GDP and has become a smaller segment as other industries have picked up the slack. While this limits the number of new manufacturing jobs being created in the U.S., it leads to cheaper goods and leaves consumers with more money in their pockets to spend on other things. It should not be a shock that the U.S. runs trade deficits with most countries as labor costs and standards of living in the U.S. tend to be higher than most, so an influx of manufacturing jobs to the U.S. seems highly unlikely and corporations would look to outsource manufacturing labor to another country with cheap labor costs as opposed to bringing those jobs here. It is important to remember that publicly traded companies are focused on protecting profits, growing the bottom line and answering to shareholders. So unless the U.S. is ready to embark in a trade war with every country, they don't appear to have much leverage here. Also, who will take the jobs even if they were moved to the US? Limiting immigration won't help fill the jobs and at 4% unemployment people are already working. The only way to lure them away would be higher pay which brings us back full circle to either higher costs or sending the jobs to another country.
The reality is much of this could just be "tough talk" and amount to little, but it's important to remember that threats to global markets always exist. They just feel worse when it is politically driven because it adds emotions to the mix and the one thing that doesn't mix well with investing is emotion.
General Electric stock was removed from the Dow Jones Industrial Average (“the DOW”) this week. This marks the first time in 110 years the ticker symbol GE will not be included in the index. This comes after losing 50% of its value last year and another 25% this year. How did this happen. Basically while other companies were increasing their cash reserves GE was building up massive debt. This is an example of why buying individual stocks doesn’t work out well for the average investor. As diversified a company as GE is one would think it would be a “safe” bet compared to other stocks. Not the case.
Just a couple links this week…
The Trump meeting with Kim Jong Un was something my mind could not quite grasp. Is it a good thing? Bad thing? It was certainly odd, weird, confusing and even a bit surreal. Throw in Dennis Rodman and the whole thing makes me wonder if we are living in a computer simulation. It’s too strange.
The optimist in me thinks maybe Trump played this well. Kim Jong Un just wants to be acknowledged and “respected” on the world wide stage so maybe Trump played to that desire. The pessimist in me thinks there is no way these two can maintain a healthy relationship.
Congrats to the Washington Capitals and congrats to all their hardcore fans. You deserve this. Let’s hope their win also opens the door for the other DC teams to finally break through.
Short list of links this week but two links that provide some evidence to two trends we have noticed. At first glance it may not seem like these two things are connected. There is a long way to go in getting women equally paid as their male counterparts. But for many households the wage gap between husband and wife has been declining for some time.
I think it is safe to say we are well past the economic recovery phase at this point. Wages are up and there is no shortage of jobs. Lately, I have been wondering if the economy is at a point where it is “over recovered”. I have been reading stories of small businesses and franchises struggling with finding quality employees. The problem stems from their inability to fire underperforming employees because of the lack of prospective new employees. Some small business are even reporting employee pay increases despite low quality employee work. They are having to increase pay just to retain “bad” employees!
This information is somewhat anecdotal but is interesting nonetheless. For one thing it has created an environment similar to the UK where it is very hard to be terminated. Is this a good thing or a bad thing? I guess it depends on your perspective.
Have you noticed a decline in customer service at small businesses?
Much has been written about the negative impacts of rising rates on the markets. Let’s look at some positives...
Currently, global pensions assets total about $41.3 Trillion and many of the largest pensions hold 25% to 50% in bonds and cash. With interest rates at record low levels for the last decade, pension plans felt the pain as a large portion of their portfolios were yielding minimal returns. On average, pension funds may benefit as every 1% increase in interest rates equates to 12% to 14% decrease in plan liabilities. While it's true they have benefited from equity market gains over the past decade, returns on a diversified portfolio have been weighed down by the low returns on bonds/cash and the underperformance of commodities, European and Emerging market equities vs. a pure U.S. equity portfolio.
Retirees also benefit as rates on savings accounts, money markets & CD's increase. It seems like forever ago, but CD's were yielding approximately 4% in 2008. This is significantly higher than what we saw from 2010 to 2017. Retirees will earn more interest which in turn aids cash flow and helps to provide some protection against future inflation.
In addition, a decade of low interest rates forced long term care insurers to significantly increase premiums. It is estimated that every 1% decline in rates lead to a 10-15% increase in premiums. With rates increasing, long term care premiums will hopefully remain steady and that helps retirees who are a majority of long term care insurance policy holders.
Real estate could also see a benefit as the prospect of higher sustained rates may compel some to make a home purchase sooner rather than later which in turn could increase demand and prices.
Lastly, while this may sound counter intuitive, rising interest rates can be beneficial in preventing an economy from over heating. Higher interest rates tend to reduce speculation as the cost of borrowing dampens the potential gain.
Many argue, myself included, that the federal reserve waited too long to increase rates. Now it seems they are set for 3-4 annual hikes over the coming years. While there will be bumps in the road, the path to normalization is long overdue. If earnings and economic growth continue to chug along, things might not be as bad as many thought. The truth is, no one knows how this will all play out and it's important to remember that volatility is normal, and the lack of volatility in 2017 was abnormal. While volatility isn't necessarily fun, it is normal and part of what makes markets what they are.