Happy Labor Day!

Summer is almost over.

Just two months ago the market was reeling from the effects of the Brexit.

Following the steep declines in January and February, it was enough to shake the confidence of many investors.

Hopefully you weren’t one of them. After a brief decline, the stock markets have since rallied strongly.

Stock markets will always be volatile – but panicking never helps.

Despite all the volatility over the past 12 months, those that stayed the course have seen their portfolios go up. At least they should have gone up if they had a globally well-diversified portfolio.

And even if your portfolio isn’t very diverse, it still should have gone up!

Just as we saw in May, every asset class is still positive for the year.

The US stock market (as measured by the S&P 500) is up 7.6% year-to-date. Small cap stocks are up 10.4%. International Stocks are up 2.2%, while Emerging Market stocks are up 12.7%.

US Intermediate bonds are up 5%, Corporate Bonds are up 10.6%, and Emerging Market Bonds are up nearly 12%.

US Real Estate Trusts were even better at 18%, with Foreign Real Estate Trusts coming in a respectable 12%.

Commodities, while down from the peak earlier this year, are still up 6.9%.

Gold is up 27%. And the biggest winner this year has continued to be Gold Mining stocks at 126%.

The mainstay of our portfolios, our Large Cap Value and Quality fund has also continued its outperformance against the S&P 500 this year, up a very impressive 18.5%.

As we saw last year, Quality and Value doesn’t always beat a simple market-cap weighted index fund (such as SPY), but when it does, it can work extremely well.

Our Municipal Bond Closed-End Fund Portfolio has also continued to be a top performer with a year-to-date return of 11%.

Year-to-date, all of our model portfolios are up between 11 and 13%.

(As per my compliance officer, I must mention that past performance does not guarantee future returns, and investor returns may be lower due to transaction costs and fees, as well as timing of deposits and withdrawals).

This is quite a surprise from what we expected at the beginning at the year. Which is why we place more emphasis on investment strategy and process, and less on the economy, our emotions, or our expectations for performance.

We also largely ignore what is happening politically.

Despite all the uproar surrounding our presidential candidates, changing your investment strategy based on your political beliefs is likely to do more harm than good.

Regardless of who gets elected, the markets are likely to find something to be upset about, and I expect a drop in the stock markets after the election.

For Hillary, it will be the threat of higher taxes. For Trump, it will be a candidate that likes to shoot from the hip, and alienate practically everybody.

But the markets will eventually find something they like about the new President.

For Hillary, it’ll likely be lower healthcare costs as she takes on Big Pharma.

For Trump, it’ll be the fact that he’s willing to offer companies a tax holiday on their cash that’s sitting abroad – this will result in about $2 Trillion coming back to the US – money that will work its way back into the economy.

Both candidates are likely to kick-start programs to revamp our aging infrastructure, something that is likely to boost the economy.

In either case, the market will rejoice. And, as is the case with most declines, it is likely to be short-lived, regardless of its magnitude.

Another thing I expect to happen in December is the Fed will finally raise the short term interest rates another 0.25%.

Last September, Fed Chairwoman, Janet Yellen, said that they were likely to raise interest rates 1% this year. So far this year we’ve seen zero rate hikes, and long term rates have actually declined a little.

But the Fed wants to try and raise the short term rates to at least 2%, so that when the next recession occurs, they have room to lower them.

At the rate they’re going, this might take a few more years to reach. Which is okay, since there isn’t any recession looming on the horizon.

I expect the economy will keep grinding higher for the next few years, just like it has been for the last five. And like the economy, our investments will likely slowly grind higher as well…

So, as usual, keep calm and carry on investing.

Wish you all a Happy Labor Day!

Nirav

P.S: If you’d like to discuss your investment performance, or you’d like a complimentary portfolio review, contact me and we’ll schedule a time to talk.

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Should You Worry About the Brexit?

By now, you probably heard of Britain’s decision to exit the European Union.
Financial experts and book-keepers all thought Britain would vote to remain, so the results came a shock.
Global markets dislike surprises and reacted accordingly.
The British pound dropped 10%, the largest move ever. European and Emerging markets dropped 6-8% and even the S&P500 was down nearly 4%.
Ironically, British markets (FTSE 100 Index) were down only 3%, presumably because the decline in the British Pound will make British exports cheaper, actually helping British companies in the near term.
Meanwhile, US Bonds held up and Gold popped 5% higher as investors sought safe haven assets.
As I mentioned last month, increased volatility is something that we’ve been expecting.
In the short-term, no one is really sure how exactly Britain will exit the European Union. It’s likely to take two years for this to unfold. And there’s a chance other members of the EU like France and Netherlands might want to exit if they think Britain can pull it off without a major recession.
The Federal Reserve has been looking for an excuse to raise interest rates for over a year now. In September they said they expected to raise interest rates four times this year. And now it seems highly unlikely we’ll see even one rate increase.
I think we might have an equal chance to follow the rest of Europe into negative interest rates.
Over the long term, none of this is likely to have any lasting effect.
Europe has survived two world wars and London remains the financial capital of the world.
If anything, we should heed Warren Buffett’s advice and “be fearful when others are greedy and greedy when others are fearful” and use this an opportunity to rebalance in to International and Emerging Market Stocks.
After nearly nine years in a bear market, they are due for a turn-around. I’m not making a prediction here but regular rebalancing in to undervalued asset classes is part of our investment process. And as I’ve said before, process is the most important (and most frequently overlooked) part of investing.
Even after this severe one-day drop, our portfolios are still positive for the year (although timing of deposits and fees may affect individual returns, and as my compliance officer insists I remind you, past returns are no guarantee of future performance).
But I’m confident the Brexit isn’t really anything to be overly concerned about.
Your investment accounts should contain a fair amount of Bonds, and a small amount of Gold, both of these will provide a ballast for your portfolios and help offset future volatility.
If there is one thing to be concerned about, it’s where to book your summer vacation this year.
The British Pound has declined to 35 year lows, and even the Euro is considerably lower, making it cheaper for Americans to travel to Europe. Take advantage of it.
If you have any questions or concerns about your investments, or retirement accounts, feel free to reach out.
Happy Investing,
Nirav

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All Asset Classes Turn Positive

Tax season is finally over!

Tax time is stressful for most people. It’s a tedious annoyance, that reminds us how much money we’re sending to Uncle Sam, our silent partner in all our profitable ventures.

Hopefully, you’ve finished filing your 2015 taxes and there were no unpleasant surprises. Only pleasant ones, like a bigger than expected tax refund.

One pleasant surprise in the markets is the revival of Commodities, and the continued performance of gold.

As I mentioned last month, I expect we’re in the beginning stages of a gold rally.  Gold is now up 21% for the year, and our Gold Miners ETF is up an incredible 88% year-to-date.

After five years of dismal losses, Commodities are finally positive, up 14%.

In fact, every single asset class is up for the year.

US Real Estate is up 3.8%
Int’l Real Estate is up 8.7%
Developed Market Stocks are up 0.5%
Emerging Market Stocks are up 6.4%
Bonds are up 3.3%
High-Yield Bonds are up 14%
S&P 500 is up 1.4%
Mid-cap stocks are up 0.8%
Small-cap stocks are up 2.7%

Our Large-cap Quality and Value index fund is continuing it’s outperformance this year with an 9.7% return so far this year. As we saw last year, Quality and Value doesn’t always beat a simple market-cap weighted index fund  (such as SPY), but when it does, it can work really well.

(As per my compliance officer, I must mention here that past performance does not guarantee future returns, and investor returns may be lower due to transaction costs and fees, as well as timing of deposits and withdrawals).

Our Municipal Bond Closed-End Fund Portfolio has also continued to be a top performer with a year-to-date return of 7%. This surprising performance, on top of last year’s 8.8% return, has undoubtedly been helped by the declining interest rates.

If interest rates turn higher, it will definitely hurt bonds. But whether or not this happens this year remains to be seen. (See here  and here for previous discussions).

If anything, there is a chance that we might see negative interest rates, as the US Federal Reserve follows the ECB and Bank of Japan in trying to fight deflation and stimulate inflation.

However, it’s uncertain that negative interest rates are the solution.

According to Jeffery Gundlach, the brilliant bond fund manager and founder of Doubleline Asset Mangement:

“There is mounting evidence that negative interest rates do the opposite of what the central bankers were hoping for. Negative interest rates are designed to fight deflation.

But they are the very definition of deflation: Your money is disappearing.

As an investor, you are going to have less money in the future than you have today with negative interest rates. That’s deflation!”

But it’s not like his opinion is going to change what the world’s central banks believe.

Given this current economic environment, I still think the market is going to remain extremely volatile this year.

The US stock market is in its 7th year rally,  it’s a little over-valued (especially compared to International and Emerging Markets) and probably due for another pull-back.

But we shouldn’t start panicking or worrying about the end of this bull market just yet.

Why not? What causes the end of a bull market?

Quite simply, it’s extreme levels of optimism.

And we’re no where near extreme levels of optimism yet.

According to a recent Gallup Poll, we’re at record low levels of stock market participation for mom-and-pop investors.

And according to a recent “Big Money” survey in Barron’s magazine, even professional investors are pessimistic about the 12-month returns of the stock market. In fact, Barron’s said the poll results were the least bullish in the survey’s 20-year history.

Older readers will recall the market was overvalued back in 1996, and it continued to rally for another 3+ years before finally turning down in 2000.

We’re still very, very far from the level of exuberance, or over-valuation, that we saw in 2000.

If you’ve been reading my prior writings, you know I’m a fan of staying calm and sticking to your investment process. In the long run, we never know when returns will show up, and trying to time the markets nearly always results in poor performance.

As Warren Buffett, the world’s most famous investor has said repeatedly, the real trick to investing is to value consistency over risk, get a few things right, and then to limit mistakes.

Buffett’s company, Berkshire Hathaway, recently held it’s annual shareholder meeting in Omaha, Nebraska. Most annual meetings are incredibly boring events, and ignored by most mom-and-pop investors. However, Berkshire’s annual meeting is legendary.

Each year, tens of thousands of shareholders and value-investing devotees descend on tiny Omaha (population: 400,000) to attend the annual shareholder meeting. When I attended in 2008, there were nearly 40,000 visitors. I couldn’t find a hotel room within a 75-mile radius and ended up sleeping on someone’s couch, along with their cat.

The reason it attracts such a large following is due to the folksy charm of Warren Buffet, and the incredible wit and wisdom of his second-in-command, Charlie Munger. Together they hold court for a full day, and just take questions from the audience. Most of the questions are related to general investing, and macro-economic events and are both enlightening and entertaining.

This year, for the first time ever, most of it was streamed live on Yahoo! Finance.

If you have any interest in learning more about investing I highly recommend you watch the recording :

https://finance.yahoo.com/brklivestream

And finally, there’s new research that shows that people who put off retirement live longer! You can read more at the WSJ.

If you have any questions about your ability to retire, or whether your investments are appropriate for you, feel free to reach out to me.

Happy Investing,

Nirav

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Gold Shines in 2016

Wow! It’s been a roller-coaster ride of a first quarter!

After dropping like a stack of bricks during the first six weeks of the year, the market staged an incredible comeback during the last six.

The S&P 500 rallied 14% since it’s February lows, ending the quarter up 1.5% for the year. This is probably the strongest rally I can remember (outside of the tech rally in 1999).

Luckily our value and quality-based strategy did even better, outperformed the market by about 5 percentage points. After last year’s performance, where mostly low-quality, unprofitable company stocks went up, and value/quality-strategies performed miserably, it’s good to see a validation of our investment strategy. (And of course, for compliance reasons I have to state that past performance is no guarantee of future returns).

The biggest gains came from Gold, and Gold Mining stocks, checking in at 15% and 45% respectively. As I explained last month, in a Negative Interest Rate Environment, gold is expected to do well.

And while interest rates in the US are not yet negative, if they do continue to decline, we can expect this gold rally to continue.

The Federal Reserve, which sets the short-term rates, has continually flip-flopped on it’s stance regarding interest rates. While stating late last year that they were going to raise the rates steadily, and continually for the next few years, they’ve since reversed their position.

Personally, I expect rates to stay at this rate for quite some time.

Rates in Europe are already negative.

Negative interest rates act as an unfair tax on savers, both at the individual level as well at the corporate level.

It especially hurts companies which need access to large amounts of capital, such as insurance companies who need liquidity to pay out claims – companies like German insurance giant, Munich Re.

According to a recent Bloomberg article, faced with the option of paying -0.4% to keep cash in the bank, Munich Re, has  instead decided to store $10 million euros in cash, in its vaults. This is on top of the 300,000 ounces of gold it already stores, currently valued at $366 million.

If global interest rates continue to decline into negative territory, more and more companies will start holding more of their cash in the form of gold. This can really start to move the needle on gold purchases.

While it’s hard to predict the movement of asset prices, but I believe we’re seeing the early stages of a gold rally.

All of my client portfolios have a small portion allocated to gold and gold mining stocks. While this diversification in alternative assets has acted as a damper on returns in the past few years, it’s worked out excellently this quarter.

And if the US joins the negative-interest rate club, it will continue to perform well.

But please don’t take this is to mean you should bet the farm on gold!

A well-diversified portfolio both protects against catastrophic losses and provides decent returns over the long-term.

Concentrated bets into any one stock or one sector may be how fortunes are made, but much more often, it is how fortunes are lost.

On another note, tax season is in full swing.

Tax-related fraud is on the rise, with thieves rummaging through mail looking for tax refunds to steal.

One way to avoid this is by having your refund directly deposited into your account – but make sure you have the correct routing number and account on your form! And you can keep tabs on your refund by using the IRS’s Where’s my Refund? page.

If you haven’t contributed to an IRA yet, it’s still not too late. For those of you who make too much money to contribute to a Roth IRA, there may be a backdoor method to contribute, providing you do not currently have a Traditional IRA. If you do have a Traditional IRA, it’s probably not worth the hassle.

If you have questions on your eligibility, feel free to contact me.

Happy Investing!

Nirav

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Economics Explained in Rap Format

I came across this amazing rap video which talks about boom and bust cycles, effects of low interest rates and government spending. Basically everything you ever wanted to know about the economy! So whether you believe in Austrian economics, or you’re a Keynesian, you’ll enjoy this video.

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Have We Turned A Corner?

Previously, (in Should you Worry About Market Declines, and Staying the Course), I advised readers to ignore the news media and recent stock market declines and stick to their long-term investing goals.

This was in response to several client calls worrying about an impending market collapse. After the volatility of the last six months of 2015, and the near 10% losses in the first 6 weeks of 2016, it’s easy to get spooked and yearn for the safety of the sidelines.

But then, as often happens, the markets turned right around and rallied for the past 2 weeks, with nearly all asset classes coming close to erasing the losses for the year.

I guess the stock market really enjoyed the political circus that has been playing out between Donald Trump and all the other 32 presidential candidates!

The strongest gains came from the worst performers of the last year – Emerging Markets, Gold and Oil Companies.

The best performer was Gold (up 9% last week, and 18% for the year), and Gold Mining Stocks (up 5.5% for the week and 35% for the year), but this comes as no surprise.

After several years in a Zero Interest-Rate Environment (ZIRP), we’re now close to a Negative Interest Rate Environment (NIRP). And in negative interest rate environments, gold can be expected to do well.

A third of all global debt (nine trillion dollars worth!) has been issued with a negative yield. This includes the Eurozone, Scandinavian countries, and most recently Japan.

As I mentioned almost exactly a year ago today, the US is going to have a tough time raising interest rates when the yield on newly-issued global bonds is negative. (As a side note, in that letter I also predicted that intermediate-term Municipal Bonds would be the biggest beneficiary – a scenario that actually came true with Munies being one of the best performing asset classes last year!)

Sure enough, as predicted, even though the Federal Reserve increased the short-term rates, the yield on long-term US treasuries declined, and even mortgage rates have dropped to levels not seen since late-2012.

Incidentally, if you’re in a 30-year mortgage with an interest rate that’s over 3.75%, now is a great time to refinance.

Oil prices seem to have stabilized, and may have reached a bottom around $30/barrel, leading to a rally in Oil Companies which were up 9% last week and nearly 4% for the year.

And after 3 years of double-digit losses, Emerging Markets finally seemed to have turned a corner. They were up 9% last week, and up 1.5% year-to-date.

So does this mean the worst is behind us, and its smooth sailing from here?

I doubt it.

I still think we’re going to see a lot of volatility this year, with major declines followed by massive rallies.
But it doesn’t make sense to sell everything and sit on the sidelines.

After all, you don’t earn interest or dividends when you’re on the sidelines. And dividends are responsible for nearly half of your long-term investment returns.

So, as usual, just keep calm and stay invested!

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Staying The Course

Depression

The market’s been quite volatile over the past several months. The talking heads on TV have been proclaiming it’s a bear market, with 2008-esq declines on the horizon.

In this environment, it’s easy to lose your nerve and consider bailing on your investment strategy, or at least curtailing your monthly investment contributions to your retirement accounts.

But the truth is hard to swallow – volatility is the just price you pay for investing in the stock market.

While it’s a rollercoaster ride, especially in terms of emotions, historically you would have earned 8-11% in a well-diversified portfolio over long periods of time. And by long periods we are talking more than 5 years. Not just a couple of months, or even a couple of years.

As I mentioned in the last post, I strongly recommend you stick with the long-term strategy you’ve decided upon, even if the next few months or years are volatile.

During the accumulation phase, your investment process consists of making periodic contributions that are invested into a sound strategy. Even the soundest strategies will not always seem that way, with long periods of drawdowns and losses. If you stop your contributions, you are breaking the process. This rarely leads to a better outcome.

Here’s a snippet from an interesting article I just read today:
…From more than 40 years of providing investment counsel to corporations, endowments and individual investors, I’ve learned that one of the keys to successful investing is to avoid the tendency to “catastrophize”—envisioning only the worst possible scenario.

To do that, it helps to know the history of market returns. Consider the following examples:

  • From 1973 through 1974, the S&P 500 Index lost a total of 37%. Over the next five years, it returned almost 15% per year. And over 25 years, it returned more than 17% per year.
  • From April 2000 through February 2003, the S&P 500 Index lost an even greater total—more than 41%. Then, from March 2003 through October 2007, the index returned more than 100%, providing an annualized return of more than 16%.
  • From November 2007 through February 2009, the S&P 500 Index lost a still-greater total— more than 46%. Then, from March 2009 through November 2015, the index returned 227%, or more than 19% per year.

source: Reality Check For Investors by Larry Swedroe

 

 If you are uncomfortable with stock market volatility, your only other options are to invest in bonds, which will yield substantially lower returns than the stock market, or bank CD’s which basically guarantee you lose 1% to inflation every year.

But if you can hang in there, you will be rewarded with the juicy long-term market returns.

Pulling out and sitting in cash until you are comfortable with the volatility is a losing strategy. You cannot predict when you get positive or negative returns, and trying to time your entries and exits leads to missing out major returns.

If this volatility is making you lose sleep at night, maybe it’s time to adjust your asset allocation. Adding some more bonds, while lowering your long-term returns, will reduce the volatility and prevent you from making catastrophic mistakes.

What are catastrophic mistakes?

Selling out of your long-term holdings due to short-term volatlity definitely fits the bill.

Keep calm and just carrying on investing!

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Should You Worry About The Market Declines?

The market celebrated the New Year by dropping 9% right out of the gate… It’s the worst start to a year ever… And the market is now at its lowest level since late 2014.

It’s natural to worry when the stock market has been down nearly everyday this year.

But regardless of how long you’ve been investing, it’s hard to accept that nothing unusual is happening in the market.

Declines of 10%-20% don’t signal the end of prosperity. They are normal market movements. And so long as you you hold high-quality, long-term investments in your investment accounts, you have nothing to worry about.

Building wealth comes from holding for the long term – including through market dips.

But I understand, it’s hard keeping calm. Especially since there’s so much to worry about….

Economic slowdown in China, lack of growth in Europe, collapsing oil prices, rising interest rates, ISIS, declining profit margins, extended valuations, stagnant wages, growing economic inequality, Hillary Clinton becoming president…or worse, Donald Trump!

If you watch CNBC, everyday they will have some talking head telling you how this is the just the beginning of the next crash, and how it’s going to be a repeat of 2008.

Someone like Peter Schiff, Dennis Gartman, or Marc Faber. Whoever they are, they will be welcomed as an expert,  and will be extremely pessimistic about the current economic environment, and have convincing reasons why we should sell everything.

Fear sells. Research shows we pay more attention to negative news or headlines.

We’re hardwired to believe pessimists. Someone with a pessimistic point of view always appears smarter, and we give them credit for digging below the surface. On the other hand, optimists appear as intellectually lazy, cheerleaders for the market.

Maybe there’s an evolutionary benefit to believing naysayers. Healthy skepticism is what keeps us alive and out of harm’s way.

Except when you take it too far.

And they will never tell you the track record of their so-called “expert”.

Consider these doomsday headlines from Marc Faber:

  • Faber on Hyperinflation: “Not A Matter Of If But When” -Business Insider, 9/23/2010
  • ‘The Bear Market Is Starting’ Marc Faber -CNBC, August 3, 2011
  • Faber: The Dollar’s Value In The Future Will Be Zero -Business Insider, 4/18/ 2011
  • Marc Faber: We Could Experience A 1987-Style Crash This Year -Business Insider, 5/10/2012
  • Marc Faber: Look out! A 1987-style crash is coming. -CNBC, August 8, 2013
  • 2014 crash will be worse than 1987’s: Marc Faber -CNBC, April 10, 2014
  • Dr. Doom calls bubble, adding to gloomy calls -CNBC, Nov 2, 2015

Every year, like a broken record, he has predicted an impending crash in the market.

If you had listened to Faber, you would have gotten out of the markets six years ago and missed one of the biggest bull markets of your life.

Eventually, he’ll be right.

But it doesn’t pay to panic and sell your investments just because there’s a chance of a major crash.

Since 1950, the market has experienced 147 declines of 5% or more, 40 “market corrections” of 10% or more, and 11 “bear markets” of a 20% drop.

We can learn a few things from these numbers.

First, the current market correction is normal. It happens, on average, every year and a half.

Second, it’d next to impossible to avoid these by “trading around them”.

If the market falls 5% and you sell your stocks in a panic… you would have been wrong 73% of the time. In 107 out of 147 pullbacks, a 5% fall represents the bottom, and then the market rebounds… So you would have sold low, and the market would have recovered without you.

Say you’re braver than that, and you wait until until the market falls 10% to sell. This would mean that you’re trying to avoid a bear market drop of 20%. Even then, you’d be wrong 72.5% of the time – only 11 out of 40 pullbacks of 10% or more turn into a bear market. And again, the market will rise without you.

In fact, you probably would have sold out last Wednesday, and missed the tremendous rally on Thursday and Friday, where the S&P 500 index gained almost 5% from the midweek lows.

Selling in a panic almost never pays off.

As I’ve mentioned before, you never want to let your emotions get the better of you. Successful investing requires patience, a process/strategy, and discipline.

Don’t let the talking heads on CNBC (half of whom have paid to be a “guest”) scare you out of your investments, or process.

If anything, a major decline is an opportunity to buy stellar global companies at a discount.

Since 2010, stock market volatility has been significantly lower than normal, possibly caused by Quantitative Easing. (Quantitative Easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply). Since the Federal Reserve has ended this program, and embarked on the quest for higher interest rates, I expect volatility to return.

You should expect the volatility of past 3 months to continue. If anything, the market might be more volatile than normal, probably for the next year or two.

Even if the current correction turns into a major bear market, within 2 years, on average, you’ll be back where you were before the decline started. And during that time, your contributions and reinvested dividends will be buying stocks at a discount.

The stock market is the only market where shoppers run out of the store the minute everything goes on sale!

If you’re already in retirement, or just on the verge of retiring, a big decline may impact your retirement planning. However, your allocation of stocks and bonds should have already been appropriately adjusted to enable you to live off your bond/cash until the market recovers. Depending on the severity, you may have to reduce your spending, but these too should have been predetermined and should not come as a surprise.

For everyone else, especially those who are many decades away from retirement, a long, protracted bear market will set you up for spectacular returns in the future.

So turn off your TV, stick to your investment process, and pray for a major decline in the stock market.

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Historic Day For The Dow

Today was a historic day for the Dow Jones Index – and a harrowing day for investors. The blue chip stock index fell 1,089 points, the biggest intraday move in the history the index, before recovering to a loss of only 588.

Over the past three months, the S&P 500 has dropped about 7.5%. There hasn’t really been any safe haven as global markets have dropped as well.

Except for bonds, every other asset class is down for the year to some extent. The biggest losers have been Emerging Markets and Commodities, down 19% and 22% year-to-date.

Today’s action was the culmination of what’s been an incredibly bad week for the global markets.

The S&P 500 is now down 10% from the peak this year, and is officially in a correction.

As I mentioned in my last post, we were anticipating a 10% or even a 20% decline sometime in the near future.

On average, the market drops 10% about once a year. However, we’ve gone 4 years without this sort of correction –  it was only a matter of time before the market dropped.

And, as usual, the news outlets are full of doom and gloom articles predicting the end of the world. After all, bad news sells.

But you shouldn’t worry too much about a decline of this magnitude.

Unlike 2008, we’re not on the verge of a major recession, nor are the financial institutions on the verge of collapse (at least not yet!). The current environment is not similar to 2000 either, where technology stocks were ridiculously overvalued, and the overall stock market was twice as expensive as it is today.

Today’s market is fairly valued, trading at a P/E of 18.

The P/E or Price-to-Earnings ratio denotes how much someone is willing to pay for a dollar of earnings. A P/E of 18 means investors are willing to pay 18 times earnings. 18 times earnings is a fairly valued market. Above 25 it’s getting expensive. Above 35 and you should be extremely cautious.

Sometimes investors get caught up in the euphoria of owning stocks, and are willing to pay any price.

This is the scenario that recently unfolded in China.

The Shanghai Composite Index soared 133% in the past year until it was trading for over 40 times earnings. This year alone, it was up 60% at the peak before eventually crashing. Instead of being up 60%, it’s now down 1% for the year.

A lot of ordinary middle-class Chinese investors got hurt, speculating in something they didn’t understand. Just like in the US stock market 15 years ago, and the US housing market 7 years ago.

But we’re nowhere close that level of frothiness in the US markets today.

Over the past several decades a well-diversified global portfolio with 80% equities and 20% bonds has returned between 9-11% over any 20 year period.

Historic returns by asset allocation

 

(Click to Enlarge)

source: http://paulmerriman.com/fine-tuning-asset-allocation-2015/

However, there have been very few years during the entire timeframe when the portfolio actually delivered 9-11% in any given year. We either see 11%+ returns (such as 2013, when this 80/20 portfolio returned about 15%) or below 9% returns (like 2014 when this 80/20 portfolio returned about 3%).

And there will be times when your account has negative returns. Maybe for a few years in a row.

Over your investment lifetime, there will be at least one or two periods when your portfolio will drop 25% or more (as it did in 2008). Despite these huge declines, the nature of the markets and compound interest will ensure a high probably of achieving satisfactory results. So long as you don’t panic and bail at the bottom of the market.

This is easier said than done. Imagine if you had several hundred thousand dollars in your account and you’d just lost $200,000. In this situation most people cry uncle and change their investment strategy.

Don’t let these short term drops in the market upset you, and derail your investment plans.

In fact, you should pray for a severe and protracted bear market so you can keep buying stocks at a cheap price.

Remember, when the price of stocks fall, they become less expensive and also less risky. However, the stock market is the only market where investors flee when they see a bargain!

The only time you’d hate these huge drawdowns in your portfolio is when you’re close to, or in retirement. But, your asset allocation should have already been modified to adjust for this, and your exposure to stocks would have declined in favor of bonds. This lowered exposure to stocks would have helped moderate the losses in your portfolio.

You’ve probably heard stories of older investors who lost 50-60% of their 401ks in 2008 and had to either put off retirement or go back to work.

These are the people who didn’t have the proper asset allocation, and had too much exposure to stocks, or volatile asset classes like REITs, commodities or small-cap stocks. The difference between a portfolio that has 60% in equities and one with 90% equities is the difference between losing 35%, and losing 55%.

A 35% loss stings, but a 55% loss results in sheer panic.

And when people panic, they tend to behave in a manner that is injurious to their health, or in this case, their long-term financial well-being.

I personally know several investors whose portfolios lost 50-75% of their value in 2008/2009 and they moved everything to cash.

Some of them are still in cash.

Meanwhile, the S&P 500 is up just over 200% since the bottom in 2009. Compared to that increase, this 10-20% loss is minor blip. As in 2008 and 2009, staying in the market through this turmoil may prove to be a very wise move.

If you have a long-term horizon, don’t let short-term events derail your investment plans. If anything, see them as an opportunity to buy stocks at a discount.

We’ve taken this opportunity in the markets to rebalance our client portfolios. In a bull market, this strategy forces you to take profits along the way. In a correction, it makes you buy back some of the assets that have dropped in price. In effect, this time-tested strategy takes a lot of the emotions out of our investment process and forces us to sell high and buy low.

Stay the course.

 

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2015 has been a roller coaster ride so far.

The stock market was down in January, up in February, and is now trending back down again in March.

Long term bond prices (US 20-year treasuries) were up 10% in January, and then drifted back down again.

And then there was today, Friday March 6th 2015, where the entire investment landscape was awash in a sea of red. It’s unusual to see all asset classes decline at the same time.

Usually, at least stocks and bonds move in opposite directions. But today everything was down – US and International stocks and bonds, real estate, energy, precious metals, you name it.

The only things up were the US Dollar, which is currently enjoying decade highs against other currencies.  And interest rates.

The yield on the 10-year treasury bond jumped from 2.1% to 2.25%, on the news of better-than-expected employment numbers.

This is likely what contributed to the major sell-off in the market today.

This may sound contradictory – better employment numbers means the economy is improving. And an improving economy should be better for the stock market, right? Unfortunately not. There’s no correlation between GDP growth and investment returns.

Investors are worried that an improving economy means the Federal Reserve will start increasing interest rates. Higher interest rates hurt businesses, and could kill the nascent recovery in the housing markets.

It’s also interesting that a lot of publicly-traded companies are issuing debt at historically low prices and using that money to buy back their stock. Companies like IBM and Apple are borrowing money at less than 3%, and instead of using that money to grow their business, they’re opting to reduce the number of shares. This acts to make each share more valuable. (Consider cutting a pizza into 4 slices instead of 8  – each slice is bigger, and thus more valuable). This phenomena has been driving a lot of the growth in the stock market, which is why large companies have outperformed smaller companies over the past few years. (Larger, more established companies can borrow money more easily and cheaply than smaller companies).

Higher interest rates could put the brakes on the bull market in stocks that has been going on for the past six years. And that’s what caused a lot of worry in the markets today.

So should we worry about rising interest rates?

I don’t think so. At least not yet.

Even if the US economy is improving, there is no inflation on the horizon. The Federal Reserve uses rate increases to help curb inflation. But seeing as there isn’t any, the Fed will be hesitant to raise rates too high or too fast.

Even if the Federal Reserve does increase the short-term rates they can’t impact long-term rates, which are set by market forces. And market forces are unlikely to let long-term rates rise any time soon.

While we’re seeing positive economic growth at home, globally, the picture looks a lot more glum.

Europe is in shambles with a recession, high unemployment, over-leveraged countries, and fears of deflation. Commodity-driven economies like Canada and Australia have been hurt by the sharp decline in oil and metal prices.  Even China, which used to be the growth engine of the world, is seeing a slowdown in its economy. And then there’s conflict in Ukraine and Russia.

To help counter this declining economic picture, 17 central banks have cut  interest rates this year.

Europe is trying so hard to stimulate economic growth, banks are paying people to borrow money! (Source: New York Times)

And already 16% of global government debt has negative yields. Yes, the yield on bonds of Germany, Switzerland, France, Belgium, Denmark, Finland, Sweden, Austria and the Netherlands is less than zero.

You give the government your hard-earned money and after a certain amount of time, you get less money back.

Not only governments, but even global food giant Nestle was able to issue short-term bonds last month with a negative yield.

If this wasn’t bad enough, the European Central Bank just initiated a trillion-Euro quantitative easing program. Injecting this kind of money in to the economy will further devalue the Euro and ensure that interest rates on European government bonds stay negative. 

There is an awful lot of money sloshing around, and it needs to find a home.

I’ll bet that a lot of it ends up in US treasuries. When US 10-year bond yields 2% more than German 10-year bond, that’s an easy bet to make. (Surprisingly,even countries like Portugal and Spain whose bonds are rating as “junk”, have lower interest rates than the US! Usually, when you lend money to subprime borrowers, you charge them a higher interest rate).

This demand for US treasuries will prop up bond prices and continue to keep the yield low. And until things turn around globally, I doubt we’re going to see an increase in the yield on long-term debt.

And wealthy foreigners, who are facing the prospect of negative yields in their devaluing home currency, may instead choose to park their cash US real estate instead.

So I’d say there is a chance the real estate boom might continue for a little bit longer.

And compared to the guaranteed loss of purchasing power with negative-yielding bonds, gold is starting to look like a high-yield investment! Maybe, 2015 will see a change in the sentiment towards gold as well.

Does this mean it’s smooth sailing for the stock market?

Not necessarily.

The current bull market in US stocks is getting long in the tooth. It’s been six years since we’ve seen a major correction. So it wouldn’t be unreasonable to see a 20% correction within the next year or year-and-a-half.

A correction isn’t something to be feared. It gives the market time to digest its gains, and for investors to buy in at a cheaper price.

Even if you’re fully invested, you shouldn’t panic and bail in anticipation of a bear market. More money has been lost in anticipation of a correction than in actual corrections.

Besides, foreign developed and emerging markets have been lagging the US stock market for the past few years and are between 20% and 30% cheaper from a valuation standpoint. It’s about time they played catch-up.

So, as I often like to point out, maintaining a globally-diversified portfolio will prove to best the best course of action.

However, I think the major beneficiary of this situation will be intermediate-term Municipal Bonds.

Most investors overlook Munies, which this is a mistake, especially for high earners.

If you’re in a high tax bracket you might be able to pick up bonds with an 7.5% tax-equivalent yield. That’s a great opportunity in this low-interest rate environment.

 

 

 

 

 

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