Stocks rallied in April, closing at the high for the year and the highest level in three years. With stocks up 9.1% through April 30th versus our 2011 forecast of 8%, we see stocks as fully to slightly overvalued. In fact, given the lack of substantial "new" news to push stocks one way or the other, we expect a 10% trading range that could last through the summer and into the fall. On February 28th, David Edwards commented on Bloomberg Radio that "the S&P 500 could fall 10% in the next six months," but that he wouldn't change his strategy because he expected a 20% rally on the other side. In fact, stocks fell 7.1% over the next three weeks then regained the entire loss over the following 5 weeks. So the risk of that 10% correction remains. As we are not making major strategy changes at this time, we will devote this commentary to the issue that concerns our clients the most:
What is the greatest investment risk? The risk that money won't be there when you need it!
An investor's biggest fear is that money won't be there when needed. Two decades ago, we thought that "beating the averages" was our prime directive. Now we believe that our mission is to "achieve our clients' financial goals with the least amount of risk." Not a glamorous philosophy, but one that helps our clients sleep at night!
Dalbar, a Boston based research company, publishes each March the "Quantitative Analysis of Investor Behavior," which analyzes mutual fund flows to determine average investor results versus average mutual fund returns, and versus indexes such as the S&P 500 and Barclays Aggregate Bond Index. For 17 years, the study has shown the same results: individual investors received substantially lower returns than either the average mutual fund return or the overall market return. Why? Investors generally hold funds for 4 years or less, often chasing funds with highest recent performance, even though such performance is rarely repeated. In general, investors buy funds when markets are rising, and sell funds when markets are falling (classic "Buy High/Sell Low" behavior.)
Our own clients are not immune. In March/April 2009, about 5% of our clients, all high net worth families, ordered us to sell out their stocks at 13 years lows. The client relationship terminates in those circumstances, so we're not sure what those families did subsequently. However we suspect that they sat out the 100% rally in stocks over the next two years and are just now reallocating assets to equities. We prevailed on other clients to increase their investments in stocks; those families were rewarded handsomely. When the market offers you good companies at deep discounts, we believe you should take advantage!
Why did some of our clients panic? They drew a straight line from the trend in the S&P 500 through March 2009 and projected that the market would hit 0 sometime in 2010. We can imagine scenarios where the S&P 500 would indeed trade at 0, but those scenarios generally involve a nuclear weapons exchange between the United States and some other country. In that situation, our asset allocation strategy would focus on canned goods. Gold would retain value because you could use a brick to bash in your neighbor's head and steal his food!
How can we protect our clients against their own fear? Purpose-based asset management
We spend a lot of time upfront and during annual reviews determining the goals of our clients' wealth, then allocate their assets to different risk categories depending on purpose and time horizon. We segregate the "near-term" funds in less risky asset classes, taking more risk with those funds with a longer investment horizon.
In dozens of times in the last 100 years, a short-term dire outlook for stocks has in fact proved to be an excellent buying opportunity. We know that stocks provide the highest long term return of any asset class, but we also know that there can be long periods of under or negative performance. Stocks delivered negative returns in only two decades in the last 140 years of US stock market history. The Great Depression delivered negative returns in the 1930's. Following outsize (plus 18%/year) gains in the decade of the 1990's, US stocks delivered returns of negative 0.95% for the ten years through December 2009. Over the 20 year stretch from 1990-2009, stocks delivered 8.2% annual returns, which is in the 8-10% range that has prevailed since 1900.
Generally speaking, we only allocate assets to stocks if the holding period is at least 5 years - retirement accounts, for example, or the growth component of a taxable portfolio. For cash flow needs in the next 1-5 years, we rely on bonds of various classes. The least risky bonds, which offer the lowest returns, are short-dated government bonds, while long-dated high yield corporates and preferred stock are the highest yielding but also the riskiest. We spread the fixed income component across different credit qualities and adjust the average maturity depending on our outlook for interest rates.
For cash needs within a year, particularly in a rising interest rate environment such as we have now, we stick to money markets - no return but (almost) no principal risk.
In a very simple example, a retired family might have 30% of their assets in fixed income, 70% in stocks. We draw their monthly "allowance" from short term government bonds and reload that asset class one or two times a year from gains in the equity portion of their portfolio. We're happy to say that during the entire financial crisis in 2008-9, we didn't have to cut anyone's allowance. We simply waited on reloading bonds until stocks recovered.
In a more complex example, a working family might have assets separated into different accounts: several retirement accounts mostly invested in stocks, accounts for pending college tuition, for tax liabilities and a "rainy day" account for family emergencies mostly invested in bonds, and a certain amount of cash, ideally 3-6 months of wage income. We encourage these clients to use a web based application called "Full View," which aggregates all their investment, bank, credit card, mortgage and insurance accounts into a single "dashboard." A quick glance at "Full View" during times of market stress reminds our clients that their wealth plan is still on track.
Common investments risks
There is no such thing as a "risk-free" investment. Consider these issues in any investment strategy.
- Principal risk - Will Rogers said, "Return of principal is more important than return on principal."
- Inflation risk - a low-yielding strategy such as money markets or short term government bonds is unlikely to provide a return greater than inflation, which leads to erosion of purchasing power over time.
- Reinvestment risk - as current investments mature, will comparable investment opportunities be available? Many seniors relied on a bank CD strategy through 2007, which provided a comfortable retirement given yields of 3-4%. With banks CD's now under 0.5%, other strategies must be employed
- Longevity risk - the chance of outliving your money. Can be mitigated by drawing annually no more than 6%, preferably 4%, of your retirement assets, or "annuitizing" part or all of your retirement assets.
- Liquidity risk - money can't be freed up when needed. Cash, bonds, stocks, mutual funds, ETF's are all liquid. Private partnerships, real estate, privately held businesses are all illiquid. During the financial crisis, Harvard University, which had an outsize allocation to private equity partnerships, suspended several ambitious building projects, slashed spending and sold stocks and bonds at big discounts just to keep dormitories open.
- Transparency risk - Do you understand the strategy? Any advisor who refuses to fully disclose portfolio holdings ("we have a proprietary "black box" strategy") is automatically suspect.
- Custodial risk - does your advisor self-custody? Ronald Reagan said, "Trust but verify." Bernie Madoff self-custodied, with disastrous implications for his clients. Many limited partnerships, hedge funds, private equity firms, venture capital firms self-custody, so what controls exist to protect your interests? Most registered investment advisors, including ourselves, do not self-custody.
- Volatility risk - US stocks fells 55% between 2008-9, rallied over 100% between 2009-2011. Total return over the last 5 years was 12%. However if you had to meet a financial need in 2009, you would have sold stocks at a 50% discount. The more volatile the asset, the longer the expected holding period.
- Margin risk - buying assets on margin leaves you vulnerable to cash calls, or being sold out not when you want to, but when you have to.
- Leverage risk - Many "hedge" funds are in fact leveraged funds. US banks and broker dealers increased leverage from a historic average under 10:1 to over 20-60:1 leading into the financial crisis. Long Term Capital, a hedge fund levered 250:1, was wiped out over a weekend in August 1998. Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, Sovereign Bank ceased to exist as independent banks during the 2008-9 crisis.
- Credit risk - the chance that your counterparty can't make good on their promises. The biggest risk of buying an annuity is that the issuing insurance company will fail. It's instructive that while the AIG parent company failed during the financial crisis, AIG policy holders were protected because policies are issued by state chartered subsidiaries that are tightly regulated by state insurance commissions.
- Operational risk - the chance that an investment product will not perform as advertised. ETF investors with stop losses faced losses of up to 60% during the May 6th, 2010 "Flash Crash." Trades outside a 60% band were cancelled, which was of little comfort to thousands of retail customers stopped out with a one day loss of 59%. The "Ultra" ETF's are particularly dangerous and should be banned by the SEC.
- Correlation risk - International investing supposedly diversifies a portfolio comprised primarily of US stocks, but in fact US and international markets move ever more in lock-step. Truly non-correlated assets move in opposite directions in times of crisis, for example, US Government bonds compared to US stocks.
- Political risk - Venezuela nationalizing the operations of foreign oil companies, or the US suspending deep water drilling by oil companies.
- Systematic risk - the entire system freezes up, as we saw in 2008-9 and during the October 1987 stock market crash. Note: systematic risk remains high right now given the debt situation of the US, Japan and many European countries
- Environmental risk - earthquakes and tsunamis as we saw in Japan earlier this year, or the long term consequences of global warming, which includes the flooding of most of Florida.
- Demographic risk - aging populations won't be able to rely on younger workers to provide for their retirement. This is already an issue in Japan and Europe, will be an issue in China within two decades. The US will address this issue by raising the minimum age to collect Social Security.
- Currency risk - Gains in overseas investing off-set by a rising dollar. Note: for the foreseeable future, the US dollar will continue falling - currency risk can benefit you if you have some non-dollar investments.
- Commodity risk - sharp rises or falls in the prices of commodities. Airlines are extremely vulnerable to changes in jet fuel prices. Transportation companies less so because they tack on "fuel surcharges" when prices are high.
Our horizon for managing clients' wealth is three generations. We don't worry too much about what happens in the stock market on a day by day basis because single day returns are almost completely random. We spend most of our time worrying about how our clients' portfolios will respond to all the risks above, yet still generate a return that achieves clients' objectives.
Odds and ends
- Bin Laden - dead, but his toxic philosophy lives on like pockets of the plague. At present, economic issues (the quadrupling of food prices in the last two years) are far more important to average inhabitant of the Middle East than sectarian issues. Not much Westerners can do except watch.
- Commodity bubble - About a week ago, one of our clients asked us about our long term forecast for commodities. We said, "Indefinitely higher, since new sources are ever harder to come by while demand continues to surge." So he asked whether 100% of his portfolio should be in commodities, as opposed to the current 14%. We replied, "No, because in the short term, commodities can be volatile." Over the next 5 days, commodities fell an average of 11%, while silver fell 25%, and the Ultra Silver ETF fell 51%. Exactly!
- Latest US Jobs report - Unemployment ticked up to 9% as "discouraged" workers starting looking for work again. YTD gains total 768K, which is positive but another 7 million jobs must be added to surpass the 2007 peak employment
- Our 2012 Presidential Election Forecast - Obama wins, not because of the successful Bin Laden hit, but because the economy will continue to build through 2012 and the Republicans have no presidential candidates of stature. Republicans retain control of the House of Representatives, remain minority in Senate.
- "Black Swans" - "The Black Swan: The Impact of the Highly Improbable" and "Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life" are excellent books by investor/philosopher Nassim Taleb. Alas, blaming "Black Swans" has become standard operating procedure every time an investment strategy fails. Students of history know that mathematical modeling of human financial behavior has limits of utility.
US earnings continue to impress, while interest rates haven't moved up yet. US stocks remain fairly to slightly over-valued. We remain cautiously optimistic about the recovery of the US economy, and will make modest adjustments in our portfolios through the summer.