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Crossing Wall Street, Part II

Back in the late 90’s, I ran a series of articles and presentations called, “Crossing Wall Street… and learning to look both ways”.  I should have written a book but that’s far too sensational for my personality.  Anyway, as the market approached extremes in valuations and money was flowing into stock funds at $70 Billion/ month, it was pretty obvious that investors needed some healthy reminders about risk and investing realities.  Of course, less than 6 months later, we saw the bursting of the dot.com technology bubble and thus began a period of nearly 13 years of frustration for investors.  Then, the content of Crossing Wall Street was clearly a warning.  Now, I have a similar type of message about investing realities in the current state of the financial markets.  Think of this as a more gentle warning.

Bad Behavior is Back

The chase in on.  Investors are looking backwards at returns, seeking out the largest, most outrageous gains over the shortest time period and yes, you guessed it, plunking down good hard earned capital on that pony.  With past returns like that, what could go wrong right?  You know the answer.  Reality check number 1;  returns made yesterday are gone.  You cannot go back in time and wish yesterday’s returns into your portfolio regardless of how much you want or need them in your life.  Furthermore, buying shares of something that has already moved meaningfully higher without waiting for at least a short-term correction is a recipe for you to continue losing money. The good news is that opportunity will develop again for those who are prudent and patient.   


Also in the bad behavior camp is the siren song of portfolio misallocation.  At this stage of the game the concentrated stock model sales guys come out in waves, tidal waves (Ken Fisher and the like).  They point to their backwards looking performance after nearly six bull market years and say, yes Mr. Retiree or person without income, you need to be in a concentrated stock portfolio.  The justification is always the same.  They say that the best returns have always come from stocks and “we own the best of them, yessiree”.  Stocks have traditionally offered investors the best returns…. As well as the greatest losses.  In the last 15 years, we have seen not one but two market cycle losses of 50% or more.  In 13 of those 15 years, the markets did nothing but trade in a wide range of loss of recovery with zero net gain (January of 2000- Feb. 2013).  Many of the “Best stocks” of 2000 have just started to recover their multi-year losses.   The sales pitch says that losses are part of “the game”.  Well some degree of volatility needs to be tolerated but I don’t have any tolerance for games in which I lose 50% of my net worth ever.  Here’s the reality check;  This is one of those times when we need to tolerate some volatility in the markets.  But when volatility turns into the risk of permanent or difficult to recover type loss, then we need to take action by becoming more defensive.  We may also be nearing that point in the markets today.  On the other end of bear market declines (near the lows), we tend to build more concentrated positions in stocks and sector ETFs.  Now, in this late stage of an aging bull market, we are doing just the opposite by spreading out and diversifying our holdings across non-correlated assets. 


Bonds are No Longer a Conservative Investment

Bonds of all types are under heavy selling pressure and it does not appear to be the end.  Intermediate term Treasury bonds (7-10 year) are now down almost 5% from the highs in February including all income payments.  Long-term Treasury bonds are down almost 6% YTD and -14% off the highs in January.  The reality check comes home when we realize that there is no such thing as a safe investment unless you are talking about pure cash and even that is subject to currency and inflation risk.  All things in the money world are subject to varying degrees of risk (stock, commodities, bonds, real estate, etc).  Bonds, especially US Treasury bonds, have a long been considered one of the safest investments in the world.  In fact, trillion of dollars of investment capital lives inside Treasury bonds assuming the full faith and guarantee of the US Treasury (+ unlimited printing of US dollars).  Retirees and sovereign countries assume that they are “conservative” and out of harms way by owning bonds.  As Bill Gross and others will attest, that assumption may be challenged with the next cycle.  Why are bonds losing money?  Economically, they tend do so on a cyclical level when signs of inflation are present, like the mid to late 70’s.  Today, we have very little inflation in the system but there are whispers.  The real drive behind sellers is simply a game of relative opportunity.  There is just little to no opportunity left in Treasury bonds after nearly 25 years of rising bond prices and falling interest rates. Bonds are going down for technical and fundamental reasons and they should not be considered conservative or safe investments to anyone at any age. 

Withdrawals are Regular, But Returns are Not

These cycles of flat returns or even mild losses in one’s portfolio make retirees very nervous, especially those who are new to it all.  When we are making income and salaries, in the back of our minds, we sleep with a sense of security knowing that we don’t really need our investment accounts as we can make ends meet with current income.  In retirement, of course it’s just the opposite.  Retirees who are living off of their investment accounts, might have a reasonable 4-5% withdrawal rate against their balances, which is never a problem when stocks are making 5-15% annually.  Since July 3rd, 2014 the NYSE has lost 1.31%.  The Dow Jones World Stock Index, our benchmark and one of the best performers YTD is still down 0.82% since July 3rd of 2014 – approaching one year.  So far, 2015 is angling toward the reality that stock markets rarely complete seven consecutive positive years without a correction or newly established bear market.  The odds are increasing that anyone withdrawing from their investments in 2015 is simply going to be dipping into investment capital this year rather than essentially skimming off returns to cover living expenses.  If returns could be earned with the same consistency as withdraws, there would never be an issue and after the last two years, it almost felt like that was the case.  For those who attended the annual meeting last October, you might remember my commentary about No Free Rides From Here On including the silly little graphic below.

What I meant was that returns would not be as consistent or dependable looking forward as they have been in the past several years.  Retirees and those living off of their accounts will need to get used to that reality and grind through cycles of flat returns trusting that gains will come again (and they will!) to refill the hole.

Bull Market Alive As Long As Rates Remain Low

For now, the trend of the world’s stock markets is still up.  However, we are in the midst of a new correction cycle, which is spreading across sectors, countries and asset classes quickly.  We have made some minor internal changes in our strategies to accommodate the new weakness and respect some of the technical problems we’ve been talking about for the last several months (new lows in Transportation and Utilities, lost leadership, rising rates, high margin debt, higher valuations).  As a bull market ages, we start to see deeper corrections develop before the final peak and this feels like just such an event.    Trends in interest rates are going to be the determining factor in the longevity of this bull market.  If rates can settle down a bit and hold near or below the 3% level on the 10 year Treasury bond, I think stocks can push on to new highs.  A strong rate move above that level would indicate a long term trend change for interest rates and stocks are likely to struggle, perhaps enter a new bear market.  Given current valuations, I see more sensitivity in stocks to rising interest rates and borrowing costs.   Beyond an obvious fear based reaction to the Fed’s first rate hike, which may be happening now, the real risk to earnings and the economy will come from higher borrowing costs and potential inflationary pressure in the form of higher wages and material costs. 

So here’s the short list if you need a recap

Reality Check (list)

*  You cannot wish yesterday’s returns into your portfolio.  Do not chase!

*  Keep your portfolio allocated according to your risk tolerance and angle toward diversification, away from concentrated holdings.

*  Being conservative does not mean investing in bonds

  • *  Withdrawals schedules do not always match your return stream
  • *  This is likely to be just a stiff correction in an ongoing bull market
  • *  Watch interest rates, not the Federal Reserve
  • *  Remain focused on risk management in this aging bull market!

Sincerely,

Sam Jones