Thoughts On The Markets Part Deux

This is Part 2 to the investment newsletter earlier in the month:

Regarding the market, we have had one of the most volatile starts to the year in the market in history. Fareed Zakaria mentioned recently on his CNN show, GPS, that America and the rest of the world look dysfunctional; which is what happens when all the country’s problems are on display 24 hours a day via television, web sites, mobile apps, etc. I believe it’s these type of headlines driving markets today and especially this month.  But negative news and warnings about impending economic doom are standard operating procedure for the news. Worries about China’s slowdown on the global economy is the flavor of the month. But fundamental economics are not driving this market, the headlines are. François Sicart of Tocqueville said it correctly in his latest investment newsletter (http://tocqueville.com/insights/why-did-stock-market-tank-yesterday),” Investor psychology trumps business fundamentals in the short term….. The stock market is made up of companies, and very little usually happens to suddenly and fundamentally alter a company’s long-term prospects… But in the shorter or even medium term, the stock market really is a beauty contest, reflecting the moods and preferences of a volatile jury: the investing crowd”

What do I think about this?  Am I concerned? How should we react? What changes should we make?

You may be surprised to know I am not concerned and see some opportunities here.  First, as some of the clients with me during the 2008 crash will attest, stay calm.  The best immediate course is to avoid an overreaction. 

To my clients who have been with me for the last 10 years, we have been here before. Different time, but same place. My narrative will not be any different in 2016. Whether it is the credit/mortgage crisis in 2008, the US debt downgrade in 2010, the Greek debt crisis in 2014, and now the China “syndrome” of 2016, stay focused on the next 5 years, not the short term noise and fluctuations driven by the latest headlines.

I know this is difficult.  To my newer clients, the clients mentioned above went through an even worse situation back in 2008.  These now battle tested stock market veterans saw their most aggressive portfolios drop over 20% in a course of 2 months.  Most stayed put and trusted the process.  Instead of overreacting they followed a strategy of rebalancing and letting the value funds pick up the discounted stocks, the same portfolio mentioned above produced returns on average of 9% a year over the next five years following this down period.  Put simply, a $1M portfolio dropped to $800,000 from Oct to Nov in 2008 but then grew to $1.6M five years later. 

How did we react back then?  Our value fund managers screened for the cheapest stocks during that time, and mainly home builders and banks popped up. Who was buying home builders and banks back then? Almost no one; but it paid off over the next five years.  Let’s fast forward to now; our value funds are buying the very cheap oil related and energy companies.  Who is buying oil company stocks right now? Almost no one.  This is called value investing.  Sounds crazy, but let me remind you of The Great Salad Oil Scandal of 1963 (https://en.wikipedia.org/wiki/Salad_Oil_Scandal).  Remember that one? Kidding, most people don’t.  The executives at American Express got caught up in a corporate scandal lending to Allied Crude Vegetable Oil which ended up costing the company almost $1billion in today’s dollars. Everyone sold off the stock and it proceeded to lose 50% of its market value. No one wanted to touch American Express’ stock.  One unknown brave, young 34 year old value investor saw an opportunity and purchased the stock.  By 1974, the stick grew 10 fold and Warren Buffet still owns it today, 50 years later, and is obviously very well-known now.  He purchased when there was “blood in the streets”. However, I am not implying we buy specific stocks that are selling cheaply, I am saying a value philosophy pays off in the long run. Our value funds inherently purchase these discounted stocks. Moreover, when we rebalance your portfolio, we will buy what has been down and sell what has been up.  On top of this, going forward, I will look to increase allocations to MLPs (down 50% over the past year) and emerging market stocks (down 30% in 2015).  Thus, we will take advantage of this opportunity by following Warren Buffet’s philosophy of buying stocks on sale and avoid the loss averse bias ingrained in the psyche of most investors who will try to time the market and sell or increase cash.  The market will rebound, as it always does, and returns over the next 5 years should be substantial.  The rebound also happens quickly and suddenly, which makes it impossible to time. If you have extra money, now is the time to invest.  If you are retired or near retirement, stay calm and patient. Avoid watching the market and focus on having a solid financial plan. 

Thoughts On The Market Part 1

See my Market Update/Investment Newsletter Part 1 below:

Happy New Year!  Well, another year has passed by and what a wild ride it has been. Welcome to stock investing. That tendency for stock prices to vary widely and often is called volatility risk, and despite the stomach-churning feeling it causes, it’s a good thing. In the end, it’s a reminder why equity investors are compensated so much more than bond investors for taking on this additional risk. Put simply: no risk, no return – a concept just as valid today as it was in the 1600s when the Dutch established the first stock exchange.

The range in returns this year is wide. As noted in the chart below, returns by investment class ranged from -26% for MLPS to 1.6% for U.S. large-growth stocks. Overall, U.S. large-caps stocks were barely up this year and, as Barron’s stated this week, “if it were not for Amazon, Google, Microsoft, and Facebook, it would have been down 4%.” The big issue last year revolved around corporate profits (earnings per share). In fact, we had one of the biggest drops in U.S. stock earnings per share in a non-recession time period. Oil was the main driver of this.  Oil prices dropped over 30%, not far from the seven-year lows. Needless to say, low oil prices hurts profits of energy related companies, which caused the overall return of the S&P energy sector stocks, like Chesapeake Energy (down 77%), to drop over 24%. This brought down the reported earnings and stock prices overall in the U.S. indices significantly. At the same time, the dollar strengthened (against the euro over 11%) which hurt U.S. companies exporting products and services overseas. All this combined with the Fed raising interest rates for the first time since June 2006 (almost 10 years ago!) and Chinese economic growth slipping could have been a recipe for disaster, so one would have thought it could have been much worse.

The biggest insight here is no one saw any of this coming. At the beginning of last year, there weren’t many people predicting oil would fall off the cliff or the Fed would wait until December to raise rates. Thus, take everything you are hearing today with a grain of salt.  Humans suffer from the recency bias, which means most people are expecting things like oil prices and emerging market stocks to stay or continue their downward path. However, things could change overnight. For instance, Saudi Arabia could decide tomorrow to restrict supply of oil and raise prices, which would cause the price of oil to double in a day.

What about interest rates? Keep in mind the Federal Reserve increased short-term rates slightly; 25 basis points so not a big move. The longer-term rates, like the 10-year Treasury bond, were actually flat for the year. So, when people say rates are rising, they are typically speaking to shorter/overnight lending rates that won’t necessarily impact longer-term bonds. Most experts expect rates to increase about 25 basis points in at least 2 or 3 of the 8 meetings next year. This will get the short-term target over 1% next year – a low level by historical standards. Many experts expect long-term interest rates to jump significantly.  In fact, this is mentioned so often you would think it’s a forgone conclusion. However, be careful with this assumption. If you look at other countries after a credit crisis or even our country during the depression area, long-term rates will most likely not go up anytime soon. It took over 20 years after the depression for the 10-year Treasury to get back to 4%. What’s more, economist and former Treasury Secretary Lawrence Summers makes a good argument regarding this issue in his latest blog (http://larrysummers.com/category/blog/).  

Keep this in mind when watching and reading the predictions for 2016. I know we’re off to a bad start (at least as I write this) and there are all sorts of scenarios – good and bad – floating around in financial press. We’re being bombarded with acronyms, short names, nicknames, and buzzwords to describe them. Could Britain leave the European Union (i.e., “BREXIT”) or could Greece’s issues percolate once more (i.e., “GREXIT”)? Will the FANG (Facebook, Apple, Netflix, and Google) stocks dominate again this year? Will Dr. Doom’s, Nourani Roubini, dire predictions come true?

All I can stay is to distance yourself from the noise, and focus where the market will go over the next 5-10 years. That’s how top investors invest, and it’s how we think as well. Despite what you may hear about central banks flooding the markets with money and inflating stock markets, most academics agree we aren’t in a market bubble. Based on stock valuations today (as measured by P/E, Shiller P/E, and Book Values), stock investors will see considerable returns over the next 5-10 years in the U.S. stock market, and even more on the international side. Maybe not as much as in past, but a considerable amount.

Jeremy Siegel, the author of Stocks for the Long Run, states we could very well have a generous increase in stock values. He thinks we could see significant growth in the already-depressed earnings if commodity prices increase and consumers continue to spend.

Regardless, the smart players stay disciplined and diversified, which means having a combination of domestic and international stocks and bonds in your portfolio. Don’t be like the ones noted in the latest Fidelity 401k survey: a recent report from Fidelity Investments found that 11% of its 401(k) account holders aged 50-54 allocated 100% of their retirement assets to stocks; mainly U.S. blue-chip stocks. These investors don’t have an advisor to educate them, and they are chasing returns by buying what has done well the past couple of years. 

Smart investors buy things cheap. That’s why your portfolio has value funds, allowing for a quantitative process to identify the stocks selling at a discount. At the same time, we rebalance regularly, which inherently forces one to buy low and sell high. So, in a nutshell, hang tight. It will all pay off.