July 2016 Investment Article

It’s a Charlie Brown Year

“Stop worrying about the world ending today. It's already tomorrow in Australia.”

                                                                                                -Charles Schultz

Remember good old Charlie Brown? He would appear to make progress in this world and, whenever he did, the rug always seemed to be pulled from under him. This is one of those years for all of us. The market seems to get ahead; then something pops up out of the blue. Before Friday, June 23 (see my Brexit article), international stocks were up for the year and have now gone negative since the vote. Luckily, emerging market stocks are up 10%, while U.S. stocks and bonds are up 3 to 5%.

Actually, this has been the story of international stocks for the past five years. During that time, there have been numerous crises worldwide: the U.S. debt downgrade, Greece leaving the Euro (Grexit), slowdown and currency crisis in China, and now Brexit. In each case, the markets never saw the result coming. Looking back though, these situations were all great opportunities to invest. This time is no different.

So what should you do? First, realize that this is just another crisis, if you can call it that. The U.K. will still exist, business will carry on as usual, and trade between the U.K. and Europe will continue; maybe in a different form, but it still will exist. Although there is still a contagion concern, this crisis soon will be forgotten and, before long, something new will replace it. As a value investor, you actually want this. It provides an opportunity for the value funds to pick up cheap investments.

Picking an Approach

Many clients are asking about portfolio positioning. Most updates I’ve read from the large brokerage houses discuss the benefits of avoiding U.K. stocks, waiting it out in high-quality assets, and moving to a risk-neutral position. This type of thinking led investors to pull a net $8.4 billion out of foreign-stock mutual funds last quarter – a reaction that probably made famed value investor Benjamin Graham roll over in his grave.

This “sitting on the sidelines” approach is the opposite of what he (and I) would recommend. Look at the banks in Europe, for example. There are issues, granted, but relative to the U.S., European bank stocks are very cheap. Right now, Barclays and RBS (two of the largest U.K. banks) are trading around 30 cents for every dollar of assets, while HSBC is at 60 cents. Moreover, the European bank index is trading for about 85 cents per dollar of net assets, while, in the U.S., the bank stock index will cost you $1.30 for every dollar of assets. Big difference. As always, investors tend to oversell what’s out of favor and overbuy what is in favor.

Why would anyone sit on the sidelines when they can buy at bargain-basement prices? We take advantage of opportunities like this via the value funds in your portfolio, which by definition, automatically pick the stocks falling out of favor. Therefore, don’t be surprised to see U.K. bank stocks becoming a bigger part of our international funds. It’s a strategy that has paid off with countless other scenarios like this one.

The Bigger Picture

The Brexit is a microcosm of a large issuer happening worldwide that all comes down to the globalization of the economy. Every country is struggling with its residual effects, including immigration and jobs going offshore. 

As populism and nationalism take hold worldwide, let’s hope the world does not go the way of Germany, Japan, and Italy in the 1930s. Xenophobia was rampant then too, and this vote in Britain highlights the immigration issue occurring not only here in the U.S. where there are rumblings of a wall being built along the Mexican border, but also in Japan, Austria, and France where some political parties are making this topic their primary platform – and gaining popularity by doing so.

Over the past 15 years here in the U.S., almost 66,000 factories have closed costing more than 4.8 million jobs. Sounds bad, right? However, when you hear this, don’t forget to ask about all the jobs that were created during this time. For example, Amazon now has over 200,000 employees, Apple employs more than 60,000, and it is estimated that over 600,000 jobs have been created outside Apple to support the iPhone operating system. When you combine these examples and others like them, things don’t look so bad in aggregate. However, converting factory workers into HTML programmers is virtually impossible, which causes a wide disparity between the rich and poor. Consequently, globalization, free trade, and immigration are viewed negatively by the majority of the population. 

As we’ve seen the past couple weeks, it’s not an issue isolated to the U.S. It’s happening everywhere, and thus, tension is rising among the populace. Hopefully, our country won’t go the direction of England, but if we raise walls and increase tariffs, we will follow the same isolationist path

With all that said, don’t lose sight of the positive effects of globalization. For example, as Great Britain gets smaller and more isolated, India, with its 1 billion people (England has a paltry 53 million), will surely overtake Britain’s standing in the world during the next couple of years. India represents 3% of the global GDP (England is about 4%) and had the fastest-growing market last year (at 7%). What’s more, they announced three days before the Brexit vote that they were opening up their market more to foreign investors, but with all the talk about Brexit, no one seemed to notice. That’s unfortunate because this change means foreign investors now are able to invest 75-100% in many Indian industries, which is a giant step forward for a country with a long history of protectionism. In other words, while the old guard builds walls, the new up-and-comers are breaking them down.

This reiterates the fact that emerging market funds should play a significant role in any portfolio. That’s why India and China represent close to 30% of our emerging markets fund.

Again, this Brexit issue soon will pass and be forgotten. Focus on the positive effects of globalization and stay diversified among many countries. The bigger news will be the U.S. presidential election, which should heat up after the conventions in late July. Hold on to your seats!

June Investment Article - The British Are Coming!

A synthesis of articles on Brexit in addition to my take.  See below:

Oh blimey, the bloody British have done it again!  If you have not heard yet, the U.K. citizens voted to exit the European Union today.  For background, the European Union ( EU) is a common economic area that allows all European participants to move and trade in other EU countries almost the same as they do in their own.  There was a country wide vote yesterday, termed “Brexit”, to vote yes or no on continuing to participate in this agreement. 

Why leave?  The primary issue revolves around immigration. Immigrants have migrated to England in droves comprising 25% of the population in some UK towns.  In most cases, the locals have lost jobs, while crime has increased.  Of course, this angers the average British citizen. 

Why even have immigration?  It makes sense especially if you look at the demographics of Europe.  They are aging more rapidly than the US, while birthrates have been declining.  They need young workers to replace the aging workforce and have babies. If it were not for the Hispanic population in the US, we would be in the same position.

 Japan is the poster child of what happens when a country prevents immigration when in this situation. They have been in a recession for the past 25 years! Europe does not want to be Japan, so they loosened immigration laws and decided to let some of the Eastern European countries into the agreement, like Bulgaria and Romania.  Economist know in the long-term this will pay off.  However, the average Joe, or Brit, is focused on feeding their families and today, not tomorrow. In the long term, we will all be dead. In the short term, the immigrants flow in droves, and take the jobs of the local citizens.   In some towns in England, immigrants comprise of 25% of the population!

What next?

Nothing immediate happens now. The UK will have to impose Article 50, which basically says the negotiations to leave the EU have a two-year timetable.  This has only been done once before when Greenland left the EU in 1982.  

After this, there are basically two routes the Brits can go:

(1)          Be like Norway, which is not part of the EU, but part of the European Economic Area (EEA). This still requires a country to pay into the EU budget and allow free movement of people, but gives more flexibility. 

(2)          Operate under the WTO rules like America.  In this case, no one really knows if Germany and other countries in the EU will accommodate them.

Thoughts

There are really 3 unknowns here: (1) how much will financial assets fall and what effect will this have on spending, (2) will the U.K. maintain the same level of trade and investment with Europe, and (3) will this cause unrest and fragmentation in Europe; Denmark or the Netherlands could be next.

With all that said, let me reiterate; the world is not ending!  However, markets will be volatile in the short-term and Britain will surely go into recession which impacts anyone that exports to them, like German manufactures.

KEEP IN MIND, Britain accounts for just 3.9% of global output.  The collapsing pound will drive up inflation up, crimping real incomes. Jobs will be lost.  Hours worked and wage growth may fall. However, the devaluation in the British pound could spur UK exports, which happened in 1992.

What should an investor do?

Think you know what I will say from here. If you are younger and still working, this is a great opportunity to invest.  If you are retired, enjoy the antics from the sidelines and take comfort in the fact you have a significant amount of money in bonds which are up strongly today.

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.