Stocks are attempting to stabilize after President Trump threw everyone for a loop by Tweeting his intention to hike tariffs on $200 Billion of Chinese goods ahead of what was expected to be the week that ended the 17 month trade war. Rather than going into the whys, hows, whats, whens of this on-going war, I thought today I'd share a chart highlighting the key moves from the US over the last 17 months (the related posts at the bottom of the page go into the other stuff).
If you look very closely you will see the S&P 500 is within a whisker of where it was in January 2018 when the President imposed the first round of tariffs. The point of this is to remind you how many times the markets were spooked and then celebrated the various announcements throughout this ordeal. It's likely going to go on for a while.
When the president was elected I asked the question -- will we get the "good" Trump or the "bad" Trump? I wasn't talking my own opinions on his policies, but what the market perceived as good and bad. We saw the "good" Trump in 2017 -- tax cuts, deregulation, getting along with other nations, etc. The market responded accordingly by posting the 2nd best year of the entire 10 year economic recovery. In 2018, the President decided to start making good on his other promises, primarily immigration reform and the trade deficit. The market doesn't like the impact both of those have on the economy and we have seen wild swings accordingly.
It's already the presidential election season, which means we are likely to see the President continue to cater to the voters who got him elected -- those more moderate/middle class voters who have fallen further and further behind the last 30 years. I'm not sure how this will be resolved, but I do know having strategies, such as ours, designed to filter through all the noise to position portfolios in a way that matches both the willingness and ability of our clients to assume risk, will pay off if this keeps up.
A week ago the S&P 500 (barely) reached a new all-time high. The next day, Federal Reserve Chairman Jerome Powell mentioned the slowdown in the economy is likely "transitory", which is Fed-speak for temporary. This seemed to remove the prospects from traders' minds about a rate cut this year and slightly elevated the chances of a rate hike at some point.
The employment report on Friday removed the fears of a rate hike with job growth coming in strong while wage increases were tepid. This "Goldilocks" economy was just what the speculators buying stocks wanted. It seems things were going too well for the market for the President, so he shocked the markets Sunday evening by threatening to impose a 25% tariff on an additional $325 billion of Chinese goods. This just ahead of the week where most people had priced in a solution to the trade dispute that has gone on for over a year. He can't blame the Fed for this sell-off!
It is important to keep in mind a few things -- first 2019 has started as one of the best year's in any of our lifetimes. The move has come in the face of decreasing earnings growth rates, falling profit margins, and a slowing economy. This means all of the growth in the market this year has been due to expanding P/E multiples, which is always a risky proposition, especially at this point in the market cycle. Second, this sell-off so far has been minor, but it doesn't mean it cannot cascade rapidly. This chart illustrates the parabolic rises and rapid drops the market has gone through since late 2017.
At SEM, the value of our diversified approach has been clear the last 15 months. Our "tactical" models are the most bullish of our three disciplines. Our "dynamic" models, which follow our economic model have been defensive since last November. Our "strategic" or AmeriGuard models are right in the middle of the two. The nice part about this position is if the sell-off continues, our tactical models are the ones designed to start putting on defensive positions the quickest. It will just depend on if the latest Trump tweets were a negotiating tactic or something that causes the trade talks to fall apart.
GDP growth surprised nearly everyone in the 1st quarter rising 3.2% in the past year. The president of course pointed to his economic policies as the cause of this "great" increase. Never mind the fact the long-term average growth rate is 3.1%. This has been the worst economic recovery in the history of our country, so "average" growth may appear to be "great" to some. What pretty much everyone is ignoring is the amount of debt that is being used to fuel this growth rate.
[Side note: Our economic model continues to show slowing growth. Digging into the numbers, the official GDP growth was the direct result of a large increase in inventories. Our internal strength measures show there is little demand for all of this inventory, so we are likely to see GDP growth drop to the mid 2% range in the 2nd half of the year.]
Looking at the 2018 debt numbers, it appears things are getting worse for our country at an accelerating rate.
Since the expansion began the economy has grown by $3.6 Trillion. Our country accumulated $15.3 Trillion in debt during that time or $4.28 of debt for every $1 of economic growth.In 2018 the economy grew by $539 Billion. In 2018 our country accumulated $2.9 Trillion of debt or $5.36 of debt for every $1 of economic growth.
Remember, debt can be useful if used to fight a cyclical slowdown so long as it is paid back during the cyclical growth period. That hasn't happened this time around meaning our country will not have the capacity to fight the inevitable slowdown that lies ahead. The 2017 tax cuts clearly did not pay for themselves in 2018 as the deficit expanded at a far faster rate than the economy. With the temporary boost from the cuts all but gone, the amount of debt necessary to grow the economy will be even greater in the years ahead. It's not just the government borrowing money at a ridiculous rate. Corporations, households, and banks have all contributed. (Keep in mind this DOES NOT include the $19 Trillion unfunded Social Security liability or the $30 Trillion unfunded Medicare liability)
Debt is future spending brought forward. The re-payment of the debt will only hurt economic growth in the future. The stock market is not ready for the shock that will come when lenders/investors realize this type of borrowing does not justify a stock market trading at all-time highs and pricing in 10%+ earnings growth in the years ahead. We'll continue riding this wave higher for as long as possible and will be ready to implement our defensive measures as designed inside each Scientifically Engineered Model.
This week the Trustees of the Social Security & Medicare Trust funds released their annual report. They reported under current law Medicare will be insolvent by 2026 and Social Security by 2035. That's in 7 & 16 years respectively. Their assumptions also include steady 3% economic growth with no recessions. [Never mind the fact we BARELY grew above 3% for a couple of quarters during the 10-year old expansion despite unprecedented stimulus from the Federal Reserve and Congress, and the odds of a recession before 2026 are VERY high.] During a recession both Payroll Taxes and economic growth decline. This will only accelerate the insolvency of both programs.
I'm only going to include two sources -- The Social Security & Medicare Trustees and AARP. Both illustrate the severe issue our country is facing. First here are the funding ratio of each of the programs.
HI = Hospital Insurance (aka Medicare) | OASI = Old Age and Survivors Insurance (aka Social Security) | DI = Disability Insurance
Notice how rapidly the "we paid into it" Social Security fund plummets. This is because most retirees will take out far more than they ever paid into it. The AARP is the first to blast any politician that dares mentioning cuts to Social Security or Medicare, butlet's see what their website has to say about the amount paid versus the benefits received.
Myth: Over their lifetimes, most people get back less money from Social Security and Medicare than they paid in Social Security and Medicare taxes.
Fact: Not so, according to a 2013 study by the Urban Institute that looked at the taxes paid and benefits received by seven categories of people, including single men and women and married couples at various wage levels. In all cases, the individuals and couples retiring at age 65 on average received more in benefits in Social Security and Medicare combined than they paid in taxes.
For instance, a typical single woman earning $44,800 in 2013 paid $407,000 in taxes during her working years and will receive $544,000 in Social Security and Medicare benefits over her lifetime. Likewise, a typical two-earner couple with each partner earning $44,800 in 2013 paid $816,000 in taxes and will receive nearly $1.03 million in benefits. However, in some scenarios younger beneficiaries, both singles and some two-earner couples, will pay more in Social Security taxes than they get out, although after taking Medicare into account, people in all cases come out ahead, according to the study.
In addition, AARP specifically dispels the myth that the money paid in during the working years was held aside for them when they reach retirement. They even go as far as pointing out how their children will be the ones working to pay their benefits.
Myth: When you work and pay Social Security taxes, Uncle Sam puts your tax money in an account under your name. When you retire you get your money back with interest.
Fact: The fact is that Social Security is based on a "pay-as-you-go" system. The taxes that are paid by people who are working today provide the benefits that go to people who are retired. The Social Security taxes I paid during my career helped pay for the benefits received by my retired mother and father. And today, the Social Security taxes paid by my children are helping to pay for the Social Security benefits I receive each month.
With Social Security & Medicare reaching insolvency before today's high school graduates hit age 40, the burden of covering the shortfall will fall directly on the shoulders and budgets of Gen Xers and Millennials. Today's retirees or those retiring in the next 5 years paid the benefits for a generation that was not only not living as long as they themselves are expected to live, but had the benefit of nearly twice as many workers for every Social Security & Medicare recipient.
This will hit the next two working generations very hard as the government will have to not only fund the escalating short-fall between payroll taxes and benefits, but also pay back all the money they borrowed over the working years for today's retirees. The Trustee report explains how this borrowing impacts the current deficit.
Under the OASDI and HI programs, when taxes and other sources of revenue are collected in excess of immediate program costs, the excess is invested in Treasury bonds and held in reserve for future periods. Accumulation of asset reserves in the trust funds improves the unified Federal budget position. When trustfund reserves are drawn down to pay scheduled benefits, bonds are redeemed and interest payments are made, creating a current-year cost to the unified Federal budget.
In their own words -- all the "investment" of excess payments helped the federal budget the last 40 years. Now the short-fall will hurt the federal budget, requiring the US to borrow money just to pay back the prior borrowing.
Let's end with a closer look at Medicare. While the "Medicare for all" movement takes hold, the current Medicare system is rapidly going broke. This chart shows where the payments to cover the promised benefits come from. Note how little payroll taxes cover and most of the shortfall is coming from the regular budget categories.
The easy 'solution' from the Progressives is to "tax the rich". They like to point out how little the 1% pay in taxes. In the next 5 years Medicare costs are expected to skyrocket by more than 2% of GDP, or AT LEAST $420 billion dollars per year. In addition, Social Security is expected to cost AT LEAST another $110 billion per year. This means at a minimum we need to raise an additional $530 billion of revenue. (Let's ignore the fact in 2020 we are expected to have a deficit of $1.1 TRILLION along with needing to borrow an additional $400 billion to cover expiring debt and off-balance sheet items.)
Using 2016 data, the top 1% of taxpayers paid $522 billion in taxes (or 37% of the overall taxes paid by Americans). Their effective tax rate was 27%. If we DOUBLED their tax rate to 54% we could raise $522 billion. This isn't quite enough to cover the expected Social Security & Medicare shortfall let alone enough to cover the "Medicare for all" movement (or the free college movement or the student loan debt forgiveness movement or the universal income movement or any of the other pet projects the Progressives are using to buy voters in 2020.) This would also mean just to cover the current Social Security and Medicare shortfall, the top 1% would be paying over 55% of the overall taxes paid by Americans (probably more because the Progressives also want to decrease/eliminate taxes for the lower income brackets.)
[Remember, the insolvency projects include 3% growth and NO RECESSIONS. I can't think of a faster way to throw our country into a recession than raising taxes to a rate high enough to cover all of the pet projects currently being thrown around.]
This isn't a problem we will solve with a blog post (but sharing this data on your social media from two independent sources is a good start). For 20 years I've been telling any client or acquaintance that is my age or younger (I'm 45 now) that we should not expect to receive any Social Security or Medicare benefits when we retire. If we do, it would be a bonus payment. At the same time we should expect to pay significantly more in taxes than we are right now (I said it in 1998, 2008, and 2018). Ross Perot was the last legitimate presidential candidate to dare say anything about the insolvency of Social Security and Medicare. That was in 1992. Since then the problem has only gotten worse, which means those older than me could be in jeopardy of not receiving the benefits they expected AND will be forced to pay higher taxes to cover the current group of retirees.
From an investment perspective all we can do is what we've always done at SEM --- watch the data and be prepared to adapt to whatever the markets throw our way. All of the easy solutions are well past us, which means the solutions used will hurt both stocks and bonds. This will have a rippling impact on pension funds, insurance companies, and anybody else that uses the stock and bond markets to cover their expected liabilities. (For more check out the Related Posts linked below.)
Debt is future spending brought forward. Another way to think about it, debt will hurt future spending. As I was talking to several advisors and clients this week after the end of tax season I couldn't help but think of our country's debt problems. Few people want to acknowledge it as a problem, but simple math and logic tells us tax rates will never be lower in our lifetimes than they are right now.
Despite the complaint from individuals that their taxes didn't go down (because they received their tax cuts each paycheck rather than in one large lump sum), tax rates were down significantly. Unfortunately, the tax cuts did not have the promised benefit of 4%+ GDP growth for years to come. Since the government is spending MORE money we are looking at even more debt. All signs are growth is slowing rapidly.
Not to be outdone, corporations have gone crazy adding to their debt loads. They used the easy money to buyback stock, pay bonuses, and increase dividends. Like the government, they did little to create sustainable growth with their debt and they too are facing a rapid decline in profit growth. Households have not gotten as crazy as the government and corporations, but they have more debt now than before the crisis. The difference this time is the fastest growth has been in student debt and car loans, both items that cannot easily be sold back to pay off the balance owed.
This isn't just a US problem. All around the world the "solution" from leaders to fight the global financial crisis was to create new currency to buy debt from the banks. This created an environment where those that shouldn't be borrowing money not only were able to do so, but at rates that were too low to compensate lenders (bond investors) for the risk they were taking.
When the economy slows and all signs point to us being already in a global recession, with the US fighting to maintain 2% growth, it will become increasingly difficult for the borrowers on the fringes to make their debt payments. The growth they were supposed to be generating with the debt never materialized, yet now they have to find money to pay back what they borrowed. When the fringes start having problems fear will set in and even previously thought of stable borrowers will start to have problems borrowing money to stay afloat. A new crisis will have begun, caused by the "solution" used to fight the last crisis.
This weekend John Mauldin had a section of his weekly letter that I think everyone should be planning for:
During the worldwide recession, there will be few qualified borrowers but a great demand for liquidity as corporate debt goes from investment grade to junk seemingly en masse. Which will disqualify them from being bought by pensions, insurance companies, and many other purchasers normally looking for yield.
What assets will the Fed buy? Under current law, that’s pretty predictable: Treasury securities and a few other government-backed issues like certain mortgage bonds. That’s all the law allows. But laws can change and I think there is a real chance they will—regardless of which party holds the White House and Congress. In a crisis, people act in previously unthinkable ways. Think 2008–2009.
They will think the unthinkable in the next crisis and try everything, including the kitchen sink, but it will just increase government debt. This will just serve to slow economic growth even further long-term and put additional strain on zombie corporations.
I of course zeroed in on the investment grade bond and insurance company portions. Our readers know I'm gravely concerned about the Investment Grade Junk bonds that are hanging over our country that will likely cause severe issues with many annuity issuers. Despite the angry emails and phone calls I received after posting those two articles I will stand by my research and experience. It's not a question of IF we have another crisis, but rather WHEN we have another one. We should expect our leaders to be too slow to respond followed by actions that will surprise all of us. The question then will be how will the citizens react if they attempt to bail out the same institutions that caused the last crisis and received bailouts last time around.
How it unfolds is anyone's guess and one we do not have to make. We will continue to follow the data led by our single best early-warning trading system, our high yield bond trend following system. If this melt-up continues, great! We are participating nicely and are enjoying one of our best starts to the year in a very long time. If it comes crashing back down we'll be ready for that too.
I was quoted in two articles this week. On Sunday, the New York Times published "When Gambling Seems Like a Good Investment". The article discussed ways financial advisors deal with aggressive clients. It gave me the opportunity to highlight our behavioral approach. In this case, I discussed how we allow clients to section off small portions of their portfolios to chase more aggressive returns. While those that know me would know I typically do not advocate "gambling", our approach allows certain clients to do this. For my direct clients I remove the entire balance of the "play money" segment from our Tolerisk projections and then show the client what would happen if they lost ALL of their play money.
This idea is the "orange triangle" at the top of our Behavioral Portfolio Approach. It only works if the other 4 components have already been solidified. We discuss this in greater detail on the Portfolio page of our website. Our platform at E*TRADE Advisor Services is designed to work with financial advisors to implement this Behavioral Portfolio Approach in the most efficient way possible. (Click here for the details) We also made this a feature in our new marketing piece, "Your Financial Advisor & SEM" (Click here to download or order your own copies).
I see a lot of financial firms saying they utilize behavioral finance, but very few actually understand the key behind a true behavioral approach. Traditional finance assumes a 100% rational participant. Behavioral finance understands we cannot be 100% rational, 100% of the time. We are all humans and will have times we are not completely rational. A true behavioral approach plans for this and works to develop portfolios around each person's specific behavioral biases. What I see most people doing is telling clients what they SHOULD do. (You should stay invested, you should have a long-term perspective, you should have a high allocation to stocks, you should ignore the noise, etc.) I agree with all of those things, but my 20+ years of experience and study of market history tells me very few people have the ability to do all of those things throughout their lives.
The author mentions two studies -- the DALBAR Study of Investor Behavior and Vanguard's "Putting a Value on Your Value". With the stock market approaching the highs from 2018 (again) I thought it would be appropriate to include those two studies as our Chart of the Week.
Regardless of the 20-year period, every year when the DALBAR data is updated it shows the same thing -- the average investor dramatically underperforms the market. This is the primary proof investors will not do what they SHOULD do, which is why we plan around what they likely WILL do.
The more eye-opening data point is for the fixed-income investor. These investors are the ones SEM can help the most. They tend to be conservative, which leads to a specific set of Behavioral Biases. I'd put our track record in the fixed income market up against anybody that has been around since the 1990s. (Side note, if you're an advisor and tired of trying to select and then monitor outside managers, we have a Platinum Portfolio line-up comprised of some of the best fixed income managers in the country. Let us know if you'd like more information on these portfolios.)
The Vanguard Study is something I think is enlightening. Even though in their marketing efforts Vanguard spends all their money telling everyone what they SHOULD be doing. Their study shows how much value Advisors have added (after paying the fees Vanguard tells you not to pay). Notice where the most value is added -- Behavioral Coaching. This can mean a lot of things, but for us it means a complete Behavioral Approach to Investing. It starts with the first conversation and continues into the creation of customized portfolios, the on-going monitoring, periodic financial reviews, and constantly working with the client to ensure they are comfortable with the path they are on.
The Vanguard Study was featured in our new "Discussion Guide" which we just posted to our website. It helps guide advisors and their clients/prospects through the beginning portion of our Behavioral Approach. (Click here to download or to order copies.)
If you're tired of constantly telling clients what they SHOULD be doing and would instead prefer to create customized solutions tailored around what your clients likely WILL be doing, we are here to help.
The last few months I've periodically pointed out some stress points that all investors should be wary of as the economic expansion and bull market approaches record length. While the Federal Reserve capitulated to the constant pressure from the president and Wall Street's panic in the 4th quarter, complacency among investors is creeping back into stock and bond prices. Nothing fundamental has shifted.
The problem is, none of the indicators mentioned in the above articles are signals of an immediate decline. In fact, our high yield bond trading system, a system that has been around since 1992 is on a buy signal. If I had to pick one signal to use to call a market or economic top, this would be it. (I am NOT recommending this. Remember each of our models has multiple trading systems for a reason -- all indicators will generate false signals.)
The reason I'm watching this system so closely is simple. The above articles discuss serious problems in the debt markets that could steamroll the stock and bond markets. High yield bonds have always been a great early indicator of looming problems in the overall credit markets. One thing to keep in mind, this system will have many false signals as shown in this week's Chart of the Week. However, given where we are at in the cycle, I would pay close attention to this system when it goes back to a sell.
For now, the sell signal in early October allowed clients in our fixed income models to enjoy a relatively quiet ride while stocks were down at one point nearly 20%. The system then went on a buy on January 7, generating some nice returns for our lowest risk models. I've heard from many advisors and clients commenting on the strong quarter for these models. My response has been the same -- this IS NOT NORMAL. Investors are desperate for yield and are chasing high yield bonds to levels that make no sense in a slowing economy. The system is certainly nimble and will look to sell as quickly as possible, but I'd be careful to take the strong quarter in high yields as a sign we don't need to worry about risk.
Last Friday the markets panicked as the yield curve "inverted". An inverted yield curve means short-term interest rates are higher than long-term interest rates. This has long been known as a leading indicator of a recession. Bond investors demand higher rates for shorter-term loans because they fear companies will have a hard time paying back their loans during times of economic slowdowns. The inversion last week started following very weak European economic data was released. This caused European bond yields to fall and then led global investors to buy US Long-term bonds as they are seen as a "safe" asset relative to other bonds.
Since then we've seen all kinds of articles and television segments discussing what the inversion means for investors and the economy. I look at it more of a "chicken and egg" discussion. Does the yield curve inversion cause a recession or does a looming recession cause the inversion? Because the markets and economy are comprised of humans, I think the answer is both. Short-term rates rising above long-term rates make it very hard for banks to make money. Banks use short-term deposit accounts to make their money on long-term loans. If they have to pay out higher short-term rates they will not be incentive to make loans. this certainly can create a recession as it resonates through the economy.
On the other hand, I've long argued bond investors are far better people to watch than stock investors. Bond investors are concerned about the ability of creditors to pay back their loans. If they are growing concerned about a looming recession, they will demand higher rates for shorter-term loans, thus inverting the yield curve.
In the whole scheme of things, it doesn't really matter to us at SEM whether the yield curve is inverted or what caused it. We follow the data and make adjustments accordingly. We mentioned at the beginning of March how the SEM Economic Model has moved to "negative". This led to our Dynamic models jettisoning a large chunk of risky assets that will struggle during a slowing economy (small caps in our Dynamic Aggressive Growth & dividend stocks in our Dynamic Income models.) Our other models adjust to the yield curve in other ways. The curve for high yield bonds has not inverted and remains positioned favorably, so our Tactical Bond and Income Allocator models remain heavily invested in that asset class. Our Enhanced Growth Allocator has had a 20% position for a while in long-term Treasury Bonds, so it too is profiting from the rally in 10-year bonds that caused the inversion.
Do you see the theme? At SEM we don't have to try and figure out why the yield curve is inverting and what it means. We simply do what we've always done since 1992 -- react to the data. For what it's worth, the Chart of the Week shows the 10 Year to 3 Month spread. I circled on the chart the times it inverted in the past. Note how both the inversion happened well before the recession and the fact the yield curve had already flipped back to normal during the recession.
This is just another example of market noise that can cause emotional reactions. As always, if you have any questions about what an indicator really means, let me know.
The 4th quarter of 2018 was the worst quarter for stocks since the Financial Crisis, with December's drop coming in as the worst since the Great Depression. The start of 2019 has seen nearly the opposite, posting the best start to the year for stocks since 1987.
The large whipsaws for stocks has led to three common questions from our clients and advisors.
1.) Why didn't I make money in 2018?
2017 was one of the best years for stocks this century. Going into 2018 investors expected more of the same. We saw conservative clients asking if they could get more participation in the stock market. In other words, very few investors wanted much exposure to assets such as cash or money market accounts.
The table to the left plots the returns for a wide range of index funds representing nearly all investment segments available. The only segment that made money in 2018 was CASH (the worst performing asset in both 2016 & 2017.)
The losses in the stock market made headlines, but the losses in the bond market were more alarming to many. Bonds usually provide some risk mitigation, but the losses served as a reminder that bonds do not always provide the protection investors are expecting.
SEM will deploy cash in all of our models at various times, but the timing is not always perfect. The speed of the sell-off in early 2018 caused our models to endure some losses. They all held-up much better than the stock market in the year-end sell-off. This is typical action in the early days of a bear market (fast sell-off, recovery, and then another bigger series of sell-offs). Our systems are designed to focus on the middle part of the move and not catching the beginning of a market shift
2.) Does the 2019 rally mean the coast is clear for stocks?
This has been the most often asked question we've seen from clients and advisors alike. While the signs are there that the bear market started in 2018, we won't know until we all have the benefit of hindsight when it began. One of the first things I learned when studying market history is the most furious rallies come inside a bear market. This chart illustrates the swings from the last two bear markets. Every trading day is represented. It is easy to forget all the big rallies that suckered clients (and advisors) into believing the worst was over.
Emotions can get the best of most of us during a bear market. In addition to very large swings in market prices, you are met with a constant barrage of negative headlines along with market cheerleaders saying it is a "buying opportunity". It is easy to manage money during a bull market. The real value of an investment manager comes during bear markets.
Whether we are in a bear market or not, remember last January started with a 7% rally in the S&P 500 only to see it lose 12% in 8 trading days. If you want to get really dark, realize this is the best start of the year since 1987. (No we are not calling for a stock market crash, just reminding you how quickly markets can switch directions.)
3.) What should I expect for returns going forward?
Buy low, sell high. This advice is easy to say, but difficult to follow. In numerous studies, the starting valuation point
has been the number one determinant of longer-term investment returns. Valuations are subjective as are market forecasts. At SEM we choose to focus on DATA not opinions. This is the reason we will use the expected returns from GMO in setting long-term expectations for clients and advisors. GMO takes the current valuation levels for all major asset classes and applies a multiple regression model to forecast the overall annualized returns for the next 7 years. They have one of the best track records we've seen.
It is easy to get lost in the short-term noise of the market. Their forecasts are not timing indicators, but expectation setters. Looking at where we are NOW we cannot think of a better reason to deploy a well diversified active management approach similar to SEM's. We have the ability to go wherever necessary to make money (or to protect it while we wait for valuations to become more reasonable.) Are you ready for negative returns in US stocks and bonds the next 7 years? How will you know when to rotate into Emerging Markets with a heavier allocation (or out of Emerging Markets and back to US stocks)? SEM is here to remove those emotional questions from your mind & to assist in customizing an investment portfolio based on your financial plan, cash flow strategy, and investment personality.
News & Notes:
2018 Year-End Tax Statements
The 2018 Consolidated 1099 mailings to you includes cost basis and sales proceeds for investments sold during 2018. This provides essential information needed to complete your Federal Tax Filing Form 1040 Schedule D and Form 8949. These were mailed in February & are available on Liberty (E*TRADE’s website) or via TD Ameritrade’s website.
For those clients that consolidated taxable accounts from TD Ameritrade to E*TRADE (formerly TCA), you should have received forms from both custodians.
ENCORE is a Quarterly Newsletter provided by SEM Wealth Management. ENCORE stands for: Engineered, Non-Correlated, Optimized & Risk Efficient. By utilizing these elements in our management style, SEM’s goal is to provide risk management and capital appreciation for our clients. Each issue of ENCORE will provide insight into investments and how we managed money. To learn more about ENCORE Portfolios, please contact your financial advisor.
The information provided is for informational purposes only and should not be considered investment advice. Information gathered from third party sources are believed to be reliable, but whose accuracy we do not guarantee. Past performance is no guarantee of future results. Please see the individual Program Reports for more information. There is potential for loss as well as gain in security investments of any type, including those managed by SEM. SEM’s firm brochure (ADV part 2) is available upon request and must be delivered prior to entering into an advisory agreement.
As we enter either the final stages of the bull market or go through the early stages of the bear market (nobody will know until they have the benefit of hindsight WHEN the bear market began) we are witnessing in client and advisor meetings something that always occurs -- confusion/angst over what is happening with the market and their investments.
This week I answered those questions in our monthly "Three in Three" (3 charts in 3 minutes) segment.
Why didn't I make money in 2018?
While we would like to make money all the time, the market does not function that way. Instead we attempt to miss the largest portions of a bear market while capturing the largest portions of a bull market. Each investment model has a specific risk/return mandate, with downside risk always the most important variable.
In 2018 the only major asset class that made money was CASH as shown in the table below (source). Even in 2008 there were a few more places to hide. While we deploy cash in most of our investment models it is only during the middle and late stages of a bear market where we will see this asset class utilized in a major way.
Making things tougher in 2018 was the big sell-off in February in both stocks and bonds. Normally bonds provide diversification and downside protection, but the sell-off came so fast in both asset classes there was little opportunity to lock in gains and move to cash. Having trading systems designed to capture those short-term (1-2 week) trends means so many bad trades in a bull market that you don't capture much of the upside at all (trust me we've tested hundreds of ideas.)
The second big sell-off started at the beginning of October, was followed by a brief but sizable November rally, only to go through another big sell-off the first 3 weeks of December. In this sell-off bonds, and in particular SEM's lowest risk programs handled the second sell-off quite well, barely losing any value. For what it's worth, SEM's Tactical Bond model was essentially flat for the year and our Enhanced Growth model made a bit of money. We monitor hundreds of other investment models and that was quite a rare feat in 2018. (For more see 'Do your job']
Short answer: The early year losses in bonds masked the diversification benefits of lower risk investments. There were no places to hide like there normally would be in a losing year.
What should I expect for returns going forward?
We've heard a lot of experts declaring the market is now either fairly or undervalued based on the 4th quarter sell-off. Yes the market dropped nearly 20%, but it has already recovered nearly half of the losses. Even with the 20% drop, valuations were still extremely high, especially if we are a year or less away from a recession.
Valuations are subjective as are market forecasts. At SEM we choose to focus on DATA not opinions. This is the reason we will use the expected returns from GMO. They take the current valuation levels for all major asset classes and apply a multiple regression model to forecast the overall annualized returns for the next 7 years. They have one of the best track records we've seen. Here is their forecast as of the end of December (source)
It is easy to get lost in the short-term noise of the market. Their forecasts are not timing indicators, but expectation setters. Looking at where we are at NOW I cannot think of a better reason to deploy a well diversified active management approach similar to SEM's. We have the ability to go wherever necessary to make money (or to protect it while we wait for valuations to become more reasonable.) Are you ready for negative returns in US stocks and bonds the next 7 years? How will you know when to rotate into Emerging Markets with a heavier allocation (or out of Emerging Markets and back to US stocks)?
Short answer: Based on valuations, we should expect losses for US investments the next 7 years. There are opportunities to make money, but it will require a nimble, non-emotional approach.
Does the post-Christmas rally mean the coast is clear for stocks?
This has been the most often asked question we've seen from clients and advisors alike. While the signs are there that the bear market started in 2018, we won't know until we all have the benefit of hindsight when it began. One of the first things I learned when studying market history -- the most furious rallies come inside a bear market. This chart illustrates every move from the last two bear markets (source). Every trading day is represented. It is easy to forget all the big rallies that suckered clients (and advisors) into believing the worst was over.
Emotions can get the best of most of us during a bear market. In addition to very large swings in market prices, you are met with a constant barrage of negative headlines along with market cheerleaders saying it is a "buying opportunity". It is easy to manage money during a bull market. The real value of an investment manager comes during bear markets.
Whether we are in a bear market or not, remember last January started with a 7% rally in the S&P 500 only to see it lose 12% in 8 trading days.
Short answer: We cannot let the current market trend dictate the perceived value of an active risk management approach. If your portfolio lost more than you were comfortable with during the 4th quarter, this rally should be used to re-position your investments into something that is more suitable.