Investing and uncertainty

There are many things in short supply, but uncertainty is not one of them. Three economists1 have compiled an index of uncertainty, which is comprised of newspaper coverage of policy-related uncertainty, expiring federal tax code provisions and disagreement among economic forecasters. You can see the trend in Figure 1 below. The index peaked with the debt ceiling imbroglio in late 2011, fell in the early part of 2012 and then rose again.

Throughout the year there has been a great deal of focus on a number of worrisome issues, including the U.S. deficit, debt ceiling and the fiscal cliff, high unemployment, and the European debt situation. Reflecting all this angst, investors through November withdrew a net $88.9 billion from actively-managed U.S. stock mutual funds (net of inflows into U.S. stock exchange-traded funds).2 Yet for 2012, stocks were up nicely.

How could stocks have gone up while uncertainty increased? While many people naturally worry about the past and still feel burned by previous sharp plunges in stock prices, the stock market is forward looking, incorporating the perceptions of millions of investors. While national economies are still relatively sluggish, actions taken by the U.S. and European central banks to combat economic weakness are having a positive impact.

Housing, while not rosy, is seeing some welcome improvements, with 6.9% of U.S. consumers planning to buy a house in the next six months, the most since August 1999.3 Confidence among U.S. homebuilders reached a 6 ½ year high in December.4 U.S. sales of previously occupied homes increased to their highest level in three years in November.5 And home prices rose 4.3% in the twelve months ending October 2012 in the S&P/Case-Shiller 20-City Composite.6

Another positive, with major longer-term implications, is the widespread development of hydraulic fracturing (or fracking, the process of extracting oil and natural gas from shale rock). The International Energy Agency projects the U.S. will become the largest global oil producer by around 2020, and a net oil exporter by around 2030.7 While there are important environmental issues associated with fracking, including potential contamination of local water supplies and massive use of water in the process, electricity produced by natural gas gives off 43% less carbon dioxide versus coal. Due to a combination of increased use of natural gas, the weak economy and more fuel-efficient cars, America’s emission of greenhouse gases has fallen to 1992 levels and is expected to continue to fall.8 So, like any energy source, there are costs and benefits. Cheaper energy will lead to more manufacturing being done in the U.S., which is good for the economy. One analyst estimates the U.S. will add three million new jobs by the end of this decade due to the natural gas industry.9

Waiting for that perfect time to invest when there is no uncertainty could lead to cash unproductively sitting on the sidelines. Investing only after good news also means buying stocks after they have gone up. A good example of this is the S&P 500 going up by 2.54% on January 2, the day after the fiscal cliff legislation passed. Another example is the MSCI EAFE index of developed countries in Europe, Australasia and the Far East, which increased 6.57% in the fourth quarter, reflecting the relative lack of bad news, and some stabilizing events, in Europe.

While uncertainty is an uncomfortable fact of life, it is easier to handle by following a well-formulated diversified investment plan that invests in stocks and bonds, the allocation to which incorporates your risk tolerance and long-term needs.

1. Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com.
2. Wall Street Journal, “Investors Sour on Pro Stock Pickers”, 1/4/13.
3. Ned Davis Research, 12/10/12.
4. http://finance.yahoo.com/news/us-homebuilder-confidence-6-1-150113216.html
5. Wall Street Journal, 12/20/12.
6. http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff–p-us—-
7.Wall Street Journal, 11/12/12.
8. U.S. Energy Information Agency, as discussed in http://finance.yahoo.com/blogs/daily-ticker/fracking-good-economy-environment-155325507.html
9. As reported in New York Times, “Welcome to Saudi Albany”, Adam Davidson 12/11/12.

Thinking ahead to your next move

From time to time, a piece of economic news will surface that leads people to question whether it is really a good time to be invested. The announcement of round 3 of quantitative easing (QE3) was one such news item that worried some of our clients (interestingly enough it added optimism to others), and it provided us at Merriman with a great opportunity to reiterate why we think making large changes to your investment portfolio based on economic news is a bad idea.

The evidence is overwhelming that markets are not predictable. If you had asked me for a reason to stay in the market in, say, 1999 or 2007 when economies looked extremely healthy, I could have given you a long list of reasons. But what followed each of those years was a sustained drop in stock prices. On the other hand, if you posed the same question in 2002 or at the end of 2008, there was hardly any good economic news to point to. And what followed? An incredible market rally that recouped market losses much faster than anyone expected. Selling and buying based on our read of the news has a high risk of whipsawing us in and out at the worst possible times.

There are always a host of positives and negatives weighing on the markets. It’s important to remember that economic news, and everyone’s expectations of its impact, is already factored into current market prices. We believe the academics’ argument that the sum of everyone’s expectations is far more accurate than the predictions of any one “guru.”

The risks of high levels of debt, uncertainty around upcoming tax changes (known as the “fiscal cliff”), and continued weakness in Europe may drive prices lower. While current trends, including a dramatically improving housing market and declining unemployment, may drive prices higher. We believe the best way to capture growth over time is to stay invested in a portfolio designed to satiate your appetite for growth while staying within your tolerance for risk, and rebalancing when your portfolio’s mix has materially changed.

If you feel like the risks have become overwhelming, there are some additional things you should consider before deciding to throw in the towel. You need to think ahead to your next move. What will you do after going to cash?

There is risk in not being invested in the markets: First and foremost, cash provides no defense against inflation. Your money may need to be defended against inflation for a long time, and cash does not provide a good defense. Beating inflation is one of the main reasons we advise people to stay invested through retirement.

If markets drop, when will you get back in? Each of the last two market rallies began well before any good news was to be found. Waiting for good news meant missing the bulk of the market gains. On the other hand, if there is a continued market rally after you sell – if markets grow faster than you expect – what will you do then? My experience is that it is very difficult for investors to get back in the market at higher prices; there tends to be a very real fear that the next challenge will cause a decline after having just missed an unexpected rise in values. We have found that over time, disciplined rebalancing has been a better way to buy lower and sell higher than “timing” based on your expectations of the future.

Our strategy is based on the academic philosophy that the future is unpredictable and our clients need to be able to stay the course through unexpected events and drops in the market in order to reap the benefits this strategy has to offer.

Simply being invested is not good enough; you have to be invested the right way. We feel that massive diversification with exposure to large and small companies in both U.S. and international markets, with a healthy allocation to bonds, is the best defense against a range of risks affecting your retirement portfolio.

If you’re ever feeling doubts about your investment strategy, I highly recommend speaking to your financial advisor right away. Rather than moving to cash, it may simply be time to re-evaluate your appetite for risk and returns. An adjustment to the percentage of your portfolio allocated to bonds may be enough to ease your mind.

In the meantime, here are some additional online resources you might find encouraging:

Young Americans: The Death of Equities May be Exaggerated

Liz Ann Sounders, Chief Investment Strategist at Charles Schwab published a piece in August that presents both the challenges facing the economy and the positive forces that are at play.

Equities critical for investment returns, despite volatility

This piece from Marlena Lee’s presentation at the Institute of Advanced Financial Planners Annual Symposium in Vancouver presents research showing that even as the market continues to be volatile, history shows that equities are the best way for clients to earn the returns necessary to meet their goals.

Dangerous words: “It’s different this time.”

During periods of significant volatility in the capital markets, investors can lose patience and/or perspective and draw the conclusion that long term risk/return dynamics no longer apply because somehow “it’s different this time.”

I’ve been in this business for over 25 years, and time and again I have seen investors come to this conclusion, making big portfolio shifts because of it, only to regret these decisions later.

I vividly recall conversations with folks in the 1980s who insisted that Asian stock funds should constitute the bulk of one’s portfolio since America was in decline and Asia was rising. In the1990s, it often was very difficult to have meaningful conversations about asset allocation and thorough diversification when so many genuinely felt that all they needed was a few technology stocks or technology stock funds. In 2008 and early 2009, few had the stomach to trim their nicely performing government bond funds and add to their stock funds during the worst stock market environment since 1932.

In each of these examples, the phrase ‘it’s different this time’ crept into many conversations. Obviously, none of the above decisions worked out well.

At Merriman, we’ve always maintained the portion of clients’ accounts invested in stocks at 50% US and 50% foreign. This has served our clients well for many years. We invest this way because the US represents less than 50% of the world stock market capitalization, and because maintaining this kind of allocation can serve to increase returns while lowering overall portfolio risk.

Lately, foreign stocks have been significantly underperforming US stocks, and this has been causing some people to ask if maintaining our desired 50/50 US/foreign split still makes sense. And once again, we are starting to hear the ‘it’s different this time’ comment again. It is human nature to think this way, but history would suggest that one should not make a big shift in allocation because of it, other than some routine portfolio rebalancing.

Keep this in mind: While it’s always a different set of circumstances driving the capital markets, rarely is it wise to conclude that a paradigm shift is at hand and make major portfolio shifts in response. As legendary investor Sir John Templeton used to say, “The four most dangerous words in investing are ‘it’s different this time.’”

The Folly of Predictions

The authors of “Freakonomics: A Rogue Economist Explores the Hidden Side of Everything” maintain a blog.   University of Chicago economist Steven Levitt and New York Times journalist Stephen J. Dubner use statistics to test many social ideas.   I found their recent podcast titled “The Folly of Prediction” to be quite interesting, especially as it relates to investing.

The gist of the podcast is something like this:

  • Human beings love to predict the future.
  • Human beings are not very good at predicting the future.
  • Because the incentives to predict are quite imperfect – bad predictions are rarely punished – this situation is unlikely to change.

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The Millionaire Next Door Revisited

Like millions of people, I read Thomas Stanley, Ph.D.’s fascinating book The Millionaire Next Door when it first came out in 1996.  So when I noticed recently that he’d written a new book called Stop Acting Rich…And Start Living Like A Real Millionaire, I wondered if it contained anything new.  As it turns out, it does contain some new insights.

My biggest take-away:  The greatest impediment to becoming wealthy is all the spending people do in order to make themselves appear wealthier than they really are.  Marketing professionals understand this and exploit it to the max.

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Maintain a long-term perspective

The last several weeks have been trying times for investors.

Since July 22nd, the S&P 500 has fallen sharply including large drops on August 8th and 10th. The main catalysts for this sharp decline include a U.S. debt deal that did not address the underlying fundamental issues in a satisfactory way, some weak U.S. economic numbers which may presage a double‐dip recession, the realization that there is little flexibility with regard to either fiscal or monetary stimulus, the S&P downgrade of U.S. debt, and the continuing debt problems in Europe.

There is a long list of troubles, and things may get worse before they get better. There are also many positives, including the following:

  • A 28% decline in the price of oil from its recent high, which has reduced inflationary pressure and helped consumers.
  • The four‐week average of initial unemployment claims declined to the lowest level since April.
  • Continuing low interest rates, on both the short and long end.
  • Greatly improved corporate profitability and cash flow, with increasing capital spending.
  • Healthy corporate balance sheets and improving consumer balance sheets.
  • A depreciating dollar which could enhance exports.

We think that the best course for long‐term investors is not to sell now. While it may be emotionally difficult, we believe it is best to stick with the asset allocation that you (and possibly your financial advisor) calmly chose which was appropriate for your circumstances and risk tolerance.

Stock prices incorporate all available public information, are forward looking and exhibit both risk and return. Selling after a sharp and sudden market decline means suffering through the market’s risk without being able to benefit from any subsequent return.

For example, there was a double‐dip recession in 1980 – 1982, with unemployment reaching a high of 10.8% while mortgage rates went above 18%. Six months after the end of the second dip, the stock market was up almost 20%.

We can’t call the market bottom with any certainty. What we do know with certainty is that institutions, investors and markets react to events. Congress may finally become serious after the S&P downgrade and work together to credibly tackle the long‐term deficit issue. Investors may look at cash‐rich companies with good earnings and lower‐than‐average valuations and eventually decide to buy. The European Central Bank has started large purchases of Italian and Spanish bonds, helping to lower rates and trying to calm the debt markets.

We certainly empathize with any distress you may have experienced due to the recent market drop. It is human nature to panic and consider selling after a steep market decline. If you are considering that, think about those portfolios which were sold at the bottom of the market in March 2009 and did not get the benefit of the subsequent recovery. Stocks have an expected positive return over time, which just became more positive with the steep price drop.

For your own benefit, avoid short‐term panic and maintain a long‐term perspective.