News & Views
Letters to Clients
The Man Behind the Curtain: Welcome to Oz, Folks
If you just started paying attention to the news recently, you’re probably wondering what exactly is going on here: trade tensions, yield curve inversions, near-miss geopolitical crises...oh my! But the stock market continues to march up the proverbial “wall of worry,” albeit with some recent volatility, as the whirlwind of concerning news events unfold at an exceedingly fast pace. Yes still, it would almost seem that someone, or something, is operating behind the scenes to keep the façade of a harmonious investment market in play.
It is true that the length of the current bull market in the US is hitting a record, and akin to an aging human, it would be reasonable to ask the question: “when shall poor old Mr. Market bite the dust?” Fortunately, we were taught at an early stage in our investment careers that “a bull market doesn’t die of old age, it dies when the Federal Reserve takes it behind the woodshed and…” (we’ll save you the gory details).
Our last letter already addressed the interest-rate setting activity of the Federal Reserve, so we’ll spare you from the agony of reading about yield curve inversions again, but we will comment on one thing: and that is how much of a 180-degree turn the Fed has made over literally just the last six months. We went from being on pace to raising short-term rates to “normal”1 levels (thus indicating the US’s ability to sequester itself from the life-supporting stimulus of the post-recession decade), to cutting rates last month for the first time since 2008. This is essentially a tacit admission by the Fed that the tightening had gone too far, and that the economy is not as strong as thought, thus meriting a decrease in short-term rates to bring the punch bowl back to the party (because no Fed Chair wants to be the party pooper, just ask Alan Greenspan).
And here we are, back to being party animals, it seems. Yet, there is something still quite unsettling lately: ongoing trade frictions (namely, the Sino-US relations). We don’t think we need to spend time convincing you that trade wars aren’t good for either contender, but the truth is that while some businesses will be disadvantaged, others will actually benefit. The stock market seems to be “pricing in” a relatively higher probability that a deal will get done eventually2, which is why we recommend just buckling your seatbelt in case the ride is longer and bumpier than expected. But of course, there is always a risk of a miscalculation by either side and we drive right off the cliff of enacting tariffs (possibly on up to $300B of Chinese imports, but this could also apply to the EU, Mexico or Canada as well). What we have to say here is that we are glad to be individual stock and bond pickers, and therefore, have the advantage of evaluating our exposures and potential risk, company-by-company, in case this were to occur. Rest assured, having a dedicated research and investment management team allows us to continue being diligent about evaluating and mitigating risk.
Another market concern that seems to get a lot of people nervous is politics. With 2020 being an election year, the campaign cycle is coming out of the gate in full force. Politics continues to become more and more polarized and it’s no wonder why some people are nervous about where the next round of leadership could take our country. What we will say is that when it comes to the stock market, political inactivity sometimes creates the best foundation for market gains. Even a split government can be positive – as gridlock leads to less uncertainty. Uncertainty regarding the direction of policy is one thing that stifles business investment and growth. But the reality is that there will probably always be a certain degree of unpredictability; and even if new policies are technically “less positive” for businesses on a whole, at least those things can be planned for and managed around by savvy companies. Again, our ability to evaluate individual company strategies is an advantage when the world constantly shifts around us.
Lastly, when it comes to things that might keep investors up at night, the recent influx of “hot IPOs” (Initial Public Offerings) is reminiscent of the 2000 Dot-Com Bust when less-than-profitable (we’re being generous) companies could reap millions of retail investment dollars just by adding “.com” to their name (now the trick is using terms like blockchain or cryptocurrency). While we continue to hold our view that participating in these IPOs at issuance tends to work out better for the founders/early investors and their helpful investment bankers (on average), many of these companies do seem to be more viable than their dot-com-era counterparts (with some notable exceptions, of course). This is partly because many have a more established track record as private companies before going public. Nonetheless, it is still something to watch as the frothiness becomes more apparent.
So perhaps there isn’t a benevolent puppeteer keeping the market chugging forward while the world seems to be falling apart – the truth is that the global economy is actually still humming along, albeit at a relatively slow rate. And while there is plenty to be worried about, new risks are constantly presenting themselves in the marketplace. It’s usually the risks that we haven’t thought about that catches us by surprise and causes disruption, as the market does a pretty good job weighing the probability and impact of most known risks. So, our job as investment managers is to constantly navigate through the world of uncertainty by establishing the right balance of risk and potential reward for our clients’ portfolios while always seeking to buy the highest quality investments available. This, in addition to proper diversification, is the right defense for managing risk. We are pleased to do this hard work for all our clients and will be ready to help you navigate through any curve balls the market throws our way.
Thank you for your continued trust and confidence. Please feel free to send us a message or give us a call anytime. Enjoy the rest of the summer!
Norris, Perné & French
1 If we could bold quotes we would, as “normal” is something that we’re not sure anyone understands now.
2 A strong case can be made that President Trump would like a deal by the 2020 elections, but also that China would love for this negotiation to be unresolved until after that date in case the next administration is more amenable on terms.
haruspex / ha-rus-pex (noun) : a diviner in ancient Rome basing his predictions on inspection of the entrails of sacrificial animals
- Merriam-Webster Dictionary
If you watch or read a lot of financial news, you’ve probably wondered at some point if a market commentator is more akin to a haruspex (see above) than a real expert – desperately attempting to predict the future of the markets based on the economic indicator du jour. Well, today that economic indicator under inspection is the current shape of the US yield curve (Technical Note: The yield curve we are referencing here is the difference between the 10-year US Treasury yield and the 3-month US Treasury Bill yield), which for at least a brief moment was recently considered “inverted.”
At this point, you are likely asking yourself “what is a yield curve inversion AND is it really as ominous as the pundits make it sound?” We will attempt to answer this in two parts: 1) a brief, but necessary, Yield Curve 101; and 2) a summary of important conclusions about yield curve inversions.
To understand the yield curve, imagine a timeline with a notch representing each year from now until 30 years into the future. Each notch along that timeline has a dot commensurate with the annual interest rate one would receive for investing for that set duration of years (using the x-axis). Generally speaking, a “normal” yield curve would be a line connecting those dots in a softly increasing slope (going uphill as you move from the short-end of the curve on the left to the long-end of the curve on the right). This upward sloping interest-rate curve is healthy because it posits that the expectation for future economic growth is positive (i.e., there must be a sufficient incentive to put money in savings vs. investing in the economy through corporate enterprise).
Another way to look at why the upward sloping yield curve is healthy is by using the old “3-6-3 rule” of banking: borrow at three percent (deposits), lend at six percent, pocket the spread and hit the golf course by 3pm. It was a good life being a banker. But more importantly, it indicates a healthy functioning of the economy – where there is an incentive for banks to make money lending capital and companies to invest in growth.
In contrast, an inversion implies the opposite. Now picture a downward sloping line where short-term interest rates are higher than long-term interest rates. Put simply, the bond market is saying that the future of the economy is not looking so great (better to lock-in lower savings rates for several years than take the risk investing in the economy). Add to that the unfavorable economics of borrowing at higher rates only to lend atlower rates in the future (again, the bank model) – not an exciting prospect for banks or investors.
By now, you’ve likely already heard the assertions that an inversion implies that a recession is imminent. It would be reasonable for someone to make this conclusion when hearing that about 75% of inversions in history were followed by recessions, with 100% of the last seven recessions occurring after an inversion.
We’ll be real with you and say a recession is definitely out there on the horizon (well, they essentially always are), but we’d be kidding ourselves and you, as trusting clients, if we said we had some reliable tool to let you know when it will occur (wouldn’t that be haruspicy?). But here’s what we can say about inversions:
- It doesn’t count as a real inversion unless the curve stays inverted for more than just a few days at a time – we’re talking multiple months of consistent inversion status for this to actually get credit.
- If it is a real inversion, then a recession is still likely 12-18 months out based on prior history.
- To grant credence to the inversion as a predictor (vs. one of the false-positive head fakes), other leading economic indicators should be flashing RED – which is not currently the case in the U.S.
- Not to say this time is different, but we are in the new frontier of central bank policy with low interest rates across the globe (and in some countries, negative interest rates). It’s a crazy world right now.
If this were a real inversion with an impending recession, what do we do about it? Well, that’s when we reiterate our sound philosophy on portfolio management (as we have been applying for our clients). First, determine an appropriate balance of stocks and bonds so that you don’t risk more of your money than you can afford to lose. Second, buy high-quality investments and stay extra disciplined when excess market fear turns to greed. And third, maintain that appropriate balance through the cycle by prudently trimming your stock exposure back to target as stock performance continues to outrun the steady, albeit slower, return on bonds (and, might we add, this also matters in reverse when you can sell safe bonds to fund investments in stocks on the cheap).
Not to risk making it sound easier than it actually is, we do have to remind our clients that setting an appropriate investment strategy is only half the battle – sticking to it when the market pendulum swings too far to the upside and downside is when things get challenging. That’s where our professional guidance and experience will provide the most value – we are passionate about helping clients through the cycles.
Thank you for your continued trust and confidence. Please feel free to send us a message or give us a call anytime. We’re standing by to be your guide through anything the market sends our way.
Norris, Perné & French
Don’t Let a Good Correction Go to Waste
“Only when the tide goes out do you discover who’s been swimming naked.” - Warren Buffett
That sinking feeling in your stomach is normal – when stock markets gyrate, and red numbers show upon your statement, it’s natural to want to sell and run to the exits. Our instincts have served us well for survival, but not so much for how we manage our own money. That’s part of the reason why market sell-offs even occur, as the cycle from greed to fear plays out time and time again.
Market fluctuations are normal. While the path to wealth over time in stocks has been great, there are frequent bumps along the road – 10% corrections almost annually, 20% every four years and 30% or more once a decade, are all typical detours to expect along the way. Markets do tend to correlate with the growth in business profits over time, but over- and under-shoot regularly.
Why? As legendary value investor Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” As economies grow and businesses generate more profits, the stock market gives credit where credit is due by valuing businesses higher – but in the short run, markets are at the whim of the often-fickle sentiment of the market participants (which by the way, has become less human and more computer-driven in recent times). And when the headlines are negative (trade wars, global slowdown, politics, etc.), the markets get nervous, and can go down in a hurry (a la Christmas Eve 2018)!
So, what do we do about this? Remember, at the beginning of 2018 we talked about preparing vs. predicting – we didn’t know that the market would correct in 2018, but our intuition was that after several years of strong performance, a correction could become more likely at some point in the future (reminder: see the correction frequency mentioned above). That was when it was time to pull in the reins – by trimming stocks back to your respective long-term strategic allocations while maintaining your long-term risk exposure. Remember, it’s a marathon, not a sprint; however, doing these prudent exercises at the appropriate times will help keep you on the right path.
That was then, so how about now? While the media might instill panic and fear at times, that’s actually the right time to go against the grain a bit. Markets can still go down from here (remember, the “voting machine” still prevails in the short run, and there are always plenty of risks on the horizon), but as buyers of stocks we strive to find great quality investments that have sold-off while the whole market was in free fall.
As it relates to bonds, we have always felt that it is important to maintain an allocation to this investment class to minimize the impact of stock market swings and/or provide stable cash flows. The amount you hold is commensurate with the level of priority these objectives hold. Now, as always, we feel it is important to focus on top-quality bonds from stable issuers as this is the part of the portfolio that should be expected to play some defense. While the bond market is not completely immune to occasional short-term price swings, we focus on the total return from purchase to final maturity, as we anticipate the principal to be returned and the interest payments to be made along the way. It may seem a little bit boring, but that may actually be exactly what you want when the stock market is providing all the entertainment, as it has lately.
Rest assured, we spend a lot of time thinking about the markets and the investments we own. The first priority is to ensure the right balance of risk in your portfolio (hence the Investment Policy Statement), then we must make sure everything we buy meets our strict quality standards. At the end of the day, it is best to be proactive rather than reactive, and that’s what we’ll continue to do for our clients.
We want to wish you and your families a healthy and prosperous New Year. Please feel free to send us a message or give us a call anytime. We’re standing by to be your guide through anything the market sends our way.
Norris, Perné & French
Our Own Worst Enemy
“All I want to know is where I’m going to die so I’ll never go there.”
– Charlie Munger, Vice Chairman of Berkshire Hathaway
We human beings are a funny race. It’s amazing what all man-kind has accomplished, and yet at the same time, how distinctly flawed (and sometimes reckless) we can be. This is particularly true as it relates to money, which by the way, is the only category of human behavior we may be able to discuss with any bit of authority. And even we, as investment professionals, are not immune to the suboptimal tendencies that humans have with money – frankly, it’s just how people are wired. Nonetheless, being aware of the fact that our emotions can cloud our judgement with money decisions is the first step for preventing it. We truly are our own worst enemies.
This is, of course, not the first time you’ve heard us dip into the realm called “behavioral finance,” but we find this to be such an important topic, particularly as overall anxiety levels continue to creep upwards for anyone with money at risk in the stock market. We get it – trade wars, politics, international conflicts – how could any of these not topple the markets at the drop of the hat? Especially now that we’ve had such a good run for almost 10 years since coming out of the abyss of the Global Financial Crisis. Well, first of all, when have we not had things to worry about? If you look at all the scary events over the last century, we’ve had wars, political assassinations, international crises, recessions, depressions, you name it! And yet, in spite of all that, being in the stock market throughout that period (particularly in the US) resulted in substantial wealth creation. Even over the last 20 years (which includes not just one, but two, severe market pullbacks) the annualized stock market performance was about 7.2%, if you just held on (key=don’t sell at the low).
But it’s hard to forget about those two most recent pullbacks. They were painful. And it affected more than just Wall Street; it seeped into the lives of hardworking folks on Main Street as well. This is where our emotions can play tricks on us – we are falling into the trap of over-emphasizing our most recent experience rather than what the longer-term averages should lead us to believe. We also internalize the pain of those losses much more than the positive feelings we get from having grown our money quite well in stocks despite these tough periods if we managed to white-knuckle it all the way through (technical jargon = “myopic loss aversion”).
Here’s a fun exercise to put this concept into perspective: if you were some incredibly unlucky soul who happened to put all your money into the S&P 500 (the stock market “proxy”) at the peak on October 9th, 2007 and fell asleep from then until September 30th, 2018 (Rip Van Winkle-style), how bad to you think your portfolio would look?
Not bad at all.
The annualized performance (with dividends) would be about 8% for that “ill-timed” mistake. Remember, the average market performance for the last 20 years or so was 7.2%. Yes, there are ups and downs, and wouldn’t it be great if we had the crystal ball to know to go all cash at the peak and put it all back in at the bottom; but alas, that is not a skill we’ve found very many individuals can do consistently (or without a lot of luck involved). And to put it into perspective what 8% per year can do in that approximate 11-year time-frame, a $1,000,000 portfolio would now be worth $2,340,000 (a 134% increase!). This is just a helpful reminder to all of us that while we’re likely correct in assuming that some type of pullback will happen in the future (they always do eventually), as long as we continue to focus on the long-term (i.e. 10, 20, or 30+ years) and hold the appropriate amount of stocks for our risk tolerance and time horizon, then that is a better strategy than trying to “time the market.”
This by no means says that we should take a haphazard approach to investing. As your time horizon for needing the money shortens, the range of potential outcomes widens (meaning, the potential best and worst cases can be more extreme). There is no doubt that the stock market can be quite volatile in the short-term (even random perhaps). So, the key here is, as we have spoken to you before, getting the appropriate asset allocation correct (i.e. mix of stocks, bonds and cash) is the most important thing (in fact 90%+ of your end result is a function of this decision). If you a) don’t have a long enough time horizon to smooth out the peaks and valleys; and/or b) you get a little too sea-sick when you’re riding the waves, then you have no business having a high exposure to stocks. That’s where our boring bonds come in, to provide more stability and predictable income relative to stocks (we mean boring in the best possible way!).
We feel honored to be trusted with your wealth to help you and your families live prosperous lives. As always, we welcome your calls and emails and appreciate the continued confidence you have in NPF.
Norris, Perné & French