Mar
13
Just ten weeks ago, investors were coming off one of the best years in a decade for a broad swath of financial assets. The S&P 500 rose by 31.5% and bonds, as measured by the Bloomberg Barclays U.S. Aggregate Index, increased by a dramatic 8.7%. Almost everything good that could happen for investors did happen. What a difference a couple of months makes. With each passing week, markets now seem to be confronted with yet another unexpected piece of news or negative turn of events. The list over the last three weeks alone would be enough to fill an entire year:
- The rapid spread of COVID-19 outside of China not only led to volatility in stock and bond markets, the likes of which we have not seen since the Global Financial Crisis, it has also severely disrupted daily life and travel plans for many around the globe.
- The tenor of the U.S. presidential election shifted substantially as a more moderate candidate emerged to challenge progressive frontrunners at the same time the economic outlook darkens.
- Instead of bolstering confidence, an unexpected emergency interest rate cut from the Federal Reserve confirmed investor concerns of an underlying shift in corporate and economic fundamentals and signaled a potential return to zero interest rate policy.
- Over this past weekend, an alliance of oil producing countries known as OPEC+ fractured, leading oil prices to decline almost 25% in a single day and causing significant declines in the prices of stocks and bonds issued by many well-known energy companies.
Collectively, these events have had a significant impact on the equity positions within investor portfolios and driven long-term interest rates to record lows in the U.S. Uncertainty and worry have turned the market upside down in short order. The speed of the transition suggests the market has gone from pricing assets as if nothing negative would ever happen again to pricing them as if the worst possible outcome is now unavoidable. As risk gets re-priced and sentiment turns negative, government bonds are trading at levels more consistent with a recession environment and stocks are trading slightly above levels that would mark the first official bear market in over 12 years.
It’s important to remember that RGT has been in business for 35 years and has the requisite experience to manage through market disruptions such as this. While each disruption is different, experience is valuable when navigating turbulent market environments.
RGT is preparing for a longer grind than many market pundits are indicating today and one with more frequent bouts of volatility. A technical recession, defined as two quarters of negative GDP growth, or even something more protracted are real possibilities. While we view many of today’s events such as COVID-19 as transitory, economic damage has been inflicted. Corporate investment is slowing, and consumer spending is shifting while risk aversion increases. While the ultimate length of time required for markets to find a bottom, and the ultimate level of that market bottom is unknowable, there are a few silver linings in play.
RGT client portfolios came into this environment balanced and well-positioned. Not only have bonds helped mitigate losses and reduce volatility during this market turmoil, high-quality bonds have performed very well. Our investment philosophy is guided by thoughtful asset allocation and diversification, two pillars that we have stood by when many abandoned them during this period of low interest rates and an uninterrupted bull market. Consequently, we have what we believe is a solid foundation from which we can manage portfolios through this environment as there are no dramatic, rash decisions to be made. Like sailing through choppy waters, marginal adjustments are much better (and easier to make) than wholesale portfolio changes.
We utilize a platform of experienced investment managers continuously focused on improving their portfolio’s risk and return profile. We regularly speak with these managers and are currently deep in the process of speaking to them about the present landscape. These conversations, which are already bearing fruit and informing our views, have reminded us of the value our managers bring in helping us make more informed, marginal changes to portfolios during volatile periods. We believe utilizing managers as a resource to stay current on how the economy and specific companies are performing is an advantage. We loathe the thought of having to look at a portfolio made up entirely of ETFs, quantitative strategies, and index funds that don’t say a word, and make no changes to their portfolios, when times are tough.
Given the significant performance differential over the last month between bonds and stocks, we are now actively looking for rebalancing opportunities between asset classes and other strategies where performance has diverged. We expect a series of smaller changes to be made over the course of months, not days. While this process can be tedious and is often dependent on individual client or family circumstances, it is a disciplined and unemotional act of strategically working to buy low and sell high. Rebalancing also allows us the opportunity to reset portfolio exposures back to longer-term targets.
Finally, it is worth noting that as riskier assets, such as stocks, decline in value they inherently become cheaper. This ultimately improves future returns, perhaps dramatically if the decline is steep or growth ends up surprising to the upside. The ultimate length and depth of economic disruption is anyone’s guess, but stocks have improved return prospects on both an absolute basis and relative to bonds, especially as interest rates plumb record lows. An investor with a long-term time horizon and no need for immediate liquidity will thus be more appropriately compensated for owning risk assets going forward.
As markets continue to fluctuate, sometimes wildly and unpredictably, it is important to remind yourself that these types of environments often give rise to significant opportunities. Current losses aren’t permanent when markets decline despite how uncomfortable it can be along the way. Maintaining a disciplined and deliberate approach centered around a long-term strategic asset allocation increases the probability of participating more fully in higher-returning environments. Responding from a balanced position also makes it easier to identify and invest in compelling opportunities when they arise.
Please let your RGT advisor know if you would like to discuss these ideas.
Mar
6
Despite all the concerns surrounding COVID-19 (see RGT’s thoughts here) and yesterday’s surprise 50bps reduction in the Fed Funds rate, it’s hard to forget that this year is an election year. We all know what that means: incessant media coverage of candidate personalities and their policy proposals – caricatures and unrealistic talking points, mainly. Many policy proposals, regardless of which side of the aisle they come from, would likely have a direct impact on your investment portfolios: higher capital gains taxes, financial transaction taxes, taxation on unrealized gains, or various regulatory changes. Other policy proposals may have a more indirect, though no less impactful, effect as they consider broader issues that could spur or hinder both domestic and global economic growth.
Feb
28
“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” U.S. Secretary of Defense Donald Rumsfeld, February 12, 2002.
We began the year 126 months into the longest economic expansion in U.S. history. On February 19, 2020 the S&P 500 closed at an all-time high of 3,386.15 (as a point of comparison, the S&P 500 reached its nadir following the Great Financial Crisis on March 9, 2009 at a closing level of 676.53). Most market concerns at the beginning of 2020 centered around volatility due to contentious U.S. elections, continued tensions around trade, somewhat stretched valuations for financial assets, and the simple fact that the expansion, and the bull market, were getting somewhat long in the tooth.
Typically, though, it’s not the things that the market worries about, the “known unknowns,” that bring about violent downturns in financial markets. A great example of a “known unknown” is the Y2K crisis. We were warned about Y2K years in advance. It received large amounts of media attention, but because it was known and years had been spent addressing the problem the impact of Y2K was negligible. Instead it’s the event that no one sees coming, the “unknown unknown,” that is potentially the most problematic for markets. The Coronavirus, now known as COVID-19, is a perfect example of the kind of shock that the “unknown unknown” can have on markets.
When an “unknown unknown” shock occurs markets often react in dramatic fashion. That’s because mar
kets are forward-looking, and they now must add a variable that they had heretofore not considered. But beyond that, the simplest explanation is that most humans fear the unknown. And fear has a way of creating quick and extreme reactions, which often turn into overreactions.
Financial markets are a perfect environment in which to see this sort of human behavior on display.
- Since the market close last Friday, February 21, the S&P 500 has dropped 11.4% through the close of trading on Friday, February 28. Foreign stocks, as represented by the MSCI-EAFE fell 6.7% over that same time frame.
- The last week has been the worst week in the U.S. stock market since the 2008 Financial Crisis.
- The 10-year Treasury is at all-time lows dropping from 1.46% on Friday, February 21 to 1.17% on Friday, February 28.
- Oil prices have fallen over $8/Bbl, or more than 15%, in a week’s time.
The last week has been a prime example of a reaction driven by the fear of the unknown. Let us stress as strongly as possible, almost everything about COVID-19 and its ultimate impact on financial markets is unknown. Another point worth noting is that reacting to unknown threats is not illogical. In fact, it’s an important human survival trait. However, it is not necessarily the best way to respond in your investment portfolio.
If indeed COVID-19 turns into a pandemic, it will not be the first pandemic of this sort with which markets have had to deal. The 2009 Swine Flu Pandemic (H1N1/09), which lasted from early 2009 to 2010, is the most recent example. Somewhere between 10 million to 200 million people are estimated to have contracted H1N1/09[i]. The exact number of deaths are not known, though one estimate puts the estimated number of deaths worldwide at somewhere between 105,700-395,600[ii].
Negative views make for great media fodder and feed into the market sell-off frenzy. But the latest news out of China, which has been the nation hardest hit by COVID-19, is beginning to seem more positive. While there will no doubt be an adverse impact on Chinese demand and output, it appears that the containment efforts by the Chinese government are starting to make an impact on the rate of transmission of the disease, which should be encouraging. Nonetheless, there is no visibility into the duration of the health crisis or to what extent this disease will ultimately spread.
What can we learn from history?
- These types of events are transitory. The key question becomes how the event lasts.
- Currently investors view the risks as to the downside, thus the violent sell-off of stocks and other “risky” assets and the rise in prices for U.S. Treasuries and other safe-haven assets. And as often happens, once markets begin to sell-off, pressure for other investors to sell rises.
- The long-term risks faced by investors are more about how the economy (and thus revenues and earnings) is impacted and for how long. If this follows the most recent global pandemics, then the economic impact should be temporary and it’s possible that markets rebound nearly as fast as they sold off.
Key Takeaways for Investors
- Right now, there is no visibility into the length of the health crisis. Thus, attempting to make a call on how this plays out from an economic and market perspective would be futile. Assuming the worst outcome is no more helpful than assuming the best outcome.
- Asset allocation is showing itself to be valuable during the latest market sell-off. Make sure your investment plan and asset allocation fit your circumstances. Well diversified portfolios are designed to lessen the impact of stock market losses, not to eliminate them entirely. The key is to be able to help mitigate your losses thereby easing your compulsion to feel the need to sell at market lows. If you can do this, you should you be better position to participate when markets recover.
- Cash for defense is just that, cash. But right now, you earn very little on cash. So, if you feel the need to get defensive in this way, you can’t concern yourself with return.
- Rebalancing and tax loss selling opportunities may present themselves. If you have a long-term outlook you should avail yourself of these opportunities, without an emphasis on trying to have perfect timing.
- Remember, you own stocks for a multi-year time horizon, not for what happens in a week, a month, or even a year. If you have cash to invest, market corrections like this can provide an opportunity to put it to work at lower valuations, thus potentially enhancing prospective long-term returns.
If you have any questions or concerns about these matters and how they impact your portfolio and your financial situation, please contact your RGT advisor.
[i] “Report of the Review Committee on the Functioning of the International Health Regulations (2005) in relation to Pandemic (H1N1) 2009” (PDF). 5 May 2011. Archived (PDF) from the original on 14 May 2015. Retrieved 1 March 2015.
[ii] Dawood FS, Iuliano AD, Reed C, et al. (September 2012). “Estimated global mortality associated with the first 12 months of 2009 pandemic influenza A H1N1 virus circulation: a modelling study”. The Lancet. Infectious Diseases. 12 (9): 687–95. doi:10.1016/S1473-3099(12)70121-4. PMID 22738893.
Jan
15
“If you keep facing in the right direction, all you need to do is keep on walking.” Buddhist saying
At the start of a new decade we are bombarded with a plethora of reviews and “best of” articles for the last ten years. Contemplating the investment results of the last ten years, it’s helpful to look back and remember the environment investors faced at the dawn of the last decade. In the first quarter of 2010 the U.S. economy posted its third consecutive quarter of growth, but the National Bureau of Economic Research had yet to declare the end of the recession. Much of the growth from the previous quarters was attributed to extraordinary government stimulus – remember TARP, TALF, and Cash for Clunkers? The unemployment rate in January 2010 was 9.8%. U.S. government debt outstanding was approaching $13 trillion, the budget deficit was approximately $1.3 trillion, and the House Budget Commission estimated the national debt would grow to $18-$20 trillion by 2020. Interest rates were low, the 6-month T-Bill yielding 0.18%, the 2-year Treasury 1.09%, the 10-year Treasury 3.85% and the 30-year Treasury 4.65%. We were coming off a year where the S&P 500 returned 26.5% but that return was eclipsed by the 79.0% return of the MSCI Emerging Markets Index. Off that stellar performance many market pundits were touting Emerging Market stocks as the growth engine for the coming decade.
Fast forward ten years – the economic expansion that was nascent in early 2010 continued uninterrupted for the next ten years. Unemployment fell all the way to 3.5% by November 2019. While the 2019 federal budget deficit, projected to come in at $984 billion by the Congressional Budget Office, is less than the annual deficit of 2010, the total federal debt is projected to exceed $23 trillion in early 2020 by Truth in Accounting. Interest rates rose on the short end of the yield curve with the 6-month T-Bill rising from 0.18% to 1.60% and the 2-year Treasury up from 1.09% to 1.58%. On the long end of the curve, however, rates fell – the 10-year Treasury from 3.85% to 1.92% and the 30-year Treasury from 4.65% to 2.39%. This “bear flattening” of the yield curve was a boon for investors in longer-dated bonds, but a bust for investors who kept their interest rate exposure short. And it was not Emerging Market stocks that performed best, but large-cap U.S. Stocks as represented by the S&P 500, which returned a cumulative 246.79% for the decade, its only year of negative performance coming in 2018 at -4.38%.
Coming off a dismal end to 2018, investors began 2019 in a cautious mood. But markets have a way of surprising us, and the S&P 500’s return of 31.49% in 2019 was its best return since 2013 (32.39%) and its second-best annual return since 1997. Other major stock indices enjoyed strong returns in 2019 as well, with the Russell 2000 up 25.52% and the MSCI-EAFE Index gaining 22.01%. The outperformance of U.S. stocks relative to foreign stocks (S&P 500 vs. MSCI-EAFE) marked the eighth time in the last ten years the S&P 500 had larger gains than the MSCI-EAFE. But investors would do well to remember that in the ten years before that (2000-2009) the MSCI-EAFE outperformed the S&P 500 in seven of those ten years.
Bond markets also enjoyed a strong 2019, the broad Bloomberg Barclays U.S. Aggregate Index up over 8% and the Bloomberg Barclays Municipal Bond 5-Year Index up over 5%. Much of the returns in bonds was driven by a decline in interest rates. The 10-year U.S. Treasury opened the year yielding 2.66% and finished the year with a yield of 1.92%. The 2-year Treasury yield fell from 2.50% to 1.58% and the 30-year Treasury fell from 2.97% to 2.39%. And thus, the last year of the decade was somewhat emblematic of the decade, starting off with trepidation yet ending the year with stronger-than-expected performance for both stocks and bonds.
Hopefully this little walk down memory lane highlights how difficult it is to imagine how the next ten years might play out. Making the right 10-year predictions based on one’s assessment of the current market environment is an exceedingly difficult task. Developing the appropriate strategic investment plan, though, at least gets you facing in the right direction. The trick is to stay disciplined, to “keep on walking,” despite the temptations to stop and change course based on the emotions of the moment.
Oct
9
“We tolerate complexity by failing to understand it. That’s the illusion of understanding.” Steven Sloman and Philip Fernbach, The Knowledge Illusion, 2017.
“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time, perhaps for a long time.” John Maynard Keynes, The Great Slump of 1930, 1930.
If you’ve ever tried to explain something to a small child, then you’re familiar with their constant response of “Why?” to whatever answer you provide. As adults, we seem to believe that this is because children enjoy annoying adults. But maybe it’s because children see the world as a complex place and simple answers just won’t suffice. Eventually we all (or at least almost all of us) succumb to the realization that we are never going to be able to understand this complexity and we learn to rely on mental shortcuts, or heuristics, to give us “good enough” explanations for what’s going on in the world.
For the most part, these heuristics work well enough. But when we try to understand complex systems, like markets, monetary systems, or broad economies, these heuristics often break down. To make matters even worse, our reliance on heuristics to understand causality in complex systems leads us to seek the easy answer, not the complex answer, and feeds into an overconfidence that we understand that which is quite often not understandable.
Performance in the financial markets in the third quarter was a bit of a jumbled mess. The S&P 500 ended the quarter up 1.70% and is up 20.55% for the year. But there was a four-week period running from late July to late August when the S&P 500 lost 5.9% before recovering over the last month of the quarter. Other equity markets, such as U.S. small-cap stocks (Russell 2000), foreign developed markets (MSCI-EAFE), and emerging markets (MSIC EM), were all down for the quarter.
Fixed income markets were no less volatile, with the bellwether 10-year U.S. Treasury yield dropping from 2.00% at the beginning of the quarter to an intra-quarter low of 1.47% on September 3 before rates backed up. The 10-year Treasury ended the quarter at a yield of 1.68%. The falling rate environment was a strong tailwind for bond returns with the Bloomberg Barclays U.S. Aggregate Index up 2.27% for the quarter and up 8.52% for the year.
What led to this intra-quarter volatility? Those seeking the quick answer had a plethora of choices from which to choose – trade wars, slowing economies, tweets, election uncertainty, falling earnings growth, more tweets, and on, and on. It’s tempting to latch on to one or two of these explanations, especially if they conform to our view of the world as we try to seek order in chaos. But the very real danger is that oversimplified explanations can imbue us with a false sense of confidence. Believing that we understand the causal relationships in these complex systems, we in turn are in danger of poor decision making based on our overconfidence. To avoid this trap when we manage portfolios, we try to develop a sound, long-term investment plan, we engage in thoughtful and deliberate decision-making processes, and we seek to build portfolios in such a way as to diversify our risk exposures and our opportunities for return.