Author: jeffajohnson135

Happiness and Money

Bill Clinton’s 1992 campaign mantra proclaimed:  “It’s the economy, stupid.”  Granted he was trying to win the presidency, but if his statement was true, then the current strong economy and stock market should make us all happy.  Right?  After all, the economy and current euphoric stock market bodes well for retirement accounts, educational funding opportunities, bucket list items, and the chance for once-in-a-lifetime dreams to come true.  And yet, it is often said that money can’t buy happiness.  The U.S. has gotten a lot richer but it hasn’t necessarily gotten happier by many measures.

Obviously, the relationship between happiness and money is not simple and there are many dimensions.

Money and happiness were linked in Franklin Roosevelt’s campaign theme song “Happy Days are Here Again.”  In the 60s the Beatles sang “Can’t Buy me Love.”  Pharrell Williams sang Happy in 2014 and TikTok now offers Be Happy by Dixie D’amelio.  Whatever the age, happiness is big and so is money.

Happiness and money (or the lack of money) are often interrelated and entangled

Money is easy to measure, but happiness from money is much harder to value.  You can easily look at your online brokerage statement and see everything from a high-level summary to great detail.  Depending on markets, this review elicits either a happy or an unhappy gut reaction.  (When markets are down sharply, people often don’t even want to look at the statements.)  Although Fidelity, Schwab and other investment websites provide great “money” detail, don’t expect an online tab or section anytime soon that calculates you your happiness value.  Without a doubt, happiness from money is far more complicated and nuanced.

Happiness can be defined as an emotional state that includes gladness, pleasure, felicity, a feeling of good fortune and possessing what you desire.  It tends to be externally triggered based on other people, things, thoughts and perceptions, and it is often transitory.  Happiness is sometimes described as joy, but joy can be differentiated from happiness based on a deeper sense of grace, gratitude, hope and contentment with who you are.  Psychologists often attach a sense of emotional and physical wellbeing to the definition of happiness.

However you define it, Amazon offers plenty of plenty of books on money and happiness.

We value and strive for more of both happiness and money

America’s founders enshrined the concept of happiness in the Declaration of Independence:  “We hold these truths to be self-evident that all men are created equal  … with certain unalienable rights, that among these are life, liberty and the pursuit of happiness.  Earlier drafts included the right to own property, but property was ultimately dropped because it was seen as redundant to liberty and the pursuit of happiness.

A current indication of the popularity of happiness is a Yale class called the Science of Well-Being. This class, the most popular course in Yale’s 320-year history, is taught by Laurie Santos, a psychology professor whose lectures attract nearly a quarter of the Yale student body.  If you are interested see Yale Happiness Class

Positive Psychology is another happiness development.  Positive psychology is the scientific study of what goes right in life.  Psychology historically held a clinical focus on human problems and how to remedy them.  It looked at weaknesses and shortcomings, including depression, despair and disorder.  Positive psychology was popularized by psychology professor Martin Seligman, a leading happiness researcher.  Positive psychology examines how individuals can create full and healthy lives.  It doesn’t deny the valleys, and it recognizes that life entails more than avoiding or undoing problems, but it recognizes positive life events as a significant part of the human condition.   A positive psychology perspective is helpful when thinking of happiness and money.

Market traders and investment pundits on the Bloomberg Market and the CNBC cable channels give real-time examples of happiness/unhappiness and money.  Frantic and panicked are words that describe the tone on big down days.  Raw base instincts are laid bare.  Big smiles, complacency, hubris and overconfidence are on display on big up moves.  (Oftentimes you can have the audio turned off and you can tell big market moves from facial expressions.)  You may wonder where are the grown-ups.  The reality is that money and happiness are amped up to the max in these circumstances.  For individuals, money (as expressed through the markets) also generates both happiness and unhappiness.  Down markets contribute to insecurity or a fear of an inadequate retirement or shortfalls related to other investment goals.  Although down markets elicit concern, up markets don’t cause individuals to say their investments are too high or too much.  It is clear that too little money causes unhappiness, but it is less clear that more money causes more happiness.

A widely cited 2010 study found that the relationship between happiness and income plateaus once you earn $75,000  (Nearly $90,000 in 2021 dollars)

This study, by Nobel Prize winners Daniel Kahneman and Angus Deaton, showed that poverty, (including insufficient education and inadequate healthcare,) causes distress and unhappiness.  That is no surprise.  When these basic needs are met, however, the benefits of additional income rapidly diminish.  A common explanation for why money doesn’t buy happiness can be described by the term psychological homeostasis.  Psychological homeostasis, among other things, describes the human tendency to get used to circumstances quickly, both positive and negative.

Another study conducted by psychologists Sonja Lyubomirsky, David Lykken and Auke Tellegen found that the way our brains internally process our circumstances is more significant than external factors.  Their research found that external factors like income and investment levels account for about 10% of long-term happiness.

Subsequent research has further refined the association between money and happiness.  Research completed in 2020 by Jean Twenge, a psychology professor at San Diego State University and Matthew A. Killingsworth, a happiness researcher and senior fellow at the University of Pennsylvania’s Wharton School of Business, shows that happiness continues to increase for high-income earners.  Their 2020 study says that the earlier “$75,000 happiness plateau” thesis was misunderstood.  Killingsworth said the original study was for a specific kind of happiness:  emotional well-being that encompasses day-to-day experiences and feelings.  When looking more broadly, however, they found longer-term life evaluation continues to be positively impacted by money.

Economic analysis of lower income families shows a clear relationship between happiness (and unhappiness) and sufficient (insufficient) money for necessities.  Adequate income allows getting enough to eat, a roof over your head and the wherewithal to take your kid to the doctor.   Within that context, relieving poverty is a major driver of increased happiness.

These studies and research have some latitude for a range of interpretations, but they do point to a relationship between money and a longer-term sense of life satisfaction, contentment and well-being.

Money allows for enriched experiences

Although money can’t generally buy sustained happiness, it can offer big benefits if used as a tool to enrichen lives.

It provides for educational opportunities, and education strongly correlates with future happiness.  With more education, people are more likely to be able to do the things that give their life purpose.  For example, it allows travel to experience different cultures.

It provides improved healthcare, which allows longer productive lives while reducing pain and suffering.

It allows charitable gifts to lift up worthy causes.  There is a high correlation between charitable giving and happiness.  Giving allows the potential for great transformation, and this can provide immense joy.  By contrast, psychologists report that self-centeredness and self-absorption tend to lead to stress behaviors, isolation and unhappiness.

It provides the potential better use of our time, according to researchers at Harvard Business School.  While increasing wealth can produce an unintended consequence of a rising sense of time scarcity, money spent to purchase time-saving services can enhance happiness and life satisfaction.  By eliminating tedious, humdrum activities, people are free to pursue their passions.

In short, greater financial resources allows people the freedom to flourish.  Meanwhile, a lack of money precludes these benefits.

The Downside

While money can be a beneficial tool, it should not be an end to itself.  There is a danger that our personal identity can be wrapped up by the amount of money we make and how much we possess.  It becomes a shallow point of pride.  If we are driven to simply accumulate it, we can lose sight of the purpose of money.  It has been described as collecting hammers instead of building a house.  We can also succumb to messages and images that entice us to pursue something more or better.  Our culture induces dissatisfaction with who we are and what we have as it drives desires for a new car, a bigger house or a work promotion.  These messages make it difficult to be content with yourself, your family, your work and with your possessions.

There can also be an unhealthy personal association or attachment related to money.  Examples include an excessive need for safety, secrecy, control, pride, power, weakness, virtue, vice, envy, regret, etc.  Moreover, shame can result from feelings of how much or little you have, and how well or poorly you spend it and even your perception of self-worth.  These dysfunctional attachments and associations typically go back to our upbringing and our culture, and they are hard to overcome.  Finally, money and spending priorities are known stressors in marital and other relationships.

Winning the Lottery Is No Curse

Lotteries provide an interesting case where a winner is instantaneously morphed from low/middle income in a “life-changing” transformation to great wealth.  This phenomenon is much different than wealth derived by an entrepreneur founding a successful company or the receipt of a large inheritance.  Media portrayals of lottery winners show ecstatic people basking in their sudden, newfound wealth.  Lottery winners are quite newsworthy and considered “good tv”, and there is a common narrative that winners will blow it and declare bankruptcy.  Popular accounts and anecdotes abound that say that winning the lottery brings bad luck and that all that money makes people miserable later in life.

Contrary to common stereotypes, academic studies find far different outcomes.  A study, published by the National Bureau of Economic Research, by New York University economics professor Daniel Cesarini and his fellow researchers found that lottery winners retained their wealth well over a decade after their big win.  They found that winners that quickly squander their wealth are rare.  In most cases, they saw that people worked a little less, and that they spent their money prudently.  They also found that people who win large sums of money do cut down on work but it’s quite rare for them to quit altogether. They cut back mostly in the form of taking longer vacations.  The study found “Large-prize winners experience sustained increases in overall life satisfaction that persist for over a decade and show no evidence of dissipating with time.”  In other research, University of Michigan economic professors Justin Wolfers and Betsey Stevenson documented that lottery winners have higher life satisfaction.  The relationship between income and satisfaction is remarkably similar across dozens of countries.

It needs to be acknowledged that research on lottery winners is difficult and complicated.  Results are often found by surveying winners, and self-reported data suffers from low quality.  In addition, lottery winners are under no compulsion to report their income and tax records to researchers.  Finally, research is biased by the fact that cases of financial ruin are more frequently publicized than cases of stability.  Another complicating factor is the reality that many lottery winners choose to remain anonymous.

Although rags-to-riches stories are popular fare and make interesting reading, it should be noted that low-income groups have higher participation rates, and many social policy advocates view lotteries as a regressive tax.  Lotteries have been disparagingly referred to as a stupidity tax.

Religious Faith & Biblical Perspective.

The Bible dedicates numerous passages of scripture to money and the use of money.  In general, the Bible doesn’t necessarily condemn wealth but it does stress the obligation to be generous and it highlights the risk of loving money.  Wealthy Biblical individuals include Abraham, Solomon and Job.  Examples of generosity include Joseph, called Barnabas, Cornelius and Philemon.  Some scriptural passages include:

Warning against the love of money.  Hebrews 13:5 says to Keep your lives free from the love of money and be content with what you have.  Matthew 6:24 says No one can serve two masters, for either he will hate the one and love the other, or he will be devoted to the one and despise the other. You cannot serve God and money.  1 Timothy 6:6-12 says But godliness with contentment is great gain, for we brought nothing into the world, and we cannot take anything out of the world. But if we have food and clothing, with these we will be content. But those who desire to be rich fall into temptation, into a snare, into many senseless and harmful desires that plunge people into ruin and destruction. For the love of money is a root of all kinds of evil.

Charitable Giving/Stewardship. Charitable giving is a recurring theme throughout the Bible.

Acts 20:35 says In all things I have shown you that by working hard in this way we must help the weak and remember the words of the Lord Jesus, how he himself said, ‘It is more blessed to give than to receive.’  2 Corinthians 9:7 says Each of you should give what you have decided in your heart to give, not reluctantly or under compulsion, for God loves a cheerful giver.

A profoundly spiritual paradox is that giving is the ultimate source of great wealth and happiness.

Blessings & Rewards:  The Bible is sometimes maligned by a narrative of vengeance and punishment, but there are many passages related to blessings and rewards.  Proverbs 3:9-10 says Honor the Lord with your wealth and with the first-fruits of all your produce; then your barns will be filled with plenty, and your vats will be bursting with wine.  Matthew 5:21 says His master replied, ‘Well done, good and faithful servant! You have been faithful with a few things; I will put you in charge of many things. Come and share your master’s happiness!’

These passages don’t endorse the prosperity gospel, but they do provide a broader perspective than is commonly portrayed.

Work and Money and Happiness.

The value of work is a robust finding in happiness research.  Quite simply, a job gives a feeling of earned success and it lifts up our pride and self-worth.  Despite long commutes, the drudgery of routine tasks, all-too-frequent Zoom sessions and bad managers, work provides a sense of achievement, creative effort, and self-reliance.  In contrast, unemployment and underemployment bring misery and despair.  There is a danger in over-romanticizing work, and there are clear cases of a bad fit.  In these circumstances there is a need for job skills and training for the marginalized.

Whether running a hedge fund or trimming a hedge, work creates a sense of purpose that transcends the paycheck.

Some things money just can’t buy

“Tell me that you want the kind of things that money just can’t buy” according to the Beatles song ‘Money Can’t Buy Me Love.’  The focus of this blog post has been on the relationship between happiness and money (and the lack of money).  As mentioned previously, happiness and money are interrelated, but there are some fundamental factors that are in many ways independent of money.  After all, there is a difference between being rich and wealthy.

Listed below are some additional key happiness factors:

Relationships.  You can’t buy friends and family.  They are there, and are important whether you live in poverty or have a fortune big enough to buy Texas.  A close bond with people we trust and confide in is essential to our happiness and overall well-being.  Relationships keep us grounded, they sustain us through good times and bad and they give us a sense of community.  People with strong ties to friends and family have the highest levels of happiness and wellbeing and friends and family relieve feelings of depression and negative thinking.  They lift us up and help us see something bigger than ourselves.

Faith and Spirituality.  Research has shown over and over that people with faith and who follow a spiritual practice tend to be happier and more able to handle life’s vagaries than nonbelievers.  Faith helps take the focus away from narrow self-interests to ponder the deeper meaning and purpose of life.  Faith is transcendent, it is bigger than us, and it helps us grow.

Purpose and Agency.  Purpose is critically important in providing meaning in our lives.  The utilization of our talents, passions and aspirations helps us gain a sense of our unique calling, and that we are here for a reason.  Personal agency is the belief that you have the ability and capacity to influence or handle your thoughts and behavior related to circumstances and various life events.  It involves faith that you can deal with life’s tasks, challenges and opportunities rather than being powerless.  The combination of purpose and agency provides meaning and wellbeing and a sense of our personal destiny.

Giving and volunteering.  There is a high correlation between charitable giving and happiness.  Giving has the potential for great transformation that provides immense joy.  By contrast, psychologists report that self-centeredness and self-absorption tend to lead to stress behaviors, isolation and unhappiness.  Volunteering our time can even give us the feeling of having more time because we feel we can decide to give some of it away.  

See  Cornerstone Charitable 

Gratitude.  Gratitude involves thankfulness and appreciation of what is valuable and meaningful.  It has been shown to improve mental health, boost the immune system and contribute to an overall sense of well-being.  Gratitude includes kindness, which research links to physical and emotional benefits.  Fight-or-flight stress hormones are diminished as your brain releases oxytocin, a hormone that is correlated with trust, reduced fear and positive emotions.

Forgiveness.  Forgiveness is the conscious and deliberate act to release feelings of anger and negative emotion directed towards someone who has wronged you.  Forgiveness gives freedom from resentment, vengeance, hatred and other unhealthy emotions that are detrimental to happiness.  It doesn’t require reconciliation.  It allows us to extend grace and it liberates us from being captive to the offended one.  Forgiveness has been shown to reduce stress, anxiety and depression and to provide a more optimistic sense of well-being.

The attributes listed above greatly benefit individual happiness, and in turn they benefit broader humanity.  These benefits are incalculable, but they are very real.

Wrapping Up

Happiness and money are interrelated and entangled in many complex ways.  This web post provides only a high-level overview.  Coverage of many of the factors is cursory, and only scratches the surface.  It needs to be said that poverty doesn’t guarantee virtue, and wealth does not guarantee vice.

The headline results show that a lack of money reduces happiness.  Time and space do not allow exploration of topics like income and wealth inequality.  Money can be harmful if it becomes a source of personal identity or dysfunctional attachments.  Money generally does not produce lasting happiness beyond a short-term sugar high.  On a longer-term basis, however, it enrichens life and it can provide a greater sense of well-being, contentment and overall positive life evaluation.

Finally, from a holistic perspective, there are non-monetary factors that are hard to measure empirically, but that have immense intangible benefits.  Arthur Brooks, Harvard professor and past president of the American Enterprise Institute, summed these up best: “like kids taught to read, habitats protected or souls saved.”

Jeff Johnson, CFA

May 7, 2021

Cornerstone exists to provide a mix of investment information within the context of a Christian perspective.

For more information  See Cornerstone Investments 

2020-A YEAR LIKE NO OTHER, & LOOKING AHEAD

2020 began with hardly a cloud in the sky.  It seems like a long time ago when we gave little thought  to simple things like going to work or socializing with family and friends.  Going or to our kids’ or grandkids’ soccer game or shopping were routine.  We knew we faced a polarizing election, but at least voters would sort it out.  Most everyone had a job and the U.S. unemployment rate was at 3.5%, a 50-year low.  Investors were benefitting from the longest economic expansion and the longest bull market in history, Chinese trade-war tensions were subsiding, and the 2020 outlook was promising. 

Then, the lights went out and 2020 became a year like no other.  COVID-19 became the dominant theme of the year, and it impacted everything.  It seemed like the word “Unprecedented” was used in every other sentence.  

The Shutdown Caused Many Hardships:  Life came to feel surreal as normal activities ground to a halt and the economy and most other activities shut down faster than at any time in history.   Lockdowns, Stay-At-Home orders, Work-From-Home and social distancing meant that many social activities, businesses, schools and churches abruptly went dark.  Parents were suddenly attending to school-aged children and helping with distance learning while dealing with a precarious work environment.  Unexpected impacts included shortages of toilet paper, Clorox and baking flour.  Bad haircuts and motion-sensing Purell dispensers became the norm.  The NBA season and the NCAA basketball tournament were early casualties.  Zoom became a staple of everyday life, and “You’re muted!” became an all-to-common refrain.  Who knew Domino’s Pizza would displace a nice restaurant. 

With no significant pandemic experience in over a century, it was naively assumed that it would be under control by summer.  Obviously, COVID-19 virus proved more formidable and forced much unexpected change.  Over 10 million were unemployed by the end of March.  Oatmeal consumption jumped over 200%.  Liquor sales spiked in 2020 as people used it as a way to cope with mental distress.  COVID fatigue set in.  Isolation took its toll.  People died without the presence of family and friends.  Little did we know that the U.S. would grieve the loss of over 340,000 deaths over the course of the year. 

Uncounted small business owners lost their life work and many displaced workers lost jobs that would not return.  The number of shooting victims in New York City more than doubled in 2020, with low-income and minority communities hardest hit.  As if the COVID virus wasn’t enough, the May 25 killing of George Floyd thrust America into a soul-searching reckoning related to racial injustice.  Although not caused by COVID, this tragic event caused social upheaval and a deep a psychic scar.  Finally, the U.S. faced a polarizing election.

Gratitude for the Real Heroes:  Despite the many hardships, there came to be a recognition and profound sense of gratitude for the real heroes.  The healthcare and other essential workers cared for the virus victims and kept the country functioning.  

-Health care workers demonstrated incredible dedicated service despite personal danger and sacrifice as they risked their lives to save others. 

-Everyday workers delivered packages and stocked shelves.

-Medical supply people provided masks, car companies produced ventilators and Clorox disinfectant production was stepped up.

-Scientists and researchers raced against time to develop treatments and vaccines.

-And finally, there were uncounted and often un-noticed acts of helping and compassion by everyday people who helped meet needs wherever possible.

These examples showed courage and persistence in the face of adversity and long hours, and they are a true inspiration.  The sacrifices add up to something much bigger than is readily evident and help to comprehend the meaning of who and what is really essential.

Charitable Contributions:  Although charitable giving typically declines during economic crises, numerous reports show that people actually increased their giving.

Meals on Wheels, food banks and health-related charities saw increased giving during the pandemic, as Americans opened not only their hearts but also their checkbooks.  There was also a big upward shift in indirect aid.  As people became more aware of the needs in their community, there was help for vulnerable neighbors and support for local businesses through the downturn.

Expressions of Basic Humanity and the Human Spirit:  A common refrain has been that we are all in this together.  This hardship brought out many unique expressions of solidarity and resolve.  A few examples:

-People across the country cheered healthcare workers and COVID-19 survivors. 

-Parades of police and car caravans celebrated birthdays and other significant events.

-Minnesota landmarks were lit in purple to honor frontline workers battling the pandemic. 

-Singing from balconies and other social distanced places battled the isolation: Boston residents belted out “Lean On Me” and Chicago metro area residents responded by singing the National Anthem and “We are the Champions.”

-These events went viral on social media and helped many others to cope.

COVID-19 tested us.  We didn’t always act in the noblest ways.  We’re all susceptible to COVID fatigue.  There were certainly situations where social distancing was ignored and super spreader events caused more cases, hospitalizations and deaths.  Nevertheless, we don’t want to forget the inspirational displays of goodness and basic humanity that helped lift us all up.

Vaccines-The Beginning of the end:  The word “Unprecedented” certainly applies to COVID-19 vaccine development as drug companies created a vaccine against a novel pathogen within a year of its discovery, the fastest ever.  The shortest timeline previously was for the Mumps vaccine, which took four years according to the Washington Post.  Not everyone gets a chance to save the world, but dedicated individuals worked relentlessly to end this pernicious virus.  The work by Pfizer, Moderna and many others represents a testament to scientific genius, the spirit of invention, persistence and a commitment to a higher cause.  There is also a bright spot related to this research because the Messenger RNA used by Pfizer and Moderna may be used for future therapeutics to target other diseases, including cancer. 

These vaccines are truly a game changer.  We can only wonder what it would be like and how we would feel if these vaccines development time took two or three years.

Return to Normal?:  As the COVID-19 ordeal ends there is a natural desire to return to normal.  As the isolation gradually winds down, how quickly will people feel comfortable again seeing family and friends, taking vacations and going back to baseball and football games?  The reality is that we aren’t going all the way back and some changes will be permanent.  It has become a cliché to state that we have experienced 10 years of change in one year.  But the pandemic has accelerated structural changes long in the making.  Some businesses will not return and some jobs have been lost forever.  There is deep uncertainty about how consumer and office-worker behavior might have changed.  There is a huge hangover of debt.  Education is likely to see many permanent changes.  What will our churches be like, and who will come back?  Adversity causes changes, and how will people react?  COVID-19 forced us to be more resilient and self-reliant.  As we think of the lessons learned and our reshaped priorities, hopefully the changes will help us be more aware, patient, deeper, compassionate and thankful.

MARKET REACTION, PERFORMANCE & OUTLOOK

Healthcare factors aren’t typically big market drivers, but COVID-19 dominated the markets in 2020.  While 2020 was volatile, it is helpful to examine the year in a broader context.  The graph below shows the longest bull market in history from March 2009 through February 2020.  It also shows more protracted historic bear markets that often last far longer than the recent short downturn in 2020.  Although accurate short-term projections are difficult, history gives a longer perspective and says it would not be prudent to extrapolate the recent market strength forward for the next ten years.   

As shown below, investors benefitted from a record long 11-year bull market.  This time period was accompanied by a record long 10 ½ year economic expansion.  But both streaks ended in February as COVID-19 abruptly shut down the economy.  Since there was no good pandemic precedent, the market panicked with the fastest decline in history into a bear market with waves of indiscriminate selling.

Both the Federal Reserve and Congress, benefitting from what was learned from the 2008/2009 Great Recession, reacted in record time with extraordinary monetary and fiscal stimulus.  The market, recognizing this unprecedented stimulus, reacted with the fastest bull market recovery in history.  The whiplash in the first half of 2020 produced the most extreme quarterly performance variance since the 1930s.

The table below provides additional perspective:

-2020 performance was generally well above historic norms.

-Volatility as measured by Standard Deviation was also high compared to the longer-term ten-year average.

-Small cap stocks and emerging markets are particularly volatile.

-Foreign developed and emerging markets stocks have been laggards over the last ten years. 

-Long maturity U.S. Treasury bonds had extraordinary performance as interest rates declined and bond prices jumped upward (more below). 

The observations from the table above provide context and perspective related to expectations for the future.  One notable point is that recent performance is a poor forecast for the future.  Listed below is additional information related to market expectations.

Consensus Economic Outlook

There is a difference between the economy and the stock market, and the two do not move together in lockstep.  Nevertheless, the economy is a major driver of corporate profits, and corporate profits are a clear driver of the stock market.  The COVID-19 virus caused a global economic recession in 2020.  China and Taiwan were the only major economies to achieve positive 2020 economic growth.  The recession caused a significant reduction in 2020 corporate profits and contributed to the sharp market decline in March.  Consensus expectations show a significant 2021 recovery and this should help increase corporate profits and help support the market.

There are a number of reasons to support the rationale for a strong 2021 economic recovery.  The rapid development of vaccines gives relief to lockdowns and shutdowns and a resumption of more normal growth.  There is also a fair amount of pent-up savings and demand, and consumers are likely itching to spend some of it.  It is encouraging that forecasts are being revised upward, and these positive revisions are a positive indicator.  It is noteworthy that many forecasts see a rising level of inflation.  Inflation has been very low over the past decade, but massive government stimulus, improving economic growth and widening government budget deficits are reasons to push inflation higher.  If inflation increases, it typically doesn’t hurt stocks too much unless inflation gets up to higher levels.  Higher inflation will crush long-maturity bonds, however.  While these forecasts focus on the vaccines and on hefty stimulus, domestic politics and geopolitical issues continue to be potential wildcard factors.  It needs to be said that economic forecasts are subject to a wide range of outcomes.

Wall Street Targets

Wall Street has long provided price and earnings targets for the upcoming year.  History shows that these expectations may not be accurate, but they do show what is priced into the market.  If there are no big surprises (like the 2020 coronavirus), then these targets provide perspective and can be helpful.

A summary of the top 14 Wall Street firms compiled by CNBC shows the following:

A few comments regarding these targets:

-Central bank stimulus and COVID-19 recovery are seen as major drivers.

-The recent uptick in mergers & acquisitions is seen as continuing in 2021.

-They all show the market moving up in 2021.  When everyone sees upside, much of the optimism may already be priced in and the stage could be set for a decline.

-All show lofty Price/Earnings ratios that show valuation levels well above historic levels.

Valuation

Equity markets are expensive by most valuation metrics.  The S&P 500 consensus Price/Earnings ratio for the next/forward twelve months is a common valuation measure and is listed below:

At a cursory level, it looks like the market is nearly as expensive as the late 90s internet frenzy, and you have to wonder if we are “Partying like its 1999.”  Many remember how that ended.  There are a couple of major differences, however, between 1999 and 2020.  The 10-year U.S. Treasury bond yield was over 6% in 1999, and now it is at 0.9%.  In addition, many technology companies in 1999 were young and had minimal earnings, and today’s leaders have dominant business models.  (Like Microsoft, Google, Amazon, etc.)

Although valuation levels aren’t quite as stretched as in late 1999, it is still sobering to remember that the tech-heavy Nasdaq fell 78% from March 2000 to October 2002.

Market bulls acknowledge high current valuation multiples, but see equities delivering decent relative returns versus even more expensive bonds.  They believe that markets look less expensive when juxtaposed on a relative basis against current low interest rates and a low inflation environment.  While conceding high valuation levels, they believe equities will grow quickly and catch up to their high valuation levels.

Market bears point to the extraordinary monetary accommodation around the world driven by central bankers dealing with the virus-induced slowdown.  This stimulus has made all assets expensive, and results in low forward returns for both stocks and bonds.

It seems clear that the market has pulled forward some post-vaccine economic growth into current valuations and it will take time for the U.S. to grow its way into these valuation levels.  Central bank monetary stimulus has also made all assets expensive as nearly-free money distorts valuation levels.  It also seems reasonable that when equities are adjusted for low interest rates, valuations aren’t quite as extreme.  This is especially true given the fact that U.S. Treasury bondholders are currently receiving negative inflation-adjusted real rates of return due to low nominal interest rates.

History shows that Valuation levels are not a good predictor of short-term returns, but they are a good predictor of longer-term returns.  Consequently, the current high valuation levels could persist for some time.  There are market pundits predicting both an imminent bear market and a sustained bull market, but it would be a fool’s errand to confidently predict either.  Regardless, current valuation levels and low interest rates point to below-trend investment returns on a longer-term basis.  While returns for stocks could be lower over the next decade, they should still perform better than longer-maturity bonds.

What To Do Now

The markets have generated big returns in 2020, and also since 2009, and it is easy to be lulled into a false sense of overconfidence.  The big gains by year-end 2020 help us forget the precipitous decline in March.  But markets run on fear and greed and the euphoric emotion can plummet once again into volatile, undisciplined selling.   Here are some factors to consider:

-Don’t let big up or down market moves change your investment objective.  Big upside market moves make us forget the pain of down markets and to overestimate our tolerance for downside risk.  This could cause additional buying of an expensive market.  Similarly, big down markets cause us to abandon all hope and to get too conservative and to sell at the bottom.

-Rebalance.  At a high level, rebalancing involves trimming the weights of the biggest gainers (because they have grown too big compared to your strategic weight) and buying the laggards (which have become underweight).  To take an extreme example, if you own Tesla-TSLA (up over 700% in 2020), then the stock and the large growth asset class are too big and should be trimmed back.  The cash proceeds from the sale should be put into the cheaper underweight assets.  If you are a self-directed Do-It-Yourself (DIY) investor, then you need to rebalance your portfolio.  If you have an adviser, then ask them about rebalancing.

-From a tactical standpoint, Small Cap stocks and Emerging Markets have trailed in recent years and look most attractive.

-Avoid FOMO (the fear of missing out). Do your own thinking.  (See below)

-Stocks that are up the most are excellent candidates for charitable giving.  This is a way to help achieve a rebalanced portfolio.  A key Cornerstone objective is to encourage charitable giving.  See Charitable Contributions

-Avoid long-maturity bonds.  If inflation heats up, these bonds will perform badly.

-Don’t make plans for 10% future equity returns.  Current high valuation levels indicate that 6% equity returns are more reasonable for financial planning and retirement expectations.

More Detail and Red flags Below:

BIG STOCK GAINS IN 2020:

Investors should utilize funds unless there is sufficient time and experience to research individual securities.  Even then, most investors would achieve greater returns with an index fund than picking stocks.  Nevertheless, it is interesting to review some high performing and high-profile stocks as listed below:

(Sorted by 2020 returns)

Some Comments:

-The big winner was Novavax, a biotech company trading on Nasdaq that is in late-stage trials with a COVID-19 vaccine.  If the vaccine gets approved, the price will be justified.  Otherwise, it might return to single digits.

– Tesla is noteworthy.  Tesla is the sixth-largest company in the S&P 500 but it is not profitable without regulatory emissions credits.  Tesla’s market value is currently 2 times the combined value of Ford, GM and Toyota.  Elon Musk is a true visionary, but the valuation looks very stretched.

-Moderna is up based on their successful COVID-19 vaccine.  Few knew of Zoom before the pandemic hit, but Zoom kept us going through all the isolation.

-The S&P 500 market value is dominated by five big tech stocks:  Alphabet/Google, Amazon, Apple, Facebook and Microsoft.  These five stocks have significantly outperformed in the past.  You might characterize the S&P 500 as the Big 5 and the little 495.  The Big 5 outperformance may continue for a while but it is not likely to persist in the longer term.  A diversified portfolio has stood the test of time, and an overconcentration in these stocks poses longer-term performance risks. 

It may be tempting to invest in a few potential high-flyers to boost your retirement account.  For example, if you bought $1,000 worth of Amazon when it came public in May 1997, it would have grown to $2,175,000 by year-end 2020.  What’s not to like?  For every Amazon, however, there are hundreds of losers like Pets.com and TheGlobe.com.  TheGlobe.com had the distinction of spiking over 10x during its first day of trading, but its business model is long gone.    

The reality is that it is difficult to find many of the big winners before they make their big moves.  Most of the big 2020 stocks benefitted from COVID-19, and no one saw the virus risk at the beginning of the year.  At this point it is difficult to identify the 2021 market drivers.

Small Cap Stocks:

Small cap stocks have outperformed large cap stocks historically, although they have been laggards over the last 10 years.  Small caps as measured by the Russell 2000 index trailed large caps in 2020 until the fourth quarter.

Although small caps are more volatile, they are important in a portfolio’s overall asset allocation plan.  Small caps are expected to offer significant forward growth because their greater operating leverage allows profits to grow faster in an expanding economy.  Small caps have been under-owned and should benefit from increased investor interest.

Foreign Stocks:

International stocks outperformed in the 1970s, 1980s, and the 2000s, but have trailed the S&P 500 since the 2008/2009 Great Recession.  International stocks are cheaper than U.S. stocks, and especially U.S. large cap growth stocks, and should benefit from investors seeking cheaper valuation levels. 

Emerging Market Stocks:

Emerging Mkts:  Emerging market stocks are another asset class that has trailed in recent years, but has provided a nice rebound in Q4.  Emerging market stocks are more volatile but offer better growth prospects than developed markets based on a younger population and a growing middle class.  China is a large component of emerging markets and it offers significant growth potential.  Emerging markets benefit from a weaker dollar, they are cheaper than developed markets, they offer diversification benefits and they look poised for good longer-term performance.

Historic Interest Rates

Interest rates have been trending lower since the early 1980s.  The 10-year U.S. Treasury bond interest rate peaked at 15.82% in September 1981 as the U.S. battled double-digit inflation.  As inflation subsided, rates have trended lower.  Interestingly, forecasters, including the US Federal Reserve, have consistently projected rising rates.  Historic long-term bond total return performance has been high due to bond price increases as rates declined.  With interest rates at current low levels, there is little potential for additional bond price gains.  Instead, any increase in yields will negatively impact bond prices and will be a drag on total return performance.  If inflation picks up faster than expected, then longer-maturity bonds will experience significant negative performance. 

Interest Rates in 2020:

The 10-year US Treasury bond began 2020 with a 1.92% yield.  As the COVID-19 pandemic spooked markets, the 10-year treasury yield briefly plunged below 0.5%, on March 9 due to recession fears.  The yield then spiked upward based on a safe haven flight-to-quality trade.  As vaccines allow for increased economic activity, rates have risen to 0.92% at yearend.  At this time, real yields (nominal yield net inflation) are negative.  Fed policy is to keep short-term rates like 90-day Treasury Bills pinned near zero through 2023.  With this low interest rate backdrop, short bonds will earn very little return and longer maturity bonds may have negative returns as interest rates eventually normalize and bond prices decline.    

Historic US Dollar:

The U.S. dollar peaked after Fed Chair Paul Volcker and President Reagan broke the back of double-digit inflation with high interest rates in the early 1980s.  The dollar rose again between 1997 and 2002 as Germany assumed high costs of reunifications with East Germany and as Europe implemented austerity plans and increased taxes.

US Dollar in 2020:

The dollar was trending up in early 2020 until markets panicked and interest rates fell over recession fears from the pandemic.  The dollar then blipped up in late March as traders pursued a safe haven flight-to-quality trade.  More recently the huge monetary and fiscal stimulus and the prospect of federal budget deficits have been factors causing the dollar to fall.  The Federal Reserve’s policy to keep short-term interest rates near zero until 2023 is also pressuring the dollar lower. 

RED FLAGS:

The 2020 market produced great returns but trees don’t grow to the sky.  There are notable “Red Flags” that warrant scrutiny and consideration.

Fed Put. The Fed “Put” is seen as a Backstop:  the so-called Fed “Put” continues to provide investor support based on the widespread belief that the Federal Reserve will move aggressively to prevent or at least mitigate any deep market swoons.  Although there is no actual Fed Put trade, (Put Option trades offset market downside risk), Fed actions are seen as providing “Put-Like” protection against severe market declines.  In any event, the Fed Put narrative encourages risk taking without having the actual wherewithal to prevent a severe market decline.

FOMO:  The recent market strength has surprised many institutional investors, and there does appear to be an element of FOMO-the Fear Of Missing Out.  Markets trade on fear and greed, and the current market strength appears to have a significant amount of momentum-based trading.  The current greed factor can be reversed quickly, as was seen this past March. 

IPOs-Initial Public Offerings:  U.S. Initial Public Offerings (including Special Purpose Acquisition Corporations) raised a record $167 billion in the U.S. during 2020, compared with the previous record of $108 billion during the 1999 dot-com boom, according to Dealogic.  These deals have jumped roughly 18% on their first day of trading, and there is a concern that the market is getting too frothy.     

Margin Debt and Options Contracts-Investors borrowed a record $722 billion in margin debt against their investment portfolios through November according to the Financial Industry Regulatory Authority.  High margin debt levels preceded market peaks in 2000 and 2008.  Option contract volume has also been at record levels.  Call option contracts and other derivative strategies can be very lucrative in bull markets, but can be disastrous in sharp market declines.

New Retail Investors and Robinhood:  Market observers point to increased retail investment activity by newer and less experienced investors.  The Robinhood trading platform grew rapidly by offering zero commission trades and an appealing user interface.  Charles Schwab, Fidelity and others quickly matched Robinhood’s zero commission trades. With big 2020 gains, investing has been eurphoric, just as it was for day traders in 1999.  No one knows where markets are headed on a short-term basis, but the Robinhood phenomenon is a clear red flag. 

The Red Flags listed above are not a call to sell all and go to cash.  Time in the market is more important than timing the market.  But the analysis points to a disciplined approach to rebalancing and tactical adjustments away from high-flyers and towards under-owned and cheaper asset classes like small caps and emerging markets.  It is also a cautionary warning against the long-maturity bonds. 

Wrapping Up:

2020 was a year like no other.  The word “Unprecedented” was used often because it is hard to find another word to better describe the year.

To recount a few examples:

-Deaths, ICU units at capacity, temporary hospitals in parking lots.

-Health care and essential workers pushed to the limit.

-Record short vaccine timeline development.

-Charitable giving and acts of compassion.

-Numerous investment and economic records for depths, heights and speed. 

Looking to 2021:

Thanks to vaccines we can look forward to a better year as we can re-connect with family, friends and work associates.

The markets are less predictable but we can say a few things: 

-Last year’s gains were surprising, and the future will bring more surprises, both good and bad.

-Last year ended up being a good year in the market but it is important to never confuse a bull market with brilliance.

-Markets are noted for teaching great humility and that definitely applies to this analysis.  The commentary is intended to provide educational perspective, but only time will tell what the future actually brings. 

-No one knows exactly when the music stops, but a proactive, disciplined approach is essential to providing good long-term returns. 

Goodbye 2020 and all the best to 2021!

Jeff Johnson, CFA

January 4, 2021

For additional investment and financial planning information See Cornerstone Investments

0.01% at the Bank? Some Alternatives

Interest Rates at 0.01% at your bank! This dates me but I remember my first mortgage at 9%. At the beginning of 2020 the economy was progressing on cruise control, unemployment was at low levels not seen in 50 years and you could earn roughly 2% on your money market fund. Nobody foresaw the COVID19 pandemic, a million+ lives lost and a global recession. Little did we know that Clorox, Peloton, Netflix and Zoom would be so important in our lives. The financial markets reacted violently with stocks first plunging 35-50% and then recovering at historic speed to all-time high levels. Interest rates reacted as well. Deposits at checking and savings accounts, money market funds and other short-term investments dropped precipitously, often to 0.01%. That’s one penny earned in one year on a $100. Talk about getting rich slowly. On the scale of things, this is not one of the biggest problems, but it is worth considering alternatives.

The Federal Reserve did what it had to do.

The Fed reacted to the COVID-induced shutdown and recession by driving down interest rates to support an economy that was in free fall. The Fed (with lessons learned from the Great Recession of 2008/2009) did a superb job and likely prevented a Depression. By driving down interest rates, they made borrowing much cheaper for car loans, mortgages, educational loans and for corporate borrowers to keep businesses running and people employed. But driving down interest rates also impacted deposits at financial institutions.

Banks, brokerage firms and other financial institutions reacted by reducing rates they paid on deposits to near zero. (It seems like a long time ago, but many money market funds were paying over 2.25% in 2019.) Banks and brokerage firms have been able to maintain sufficient depositary assets while paying little interest because these assets are “sticky”. It is a hassle to switch to alternative accounts that pay higher interest rates, but it may be worth it.

What You Can Do.

These low rates are not going to pop back up quickly again, either.  The Fed has communicated a policy to keep short-maturity rates near 0% until 2023, essentially “Lower for Longer”.  For perspective, the Fed kept rates near 0% after the Great Recession for 7 years-from late 2008 through late 2015.

With the prospect of essentially 0% for perhaps the next three years, it makes sense to consider alternatives. Although there is no silver bullet, a high-quality, short-term bond fund makes a lot of sense as a substitute for current money market holdings in cases where there is not a need for near-term liquidity.

Short-Term, High-Quality Bond Funds:  A good example is the Schwab Short-Term Bond Fund-SWSBX. There are others as well. For example, the Vanguard Short-Term Bond Fund-BSV is another candidate. In addition to purchases in Schwab or Vanguard, these funds can be purchased in many other brokerage accounts like Fidelity or JP Morgan as well.

The Schwab Short-Term Bond-SWSBX is recommended based on my Cornerstone LLC fund rating analysis.

Recommendation Rationale:
Higher Performance and Yields than most bank accounts and money market funds: SWSBX is up 4.18% for 2020 through October 23. The fund’s 12 Month Distribution Yield is 1.84% and the current month distribution yield is 1.17%.

Reasonably Conservative: 72% US Treasury’s, 28% Investment Grade Corporate bonds. Overall Credit Quality = AA.

Relatively short maturities and less vulnerable to unexpected rising interest rates. The Duration = 2.75 and Effective Maturity = 2.9 years.

Good Overall Ratings: Morningstar Overall Rating = 4 Stars (1 Star is lowest and 5 Stars is highest). Morningstar ranks it as Above-Average Return and Below-Average Risk compared to the comparable benchmark.

Lower Volatility: The NAV value increased every month in 2020, including March when stocks sank over 30%. It should be noted that this fund could have some negative monthly performance, but total return performance over a longer period of time should significantly exceed bank accounts and money market funds.

Future Performance: Fund Distribution rates and investment performance will likely come down over time as older higher-yielding bonds mature, and are replaced by new bonds that have lower yields.

As with all investments, there is a need to continue to monitor this fund and other alternatives and there may be a need to make changes based evolving market conditions.

Intermediate-Term Investment Grade Bonds represent the next step up in the risk/reward tradeoff. An example is the Vanguard Intermediate-Term Bond Index-VBIIX. This fund has a Credit Quality rating of A, a Duration of 6.5 and a Maturity of 7.4 years. This fund has returned 4.5% annualized over the last 5 years, but it represents more risk, and especially during economic recessions. This fund would also be more vulnerable to a sharp, unexpected rise in interest rates.

Other Alternatives Less Appealing:

Certificates of Deposit:
Bank and brokerage CDs are mostly locked in at very low interest rates and look less attractive. Some examples are listed below:

Schwab CDs: APY**
1 to 9 Months: 0.1%
10 to 18 Months: 0.15%
1.5 to 2.5 Yrs: 0.2%

Higher Yielding Online CDs-1 Yr* APY-1 Year
Ally Bank 0.65%
Marcus Bank by Goldman Sachs 0.65%
Synchrony Bank 0.60%

Online Savings Accounts:
These online savings accounts likely offer interest rates above your local bank, but you will need to set up the online account.
Higher Yielding Online Savings Accounts* APY
Vio Bank 0.76%
Citibank 0.70%
Synchrony Bank 0.65%

Top Online Money Market Accounts:
Online money market accounts also require setting up an online account.
Higher Yielding Online Money Market Accounts* APY
First Internet Bank 0.60%
Ally Bank 0.50%
Synchrony Bank 0.50%.

* Source = BankRate.com as of 10/23/20
**APY is the Annual Percentage Yield.

Note: The data listed above provides an indication of rates for larger, more well-known names, and it doesn’t necessarily reflect the highest rates. Rates often vary depending on the amount deposited and some of the highest APYs may include monthly service fees. Not all rates have identical terms and conditions, and some rates may be introductory promotional rates. ATM access and fees also varies widely. It is important to carefully review the terms and conditions of each offer before making any investment. The financial institutions listed above are not specifically recommended. Data as of 10/23/2020.

In addition to BankRate.com, other online sources include:
BestRates.com
DepositAccounts.com. (Lending Tree)
BestCashCow.com.

See Cornerstone Investments for more information related to investing and financial planning

Jeff Johnson, CFA
October 24, 2020

Disclaimer:
The information provided above is for informational and educational purposes and it does not constitute personal investment recommendations or investment advice. The investment information presented is generalized and it does not take into consideration the individualized needs, objectives, constraints or unique circumstances of individual investors. Historic market trends, risks, patterns and relationships may not continue into the future and assumptions and predictions may not prove valid. Past performance does not guarantee future performance. Markets are dynamic and subject to change and all investment commentary is subject to change or revision without notice. Cornerstone uses multiple data sources wherever possible to help provide data and information that is comparable across various asset classes and is consistent over the course of time. All data and content is derived from what are considered reliable and credible sources, but Cornerstone does not accept responsibility for any errors. The user accepts all responsibility for actions taken based on information from Cornerstone Investment Associates, LLC.

2020 Mid-Year: Clorox, Zoom, FOMO and More

We all know that 9/11 changed everything, and so does COVID-19.  Stay-At-Home orders, social distancing and masks are now familiar parts of our routine.  Just as we evolved from 9/11, we will evolve from the novel coronavirus.  Nevertheless, “Unprecedented” seems to be the word that best characterizes the first half of 2020.  Listed below are relevant factors:

Noteworthy Movers: 

Although the broad stock market was down 3.1% for the first six months of 2020, Clorox was one of the top stock performers with a gain of 45%.  Few people knew of Zoom at the beginning of the year, but it is up 6X from it’s April 2019 IPO.  More obvious first-half winners include Amazon up 49%, NetFlix up 41% and Apple up 25%.  On the speculative side, Tesla was up 158%.  Airlines were the obvious losers with Delta down 52%

Index Benchmark Performance As Of 6/30/2020:

Major Benchmark Performance: Last 3 Last 12
1 Mo  Months YTD Months
Since: 5/31/20 3/31/20 12/31/19 6/30/19
As Of: 6/30/20 6/30/20 6/30/20 6/30/20
US Large Cap-S&P 500 1.99% 20.54% -3.08% 7.52%
US Small Cap-Russell 2000 3.53% 25.42% -12.98% -6.63%
Foreign Developed-MSCI EAFE 3.40% 14.87% -11.36% -5.15%
Foreign Emerging Mkts-MSCI EEM 7.35% 18.09% -9.77% -3.38%
US Bonds-Barclays Aggregate 0.63% 2.90% 6.14% 8.74%
Long Treasury-20 Yr+ US Treasury Bonds 0.13% 0.12% 21.62% 25.97%
High Yield-Bloomberg 0.98% 10.18% -3.80% 0.03%

The Bear Market struck with a vengeance in March after a record long 11-year bull market and a record long 10 ½ year economic expansion: 

In addition, the drop was accompanied by record-high volatility. The S&P 500 fell from an all-time high to a bear market decline of over -20% in only 22 trading days, the quickest decline in history, even faster than during the Great Depression. Moreover, the S&P 500 set a record of eight consecutive days in which the index moved up or down by at least 4%. Then, the S&P 500 made the quickest recovery in history from a Bear Market to a technical Bull Market (up 20% from a recent low). With the price volatility at record levels in both directions, the overall investment performance has improved significantly since the March 23 lows.

Performance has rebounded since the March lows:

Although the S&P 500 fell -33.9% by March 23 from the all-time high, it is now down only -3.1% YTD as of June 30.  The first quarter had the worst performance since the 2008 Great Financial Crisis, and then the second quarter was the best performance since the 4th quarter of 1998.  This whiplash was the first time with such extreme quarterly performance since the 1930s.  U.S. small caps continue to lag behind the perceived relative safety of larger U.S. companies and are down -13% so far in 2020.   Foreign developed equity is down -11.4%Emerging markets were the big surprise during June with a gain of 7.4%.  Longer maturity U.S. Treasury bonds benefited from declining interest rates and from investors seeking a safe haven, and are up 21.6% so far this year. Corporate bonds and especially high yield declined sharply in March due to increasing recessionary fears, but have since recovered somewhat in April through June largely due to the Federal Reserve’s corporate credit support.

Some market prognosticators refer to the big Q2 price recovery as the “Hopium” Trade and the Silly Season, but the reality is that the short-term market is difficult to predict and it forces humility on us all.

Economic Statistics are coming in better than expected:

Although economic statistics initially dropped precipitously due to the government-induced shutdown, they are now showing a significant improvement.

Unemployment (at a 50-year low of 3.5% in February) spiked to 14.7% in April but has since dropped to 11.1% for June.  Although this unemployment level is still a high level, it reflects the addition of 4.8 million new jobs and it was much better than the market expected.

– The Conference Board reported that its Consumer Confidence Index rose to a reading of 98.1 for June from 85.9 in May. Economists polled by Reuters had forecast the index rising to only 91.8 for June.

Retail sales for April declined 14.7%, the largest decline since 1992 when this data series was initiated. However, May retail sales jumped a record 17.7% on a month-over-month basis, well above the consensus expectation of 7.5%.  Retail sales were impacted by pent-up demand and government checks, so it is difficult to know what retail sales level will be reported in the future.  It is important to note that the May sales report was still down -6.1% on a year over year basis.

-The Leading Economic Indicators came in at a positive 2.8% after falling -6.1% in April and -7.5% in March. These statistics point to the sudden, large shutdown of the U.S. economy caused by the unprecedented coronavirus pandemic, and then an encouraging uptick.

Progress on Vaccines and Treatments:

Vaccines and treatments hold the promise of allowing the global economy to get back closer to normal, and there are numerous reports showing progress.  The U.K. government approved the use of dexamethasone, a steroid that cuts the risk of death for patients on ventilators and for those on oxygen.  There is also preliminary evidence supporting Gilead Science’s Remdesivir, an anti-viral treatment, and by vaccines from Moderna, Pfizer and others.  Moderna was said to “show promise” in phase-one trials and is progressing to phase-two trials.  Dr. Anthony Faucci, Director of the National Institute of Allergy and Infectious Diseases, also expressed optimism regarding a relatively quick approval.  However, a 12-18 month timeline still looks more likely.  Any COVID-19 vaccine would likely be first used to protect front-line health care workers and elderly who are at most risk to the virus.  Over time, a vaccine would achieve “herd immunity”, whereby the antibodies of the majority of individuals built up, either via exposure or vaccination, are sufficient to protect the remaining vulnerable people.  In the short-term, however, there is clearly a risk of a “Second Wave.”  Broad-based testing needs to be expanded so virus carriers can be identified and isolated.

FOMO-the Fear Of Missing Out:

The recent market strength has surprised many institutional investors, and there does appear to be an element of FOMO-the Fear Of Missing Out.  Markets trade on fear and greed, and the current market strength appears to have a significant amount of momentum-based trading.  Retail trading is up sharply based on commission-free trades and accounts like Robinhood that are said to be having significant trading volumes based on inexperienced traders.

Virus Resurgence:

As states move to reopen, there has been an unfortunate surge in new coronavirus cases and rising hospitalization rates in states like California, Texas, Florida and Arizona.  This has once again overstretched the health care system, and especially ICU units.  As a result, a number of states have paused or rolled back their re-openings, especially related to bars and restaurants.  There is also the prospect of a mutated version of the virus flaring up in the fall and winter.  Consequently, COVID-19 remains a global wildcard.

Market Valuations remain rich:

At this point, markets are ignoring weak 2020 corporate earnings, and are trading on expected 2021 earnings.  Nevertheless, various valuation metrics (like Price/Earnings ratios) for 2021 are still elevated.  It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential.  In other words, markets could continue to move up on a short-term basis, but the longer-term performance might be a 5-7% average return/year rather than the historic 10%/year long-term U.S. stock return average.  See Market Valuation

Election Volatility:

According to recent political polls, Vice President Biden is leading President Trump by a significant margin, and the U.S. Senate might shift to control by the Democrats.  In the case where the Democrats win the presidency and control both the House and the Senate, then tax increases are likely.  Joe Biden has said he would raise the corporate tax rate from 21% to 28%, rolling back Trump’s 2017 corporate tax reforms.  Greater restrictions on corporate share buybacks are also likely.  A report from Goldman Sachs estimates that such an outcome would shift 2021 earnings per share for the S&P 500 to $150 from a current estimate of $170.  It is probably safe to say that a large earnings decline caused by a corporate tax increase would negatively impact market performance.  For individuals, higher capital gains tax rates, the elimination of the qualified dividend tax rate, and/or higher tax rates on top income earners are expected.  Without getting too deep into tax policy, there is a strong argument that higher corporate taxes makes our U.S. companies less competitive in international markets.  To the extent that U.S. companies are less competitive in the international market place, then they don’t expand  U.S. operations and they don’t hire U.S. workers.

Stock Market and Economic Disconnect:

The markets were buoyed in the second quarter by progress in “a flattening of the curve”, the prospect of re-opening the economy, and early reports regarding treatments and vaccines.  Moreover, recent economic statistics show a stronger-than-expected rebound from the initial dramatic declines.  As a result, the market seems to be anticipating a V-shaped recovery.  Although a downdraft to the March lows does not appear likely, there are numerous risks that could cause market weakness.

While recent economic statistics have been stronger than expected, they may reflect more pent-up demand rather than long-term growth.  Economic growth over the next year faces significant headwinds and is not likely to quickly recover lost output.  The economic recovery still looks like a “Nike Swoosh” or even a U-shaped recovery, not V-shaped, and it looks like there is a disconnect between the recent market rebound and the broader economic landscape. Although the market was up in the second quarter, it still looks vulnerable to additional sell-offs. The current situation seems to be the opposite of what happened in December 2018. At that time, the market sold off hard based on fears of a global economic recession, even though the economic data did not show an imminent recession. In January, 2019, Cornerstone described a Market/Economic Disconnect where economic fundamentals in late 2018 were much stronger than indicated by the sharp market decline. This time, however, the economic fundamentals are very weak, but the market has been ignoring these weak fundamentals as it rebounded significantly in April through June.  Only time will tell how the coronavirus recession plays out, but it is helpful to stay grounded in longer-term economic and market fundamentals.

It is helpful to remember that Bear Markets since 1950:

-the average bear market declined -35% and lasted an average of 14 months.

-the average bull market gained 199% and lasted an average of nearly 6 years.

Bear markets are typically much shorter than bull markets, they go down less, and they have always given way to another bull market.

The Federal Reserve has been very proactive:

ensuring funding for banks and companies. The Fed re-established many of the initiatives from the 2008 Great Financial Crisis that have proven positive in the past. A major difference is that the Fed established these support programs so quickly.  The Fed cut the Fed Funds rate to near zero in an emergency meeting.

The Fed also provided a “do whatever it takes” stance to support lending for small and large businesses, money market funds, state and local governments, and global central banks for foreign investors seeking the safety of the U.S. dollar.

U.S. Fiscal Legislation:

Congress passed a $2.2 Trillion coronavirus aid package to help stabilize the U.S. economy. Key provisions include support for individuals (the Paycheck Protection Plan and increased unemployment benefits), small businesses, large corporations, public health, and state and local governments.  This package is being called a rescue plan, and many politicians say there will need to be another round to provide stimulus. As with the Federal Reserve’s timely actions, the legislation is being implemented far faster than was the case in the 2008/2009 Great Recession.

U.S. Federal Budget Deficit:

Morgan Stanley released an estimate of the U.S. budget deficit of $3.7 Trillion for calendar year 2020, and they see an additional $3T in 2021. This would make the deficit approximately 15-20% of the U.S. GDP. This is larger than the 2008/2009 Great Recession level. This analysis does not incorporate the proposed $2T infrastructure bill. Although there is a clear need for monetary and fiscal spending during this downturn, there is also a looming longer-term issue related to U.S. budget deficits.

International: 

China was the first country to lockdown its economy in January, and official data show positive economic manufacturing and non-manufacturing growth resuming in March.  These reports do not indicate an imminent global turnaround, but they do represent a measure of improvement in China.  The Eurozone is experiencing economic improvement from the lows of March and April, but they are mired in an economic recession.  Japan is also stuck in a deep recession.

On a global basis, a June International Monetary Fund forecast shows a -4.9% 2020 global economic decline and then a 5.4% recovery for 2021.

What’s Next?

There is no good historic precedent for the coronavirus given that globalization has allowed pandemics to spread much more quickly than in the past. Consequently, we are in the midst of a global recession.  The first quarter market downdraft caused a lot of economic weakness to be priced in, but the strong second quarter market performance has now priced in a fairly optimistic outlook.  Since the depth and duration of the coronavirus remain unknown, continued market volatility can be expected.  With all these crosscurrents, it remains critically important to stay focused on longer-term fundamentals that should gradually improve.

WHAT YOU SHOULD DO:

Portfolio actions that you take (or don’t take) at this point can feel highly uncomfortable but the decisions are not rocket science. Investors were bailing on investment holdings at a near-record pace and then have been charging back in.  This is no time to be part of the herd’s stampede in either direction. Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know. There is nothing unique about the list below, but it is supported by ample historical evidence.

-Stay the course. Fear and Greed are really the biggest risks.

-Don’t sell unless you have a dire need for cash.

-Rebalance the portfolio to restore beaten-down equity holdings to a weight consistent with your long-term investment objectives.

-If you have cash, then add to equity holdings on a systematic basis. This isn’t easy, but a good strategy is to make several smaller investments over time rather than one larger trade. No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

– Remember that investment performance is improved by buying in bear markets, not selling.

-Dollar Cost Averaging that invests a predetermined amount of dollars on systematic predetermined dates is a method that remains a valid investment strategy.

Jeff Johnson, CFA

July 9, 2020

 

 

SEE MORE POSTS

Why So Volatile!

One for the Record Books-March 14, 2020

Coronavirus Comments-March 1, 2020

Big 2019, 30 Yrs of Ups & Downs, Outlook/Recommendation, January 9, 2020

Charitable Giving Update and Comparisons-2019, October 26, 2019

Market Record, Panic, New Record-What’s Next? July 13, 2019

Educational Investment Seminar-Take Aways.  May 22, 2019

A Wild Year, A Great Decade and a Market/Economic Disconnect.  January 3, 2019

Investments:  Faith-Based & Environmental, Social and Governance.  November 9, 2018

Investment Guidelines 101-(Are Financial Advisers Worth It?).  June 22, 2018

Paul, Apostle of Christ and Economic Priorities.  April 2018

Charitable Contributions.  January 13, 2018

WHY SO VOLATILE?

If you think this market is crazy volatile, then you are right.  The market fell into a bear market (down -20%) faster than at any time in history, even including the Great Depression.  The daily price moves looked more like an out-of-control roller coaster than a rational, orderly market.

Considering this manic behavior, you have to wonder where are the grown-ups?  You also have to ask why investment people making the big bucks can change their minds so quickly and erratically.  Where’s the conviction?  Disciplined or fickle?

The COVID-19 pandemic has been called a Black Swan-a hard to predict rare event that comes as a complete surprise and has a major effect.  It has been characterized as a Known Unknown, and it has been a trigger for the market volatility and downdraft.  There have been a number of other factors that combined, however, to cause a “Perfect Storm” of Volatility.

Despite the historically high volatility level, there has not been historically bad investment performance.  So far, investment performance has been similar to a typical bear market.  It is understood, that investment performance could still get worse.

The graph below shows the incredible volatility starting in March.

Listed below is the actual S&P 500 index performance.  It is down so much because there were more large volatile down days than up days.

VOLATILITY CULPRITS:

Two key contributors to this Perfect Storm of volatility include:

-Human nature, with all the emotional euphoria on the way up and despair on the way down.

-Big, fast computers.  Algorithmic Trading, High Frequency Trading, and increasing use of momentum and volatility strategies represent the second major contributor to the volatility.  This trading was magnified by excessive financial (debt) leverage.

(Details are listed further below:)

 

WHAT DOES IT MEAN FOR YOU?

First, it is important to keep perspective.  The main priority is saving lives.  Everything else comes back.

It shouldn’t impact your Investment Objectives:  It is important to maintain a long-term perspective.  The huge volatility in March shouldn’t impact a long-term focus.  This is not a financial crisis, but rather a crisis of confidence.  The depth and duration of the coronavirus are not known, but it does not appear to constitute the fundamental, systemic problems associated with the 2008 Great Financial Crisis.  Moreover, the massive government monetary and fiscal support being implemented is much larger and coming much quicker than in 2008.

The sudden -20% market decline has been painful (especially after 11 big years), but the decline is well within the historic range for bear markets.  The market decline should also be remembered within the context of the 31.5% gain by the S&P) 500 in 2019.  More importantly, the market will come back.

A review of Bull and Bear markets since 1950 shows:

-the average bear market declined -35% and lasted an average of 14 months.

-the average bull market gained 199% and lasted an average of nearly 6 years.

Bear markets are typically much shorter than bull markets, they go down less, and they have always given way to another bull market.

It might sound flippant, but in a way the market had gone too far too fast and was due for some downside.

It is important to remember that there are wide ranges around the average length and return of bull and bear markets.  Nevertheless, history shows that all bear markets end.

Portfolio actions that you take (or don’t take) at this point can feel highly uncomfortable but the decisions are not rocket science.  Investors have been bailing on investment holdings at a near-record pace and this is no time to be part of the herd’s stampede.  There is nothing unique about the list below, but it is supported by ample historical evidence.

-Stay the course.  Fear is really the biggest risk.

-Don’t sell unless you have a dire need for cash.

-Rebalance the portfolio to restore beaten-down equity holdings to a weight consistent with your long-term investment objectives.

-If you have cash, then add to equity holdings.  This isn’t easy, but a good strategy is to make several smaller investments over time rather than one larger trade.

– At this stage in the bear, there is likely to be far more upside than downside.  Remember that investment performance is improved by buying in bear markets, not selling.

It’s Deeper than Fear and Greed — Non-Investment Observations:

It is often said that the markets run on the animal spirits of Fear and Greed.  It’s not really that simple.  It’s too early to know the depth and duration, but here are some non-investment observations:

-It would be a mistake to bet against the resilience, creativity and persistence of Americans in this time of challenge.

-Health care workers are showing incredible dedicated service despite personal risk and sacrifice and are a true inspiration.  This is especially true for the nurses who have the most frontline exposure.

-Essential workers are taking on a new meaning as we see who really is essential.

-Human ingenuity from both the government and the private sector are working furiously and there are good reasons to remain optimistic.

-Many companies are forgoing profits and are keeping employees or paying what they can.

-The general public is showing impressive broad-based acceptance and support for social distancing and quarantines.  It has changed lives, but everyone seems to recognize that we are all in this together.

-There are uncounted and often un-noticed acts of helping and compassion that add up to something much bigger.

When considering all this, I am reminded of Genesis 1:27 where it says that we are created in the image of God.  It is gratifying to see humanity set aside mundane differences and rise up to face this challenge.  These are the times that bring out the best in all of us.

 

DIGGING DEEPER-VOLATILITY DRIVERS

Human Nature-Complacency and then Panic:

Investors received stellar performance during the longest bull market in history, 11 years, and this was accompanied by the longest economic expansion in history, a stretch that ran for 10.5 years.  For years, investment performance ratcheted upward, causing a sense of complacency.  Central banks around the globe kept interest rates low, and encouraged investments in riskier assets.  Investing was characterized by the Fear Of Missing Out-FOMO.  With this benign backdrop it is little wonder that the sudden recognition of the coronavirus was a major factor that upset the apple cart and caused such volatile emotional selling.

Economic prospects-V-Shaped Recovery, or U, or L:  Epidemics historically cost lives but have not had big longer-term impacts on markets or the economy.  This time it looks different.  The speed and suddenness of the global shutdown is unprecedented and economists and others are only gradually beginning to understand the magnitude of this change and then to incorporate this into their models.  For example, Goldman Sach’s initial analysis of COVID-19 impact foresaw minimal impact to the U.S. and they saw 1.2% US GDP growth for 2020.  A subsequent forecast revised U.S. 2020 economic growth to 0.4%.  As of March 21, Goldman has significantly revised their 2020 GDP growth rate down to -3.8%.  This forecast includes a -24% annualized negative growth rate for Q2 and then a sharp Q3 recovery of 12% annualized and Q4 gain of 10%.  This analysis sees a V-shaped recovery.

The point is not to throw rocks at Goldman Sachs, because they are smart, savvy investors.  The point is that analysts are increasingly negative about near-term prospects.   Further, it warrants caution regarding how much we really comprehend about the coronavirus impacts.  Given the unprecedented nature of the shutdown, it seems that there may be more caution by both consumers and companies as we emerge on the other side and a U-shaped recovery is more likely than a V.  Finally, the coronavirus outbreak may prove to be worse than the 9/11 terrorist attacks, but it doesn’t look to be as severe as the full-blown 2008/2009 Great Financial Crisis.

COVID-19 Backdrop:  As 2020 began, investors were optimistic the economic expansion would continue, as calming trade tensions between the U.S. and China and three 2019 interest-rate cuts from the Federal Reserve lifted stocks.  The coronavirus was widely publicized by mid-January, but it was first ignored and markets went on to post all-time record highs by February 19.  For years, it paid to buy each dip in stocks and to embrace trades that bet against the return of volatility.  Then the COVID-19 virus became increasingly problematic and ultimately caused an unprecedented global shutdown.  Millions of the nation’s businesses suddenly closed their doors, international travel ground to a sudden halt, and personal interactions were sharply curtailed.  Markets reacted negatively with unprecedented volatility.  As the severity of the situation became increasingly apparent, economic and earnings forecasts were repeatedly revised down lower and lower.  The transition from complacency to a sudden, unprecedented global shutdown caused a huge emotional reaction and produced panicked selling.

ALGORITHMIC TRADING:

Algorithmic trading was the other major factor in the huge March volatility.  Algorithmic trading essentially involves computer programs that follow defined sets of instructions (algorithms) to do stock trading far faster than humans can do.  It often utilizes back-testing of technical indicators like movements of 50-day and 200-day moving averages, trend following patterns and arbitrage opportunities based on pricing anomalies.

Algorithmic trading is different from fundamentally driven trading that is based on rigorous analysis of company valuation and revenue and earnings growth prospects.  Instead, “algo” trading looks for relatively small market dislocations and inefficiencies that can be rapidly exploited with strategies related to volatility, momentum and risk parity.  Quite simply, it’s not based on strong company earnings growth or an attractive valuation level.  Analysts at J.P. Morgan said “fundamental discretionary traders” accounted for only 10% of recent stock trading volume.  Goldman Sachs analysis shows equity algorithmic trading is nearly 3 times the level from 15 years ago.

High Frequency Trading-HFT:  Algorithmic trading is often based on High Frequency Trading (HFT) that utilizes powerful computers moving in and out of markets at lightning speeds measured in milliseconds.  In normal markets HFT adds liquidity and lowers costs by reducing bid-ask spreads on trades.  In March, however, profits at the large HFT algorithmic traders were reported to be extremely high, and there is now a question about the value of HFT in times of market duress.

Volatility Trades:  The 11-year bull market was accompanied by a below-average level of price volatility.  In this environment, hedge funds and other institutional investors utilized a variety of algorithmic strategies to trade on small changes in market volatility, regardless of whether they went up or down.  Since price volatility was low, many of these strategies used financial leverage at up to 10X.  As markets moved up, low volatility caused traders to buy risky assets.  As markets fell, volatility rose and the computers began selling.  As a result, during March this computer-based trading magnified both moves upward and downward.  In another example, investment strategies were established by market participants to either dampen volatility or enhance returns based on previously reliable relationships between assets.  Unfortunately, these pricing relationships fell apart when volatility spiked and caused devastating effects in panicked markets.

Six Sigma:  The Wall Street Journal reported prices gyrating by an incredible six standard deviations from the short-term norm.  These moves were exacerbated by the presumed low likelihood of extreme market moves with risk models largely based on a period of relative market calm. Since many of these trading strategies were structured with high financial leverage, it became a situation where everyone headed for the exit at the same time.  It is easy to see how unwinding these trades caused such panicked selling.

Momentum Trades also benefit from Algorithms:  Momentum trading is an investment strategy that has a good historic track record.  Momentum traders buy the stocks that are going up the fastest.  Or they might buy the stocks that have the greatest revenue or earnings momentum.  Regardless, this feeds on itself and the more momentum traders, the more it spirals upward.  When markets (or stocks) reverse and head down, then momentum traders are selling the assets that are falling the fastest.  They essentially turbocharge the upward buying interest and then magnify the downward selling pressure.

Fundamentals prevail over Algos on a long-term basis:  Since Algorithmic trading is focused on short-term factors like volatility and momentum, it has less relevance to fundamental factors.  Fundamentals still function to differentiate the merits between various companies and future prospects, and fundamentals still determine the long-term performance of investment assets.  What this means to a long-term investor is that algorithms probably reduce trading costs by a small amount during normal market activity, but a disciplined investment process still prevails on a long-term basis.

Liquidity Dried Up:

Liquidity in the financial markets means the ability to sell an investment asset quickly without having to sell it at a big discount.  Liquid investment assets usually have a large number of buyers and sellers readily available so that a transaction is easily traded and it minimally impacts the price.  US Treasury securities normally have the greatest liquidity.  Your house is far less liquid.  The sudden shutdown of the U.S. economy was unprecedented and it precipitated an immediate dash for cash.

Dash for Cash:  Individuals suddenly faced unemployment or reduced hours, particularly in the airline and entertainment industries. Businesses, seeing markets and revenue shutting down, drew down bank credit lines.  Small business owners were particularly vulnerable because they typically lack the financial flexibility of larger firms.  Fund managers faced redemptions as investors liquidated holdings.  Traders attempted to unwind trades that had worked in a low volatility investment environment.  In many of these cases, normal cash flow patterns were disrupted and caused an immediate need for cash.

US Treasuries & Gold-Traditional Safe Havens Didn’t Work:

US Treasuries prices typically rise (and yields drop) when investors seek a safe haven.  This time, Treasurys dropped the at the same time stock prices were dropping, so there was no safety anywhere.

The Treasury market was disrupted by other factors as well.  For example, even short maturity Treasury securities (due in 30 days or less), sold off because people wanted cash, NOW!

Gold is another asset the investors buy in scary times, but gold actually declined at the same time that the stock market began falling.

Risky Assets were Crushed:

With fears of an imminent recession, investors fled riskier debt, afraid companies that loaded up on credit amid low interest rates would have trouble repaying.  These assets became extremely illiquid, and the only way to unload them was to sell at a huge discount.  As an example, the high yield (junk bond) Exchange Traded Fund- HYG quickly fell 15%.  Somewhat ironically, investment managers during times like this are typically forced to sell their highest-quality assets because the discounts on lower quality assets are so extreme.

Short Covering:

Short covering is often the cause of markets spiking upwards.  A short trader essentially uses a derivative security to sell an investment asset today with the provision to buy it later before a specified date.  For example, a short trader hopes to sell a stock today for $100, and buy it in the future at $90, a lower price.  This can be extremely risky, but it can be lucrative.  When the market is going up instead of down, this trade becomes increasingly unprofitable.  You have already sold at $100, and now you have to buy at perhaps $110 or more.  As the market goes up, short traders have to sell (Cover) before they lose even more money.  A large number of short sellers covering (closing out their increasingly unprofitable trade), means prices go up even higher.  This was a part of the reason that the S&P 500 went up 9.4% on March 24.  Many times, large upward price moves are caused by short covering.

Margin Calls:

Investors are allowed to borrow money in their brokerage accounts to buy even more stock.  This works great in rising markets, and it made you feel like a rock star in 2019 when the S&P 500 went up 31.5%.

When stocks decline, investors are required to put in more collateral.  They need to add to their margin account.  When they don’t have the cash, their broker will liquidate some of their securities to re-establish their required margin.  This is a “Margin call”.  Obviously, the more selling pressure in the market place, the greater the number of margin calls and this results in a negative downward spiral.  Margin calls were a major negative factor in the 1929 stock market crash.

Final Comments:

These Cornerstone blog posts are designed to provide education and a long-term perspective related to investments.  The commentary relies on my career experience, credible sources and hard data as much as possible. Even so, there are always many surprises and unexpected outcomes and this certainly applies to the comments listed above.  As always, your feedback is helpful and beneficial.

Jeff Johnson, CFA

April 1, 2020

 

One for the Record Books

The longest bull market in history, 11 years, ended March 12, 2020.

The longest economic expansion in history, 10 and a half years, is likely to end.

The fastest move in history for the S&P 500 index from an all-time record high to a Correction (down more than 10%) in six trading days and a Bear Market (down more than 20%) in 16 trading days.

Biggest down day since 1987 with the S&P 500 down 9.5% on March 12.

Biggest up day since 2008. A day after the ominous sell-off, the S&P 500 rebounded 9.3% on March 13.

The CBOE Volatility Index, a closely watched measure that is often called the “Fear Gauge”, rose to its highest level since 2008.

The Stoxx Europe 600 index shed 11.5% on March 12, its worst one-day performance on record. It is down 32.0% from its recent peak.

What’s Next?

No Good Precedent: There is no good historic precedent for the coronavirus given that globalization has allowed pandemics to spread much more quickly than in the past. As a result, a recession, both globally and in the U.S., looks likely.

Although a recession looks likely, the current market downdraft means a lot of economic weakness is already priced in. Nevertheless, the depth and duration of the coronavirus remain unknown and continued volatile market downdrafts can be expected.

Different than 1987: The coronavirus outbreak does not look like the 1987 market crash. Earlier in 1987 both the Dow Jones Industrial Average and the S&P 500 set all-time high records. Then by October 19, 1987, the Dow plunged 22.6% and the S&P 500 dropped 20.5%. Although economists forecast a recession at that time, the economy continued to grow and did not experience a downturn. This time, the coronavirus disruption looks likely to induce an economic recession.

9/11 Surprise: The terrorist attacks in September 2001 caught everyone by surprise. At the beginning of 2020, most investors expected continued market gains for 2020, but the coronavirus has caused another surprise. There was a mild recession associated with 9/11, but markets had already sold off hard for 18 months due to the internet/tech crash. At this time, there are too many unknowns associated with the coronavirus to assume a mild recession.

Different than 2008: The coronavirus outbreak is much different than the 2008 financial crisis and Great Recession. That downturn was driven by fundamental, systemic weaknesses that needed time to correct. The good news is that the Federal Reserve learned a lot during the 2008 crash, and they are able to apply the lessons learned to the current situation.

Liquidity: The U.S. government has stepped in aggressively to provide much needed liquidity. This is critically important for the airlines, energy companies, entertainment companies, restaurants and other small business operators who are facing short-term disruptions caused by the sudden social distancing and retrenchment in normal consumer behavior. The banks who lend to these companies are not structured to provide funds so quickly. Banks typically hold short-term U.S. Treasury securities that mature (become liquid) in weeks or months. In cases where companies suddenly need to borrow funds quickly, the banks lack ready cash. However, the banks can turn to the government to secure these “liquid” funds immediately and then lend these funds to these troubled companies. Keeping these companies afloat is important to maintaining employment.

Liquidity is also being provided to a wide range of institutional investors who are involved in a wide range of lending and foreign currency transactions.

President Trump has declared a national emergency and the U.S. government is providing broad-based support:

-to free up billions in assistance to states and provide authority as the rapidly spreading virus upends life across the country. This would also open up access to up to $50 billion in financial assistance for states, localities and territories.

-to call on every U.S. state to immediately set up emergency operations centers and every hospital in the country to activate emergency preparedness plans.

When these measures were announced on March 13, equity markets shot upward quickly.

Congress last week passed an $8.3 billion measure to help the government develop a vaccine and provide money for states to expand their lab-testing capacity and attempt to limit the damage from the virus.

-Legislation is being structured that would make coronavirus testing free and provide paid sick leave to many of those affected by the pandemic.

-Proposals are being discussed to help laid off workers, including direct cash payments that are along the lines of the 2008 policy response.

-Initiatives are in process to establish low-interest loans for small businesses.

-Consideration is being given to student debt relief.

Foreign Government actions are being crafted across the globe to provide similar monetary and fiscal stimulus packages.

There is an open question about whether these initiatives will be sufficient, or whether they are already too far behind the curve. There are also some that say these actions are over-reacting. Given the unprecedented nature of this pandemic, it seems prudent to respond as aggressively as possible.

For More Details See Below:

The Coronavirus was largely unknown in mid January, but it has since morphed into a global phenomenon. As of March 10, the World Health Organization reported 113,702 confirmed cases and 4,012 deaths. China is the epicenter of the outbreak, but South Korea, Iran and Italy are also hard hit. The U.S. has 1,267 cases and 38 deaths as of March 11, 2020. Harvard epidemiologist Marc Lipsitch has estimated that between 20% to 60% of adults world-wide might catch the disease. Although the coronavirus has spread across the globe, the newly reported cases in China are declining and Chinese workers are beginning to go back to their jobs. In addition, Reuters is reporting that new cases in South Korea are falling behind the number of patients who recovered and this could be an indication that the outbreak is slowing. There are also reports that the coronavirus is more lethal for smokers and for people living in areas of poor air quality. If this is the case, then some early cases may have overstated the risk to a broader population that has fewer smokers and better air quality.

Due to a lack of testing in the U.S., we don’t know how many Americans are infected. Although social distancing is helping reduce the spread, it is possible that the number of people already infected is far greater than currently reported cases suggest. If the number of cases exceeds current expectations, then hospitals might experience a surge in patients and the healthcare system might become overwhelmed.

Panicked Selling:  While the coronavirus has been a human tragedy, it has also negatively impacted global markets with waves of panicked selling based on the fear of the economic fallout on a global basis. For example, the S&P 500 index fell 9.5% on March 12, the greatest one-day decline since October 1987. Then the index rebounded 9.3% on March 13.

Ironically, equity markets first ignored the early reports of the coronavirus in January.  During February, new records were set for the S&P 500, Nasdaq, the Dow Jones Industrial Average, and the European Stoxx 600.  In fact, he S&P 500 set an all-time record high of 3,386 as recently as February 19, just before plummeting 13.0% in the next seven trading sessions.  As an indication of the panic, The Wall Street Journal reported that this was the fastest decline on record from a record high to a correction of below -10% and also the fastest bear market sell-off below -20%. This selling pressure has been exacerbated by President Trump’s 30-day travel ban on persons coming from Europe and continuing cancellations or suspensions of large conferences and entertainment events. The S&P 500 index is now down 19.9% from the February 19th all-time high, and down 15.8% on a year-to-day basis. Small cap stocks have been hit even harder based on the fact that they have less overall financial strength than larger, more established companies. International stocks are down even more than U.S. stocks. Meanwhile, so-called safe-haven U.S. Treasury bonds are up 13 percent year-to-date and an incredible 31% over the last year. These bonds have performed well because the bond prices have moved up sharply as interest rates declined.

Past Epidemics were historically short-lived:  Although it is difficult determine the global impact, the Severe Acute Respiratory Syndrome-SARS epidemic in 2003 reduced Chinese GDP by an estimated -0.8%.   Analysis by Charles Schwab found that for the 13 global epidemic outbreaks since 1981, the MSCI World Index gained 0.8% in the month after the outbreak, and 7.1% after six months. Morningstar examined the companies that they followed after the SARS outbreak and found no significant long-term effect. In addition to SARS, other notable outbreaks that did not have a significant global impact include the avian flu in 2006, swine flu in 2009, Ebola in 2014, and Zika in 2016. The coronavirus was categorized a pandemic on March 11th, however, and it looks like it will have a much more negative impact than past outbreaks.

History indicates that the market overreacts to short-term headlines and these previous outbreaks did not have a negative impact on longer-term performance. Nevertheless, the current coronavirus appears to have a much bigger impact because China now represents a much larger share of the global economy. Data from the World Bank shows that China’s GDP was at $1.3 Trillion in 2003 during the SARS outbreak and now GDP is $13.6 Trillion. In addition, global exports grew from $438 billion in 2003 to $2.5 Trillion in 2018. Finally, visitors from China to the U.S. grew from 157,000 in 2003 to 2.8 million in 2018.  Consequently, there is much greater downside potential than in the past.

Global Economy:  Although the Chinese economy appeared to be improving by the end of 2019, the coronavirus is clearly causing a downdraft.  The Chinese National Bureau of Statistics reported that the official February manufacturing survey declined from a stable level of 50.0 in January to 35.7 in February, the lowest manufacturing level ever recorded.  In addition, the official services data showed a decline from 54.1 in January to 29.6 in February.  Although there are reports of Chinese workers beginning to go back to work and some recovery is expected, it is clear that Chinese economic growth will be significantly impacted. The Euro area and the UK were also experiencing improving economic prospects at the beginning of 2020. Germany and Japan were the two major countries with weak year-end economic performance.

The U.S. is described as starting from a good place with solid economic fundamentals. For example, The Citi Economic Surprise Index showed a solid 69.6 rating at the end of February. In addition, the March 6th employment report showed employment gains of 273,000, well above estimates. Although this report covered a period before the coronavirus was seen as a problem, it does indicate the economic strength and momentum going into the coronavirus headwind.

Oil Price War: Russia did not agree to crude oil production cuts proposed by OPEC to support crude oil prices as oil demand fell due to the coronavirus impact, so Saudi Arabia countered with crude oil production increases. These actions essentially resulted in an oil price war between Saudi Arabia and Russia. This pushed crude prices down to $30 per barrel and it contributed to the massive March 9 stock market decline. For the U.S., lower oil prices are a clear benefit for consumers. However, lower oil prices hurt the oil exploration and production segment of the oil industry. Many of these companies have their production hedged (to lock in their prices), but these hedges will roll off going into 2021. If oil prices do not improve over the intermediate term, then many companies will face defaults and even bankruptcy. On an overall basis, there is significant economic analysis showing the benefit of lower oil prices to consumers is roughly offset by the losses to the exploration and production companies.  Consequently, falling oil prices may impact short-term U.S. market volatility, but the net longer-term impact to the U.S. economy should not be large.

Deteriorating credit conditions are the clear issue. High yield funds that hold non-investment grade “junk” bonds will experience increasing defaults and bankruptcies, and this will lead to weaker investment performance.

Forecasts:  The term Unknown Unknowns might seem appropriate to describe the current environment because it is difficult to know the depth and duration of the spread of the coronavirus. It now seems clear that previous analysis and forecasts from Goldman Sachs, Deutsche Bank and others were too optimistic, as they projected a direct short-term impact on Chinese GDP but minimal impact to the global economy. Recent forecasts are now recognizing a greater negative impact. For example, the Organization for Economic Cooperation and Development-OECD reduced their 2020 global growth forecast from 2.9% to 2.4%. Given the fact that the coronavirus is still spreading and there is no way to know when it peaks, it seems likely that global growth will be reduced by at least 0.5% and the global economy may even dip into recession.

The Wall Street Journal consensus forecast (conducted March 6-10) shows a 49% chance of a U.S. recession in the next twelve months compared to a 26% chance a month ago. On an annual basis, the WSJ survey shows U.S. GDP down -0.1% in Q2, and up 1.2% for the full year. Based on recent data and analysis, it appears that the short-term economic downdraft may be deeper, but prospects for 2021 should be much less impacted. Initially, many economists saw a V-shaped recovery, with a negative impact in the first quarter and then a second quarter recovery.  More recently, there is more commentary about a U-shaped recovery. A prolonged L-shaped economic period is also possible if the coronavirus proves worse than expected. It needs to be said that forecasts often initially understate the magnitude of significant declines. For example, practically no one foresaw the depth or duration of the Great Recession. The reality is that there is also an epidemiology factor that is new to economists’ models. Only time will tell, but a global recession appears likely.

Interest Rates:  One notable aspect of the current market decline has been the precipitous decline in interest rates.  The 10-year U.S. Treasury bond interest rate declined to a record-low level of 0.5% on March 9.  Part of this decline is due to concerns of weaker economic growth, but a flight to quality is a greater factor.  When market participants grow fearful, they seek safe havens by buying U.S. Treasury bonds.  These panicked purchases drove the price of the bond up and the yield down and caused long U.S. Treasury bonds to gain over 30% in the last year.  As fears eventually subside, the price will go down and the yield will rise, setting the stage for huge Treasury bond losses.

Federal Reserve:  In reaction to the coronavirus economic threat, the U.S. Federal Reserve executed an emergency half-percentage point rate cut to a range of 1.0% to 1.25%, down from the previous range of 1.5-1.75%. The Fed is also likely to reduce interest rates even further at the upcoming FOMC meeting on March 17th and 18th.  The difficulty is that the Fed is best positioned to deal with weak aggregate demand, and the coronavirus represents a supply-side shock related to disrupted supply chains.  Lower interest rates would help keep the U.S. dollar lower (to help maintain U.S. exports), but lower interest rates don’t create what is really needed-a vaccine. If economic prospects weaken, however, then Fed-induced interest rate cuts will help support aggregate demand. The Federal Reserve has also been an active buyer of short-term Treasury securities to maintain liquidity and an orderly market.

Fiscal Policy: Countries around the world are playing catch-up to the fast-paced coronavirus developments. President Trump has signed an $8.3 billion emergency spending bill. There is also discussion related to payroll tax reductions and low-interest small business loans, but political realities may hamper any significant bipartisan legislation. Globally, there are numerous fiscal policy initiatives that may prove beneficial. Since interest rates in the developed world outside the U.S. are extraordinarily low or negative, there is less potential monetary support. From an economic perspective, tax cuts have the greatest multiplier effect.

It’s not 2008:  While the market sell-off has been reported as the worst decline since October 2008, it should not be compared to the 2008 global market meltdown and Great Recession.  Back then, there were significant fundamental issues related to over-valued real estate, highly speculative financial transactions and insufficient capital for the global banking system.  We don’t know when the number of global coronavirus cases will begin to decline, but it does not appear to be on a scale similar to the massive systemic breakdown from the past.

A Good 30 Years:  The quick 2020 sell-off erased significant portfolio value through mid March, and it could get worse before it gets better.  That being said, it is helpful to remember that the S&P 500 gained 31.5% in 2019.  In addition, it is up 422% on a total return basis (and up 14.0% annualized) as we pass the 11th anniversary of the bull market that started March 9, 2009. Market complacency had become pervasive over the past 11 years. The U.S. has been in the longest economic expansion on record, and the S&P 500 has been in the longest bull market without a -20% bear market. It is important to remember that historically going back to 1950, market corrections (down more than -10% from a recent high) occur once every 2.5 years and bear markets (down more than -20%) occur every 7.8 years. Based on these averages, it puts the current decline in perspective.

Additional Thoughts: Although there has been panicked selling, there is also cash on the sidelines waiting to get into the market and these two factors can cause increased price volatility. Moreover, the market is forward-looking and is attempting to front-run “Peak Virus.” In other words, when new cases and deaths begin to diminish, then this will indicate less economic downside and better corporate earnings. However, there is likely to be a series of negative news reports about downgraded economic forecasts and corporate earnings reductions. This will likely include the prospect of a global recession and a recession in the U.S. These negative reports will provide continuing market angst and downside market volatility. Given that the depth and duration is not known, this peak virus event might be in a month but it will probably be much further out. On the plus side, the sell-off has driven market valuation levels much lower and recessionary risks are already partially priced in. For investors with cash, now is the time to begin buying equities. Rather than trying to nail the bottom, it can be advantageous to average in with several investment moves over the course of time.

WHAT YOU SHOULD DO:  Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know:

-First, remember that emotional reactions to short-term headlines are the biggest risk.  As hard as it is, investors should not abandon long-term investment objectives.

-Use the current market volatility to rebalance portfolios back into alignment with your long-term investment objectives and asset allocation plan.

-If you have cash to be invested, then this sell-off looks like a good time to invest potentially one third of your idle funds.  Then set a date in three months to invest another third or if the market drops another 10%.  Finally, set a date in six months to invest the last third or sooner if the market drops by 20%.  If the market declines further, you will be getting in at lower prices.  If the market moves upward, your first purchases will be at lower prices.  No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

 

Jeff Johnson, CFA

March 14,2020

Coronavirus Comments

The Coronavirus was largely unknown six weeks ago, but it has since morphed into a global phenomenon.  At this stage it is hard to know if the media pundits are providing a valuable public service or are hyping a story for more viewers and Likes.  Fortunately, we have sources like the Centers for Disease Control and the World Health Organization to give perspective.  Through the end of February, there have been over 87,000 reported cases and nearly 3,000 deaths.

Panicked Selling:  While the coronavirus has been a human tragedy, it has also negatively impacted global markets with waves of panicked selling.  Equity markets have sold off hard based on increased reports of the coronavirus spreading outside of China.  Although there are reports that the number of new cases in China is declining and Chinese workers are beginning to go back to their jobs, there is a greater fear of the economic fallout on a global basis.  Ironically, equity markets first ignored the early reports of the coronavirus in January.  During February, new records were set for the S&P 500, Nasdaq, the Dow Jones Industrial Average, and the European Stoxx 600.  In fact, he S&P 500 set an all-time record high of 3,386 as recently as February 19, just before plummeting 13.0% in the next seven trading sessions.  As an indication of the panic, The Wall Street Journal reported that this was the fastest decline on record from a record high to a correction of below -10%.  Markets across the globe suffered similar declines.

Past Epidemics:  Although it is difficult determine the global impact, the Severe Acute Respiratory Syndrome-SARS epidemic in 2003 reduced Chinese GDP by an estimated -0.8%.   Analysis by Charles Schwab found that for the 13 global epidemic outbreaks since 1981, the MSCI World Index gained 0.8% in the month after the outbreak, and 7.1% after six months. Morningstar examined the companies that they followed after the SARS outbreak and found no significant long-term effect. In addition to SARS, other notable outbreaks that did not have a significant global impact include the avian flu in 2006, swine flu in 2009, Ebola in 2014, and Zika in 2016.

Forecasts:  Recent analysis from Goldman Sachs and Deutsche Bank indicates that the virus will reduce Chinese GDP by -1.5% for the first quarter of 2020 and by -0.3% for calendar year 2020. US GDP is seen being reduced by as much as -0.5% in the first quarter and by -0.1% for the full year. On a global basis, GDP is seen down -0.2% for 2020. This analysis essentially sees a negative impact in the first quarter and then a recovery. Only time will tell.

History indicates that the market overreacts to short-term headlines and these outbreaks do not have a negative impact on longer-term performance. Nevertheless, the current coronavirus may prove to have a bigger impact because China now represents a much larger share of the global economy. Data from the World Bank shows that China’s GDP was at $1.3 Trillion in 2003 during the SARS outbreak and now GDP is $13.6 Trillion. In addition, global exports grew from $438 billion in 2003 to $2.5 Trillion in 2018. Finally, visitors from China to the U.S. grew from 157,000 in 2003 to 2.8 million in 2018.  Consequently, there is much greater downside potential than in the past.

Chinese Economy:  Although the Chinese economy appeared to be improving by the end of 2019, the coronavirus is clearly causing a downdraft.  The Chinese National Bureau of Statistics reported that the official February manufacturing survey declined from a stable level of 50.0 in January to 35.7 in February, the lowest manufacturing level ever recorded.  In addition, the official services data showed a decline from 54.1 in January to 29.6 in February.  Although there are reports of Chinese workers beginning to go back to work and some recovery is expected, it is clear that Chinese economic growth will be significantly impacted.

Market complacency had become pervasive over the past 11 years.  The U.S. has been in the longest economic expansion on record, and the S&P 500 has been in the longest bull market without a -20% bear market on record.  It is important to remember that historically, market corrections (down more than -10% from a recent high) occur almost once a year and bear markets (down more than -20% from a recent high) occur every 4.5 years.  Based on these averages, it puts the current decline in perspective.

Interest Rates:  One notable aspect of the current market decline has been the precipitous decline in interest rates.  The 10-year U.S. Treasury bond interest rate has declined to a record-low level of 1.13%.  Part of this decline is due to concerns of weaker economic growth, but a flight to quality is a greater factor.  When market participants grow fearful, they seek safe havens by buying U.S. Treasury bonds.  These panicked purchases drove the price of the bond up and the yield down and caused long U.S. Treasury bonds to gain over 30% in the last year.  As fears eventually subside, the price will go down and the yield will rise, setting the stage for huge Treasury bond losses.

Federal Reserve:  In reaction to the coronavirus economic threat, the U.S. Federal Reserve is likely to reduce interest rates at the upcoming FOMC meeting on March 17th and 18th.  The difficulty is that the Fed is best positioned to deal with weak aggregate demand, and the coronavirus represents a supply-side shock related to disrupted supply chains.  Lower interest rates would help keep the U.S. dollar lower (to help maintain U.S. exports), but lower interest rates don’t create what is really needed-a vaccine.

Recovery:  Although the U.S. is described as starting from a good place with solid economic fundamentals, it is difficult to know the ultimate outcome.  Many economists see a V-shaped recovery, with a negative impact in the first quarter and then a second quarter recovery.  If the coronavirus proves worse than expected (and worse than historic epidemics) then there may be an L-shaped recovery.

It’s not 2008:  While the market sell-off has been reported as the worst decline since October 2008, it should not be compared to the 2008 global market meltdown and Great Recession.  Back then, there were significant fundamental issues related to over-valued real estate and highly speculative financial transactions.  We don’t know when the number of global coronavirus cases will begin to decline, but it does not appear to be on a scale similar to the massive systemic breakdown from the past.

A Good Run:  The quick sell-off erased over 10% of value through the end of February, and it could get worse before it gets better.  Nevertheless, it is helpful to remember that the S&P 500 gained 31.5% in 2019.  In addition, it is up 490% as we approach the 11th anniversary of the bull market starting March 9, 2009.

WHAT YOU SHOULD DO:  Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know:

-First, remember that emotional reactions to short-term headlines are the biggest risk.  As hard as it is, investors should not abandon long-term investment objectives.

-Use the current market volatility to rebalance portfolios back into alignment with your long-term investment objectives and asset allocation plan.

-If you have cash to be invested, then this sell-off looks like a good time to invest potentially one third of your idle funds.  Then set a date in three months to invest another third or if the market drops another 10%.  Finally, set a date in six months to invest the last third or sooner if the market drops by 20%.  If the market declines further, you will be getting in at lower prices.  If the market moves upward, your first purchases will be at lower prices.  No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

Investment Performance:

Last 3 Last 12
Major Benchmark Performance:  Months YTD Months
Since: February 10/31/19 12/31/19 1/31/19
As Of: 2/29/20 2/29/20 2/29/20 2/29/20
US Large Cap-S&P 500 -8.23% -5.50% -8.27% 8.21%
US Small Cap-Russell 2000 -8.42% -8.81% -11.36% -4.93%
Foreign Developed-MSCI EAFE -9.04% -8.05% -10.94% -0.58%
Foreign Emerging Mkts-MSCI EEM -5.27% -2.95% -9.68% -1.88%
US Bonds-Barclays Aggregate 1.80% 3.68% 3.75% 11.69%
Long Treasury-20 Yr+ US Treasury Bonds 6.87% 11.04% 14.34% 32.48%
High Yield-Bloomberg -1.41% 0.59% -1.38% 6.10%

For more information see: Cornerstone Investments LLC

Jeff Johnson, CFA

March 1, 2020

 

Big 2019, 30 Years of Ups & Downs, Outlook/Recommendations

What a difference a year makes.  By Christmas Eve 2018, markets were filled with despair at the prospect of a global recession, and the S&P 500 plunged nearly 20%.  Since the panic selling at the end of 2018, markets generated stellar 2019 gains, led by a 31.5% total return for the U.S. S&P 500 index.  At this time the market narrative is giddy and euphoric based on fading fears of a global recession, less concern of a trade war and more accommodative central banks.

WHAT A BULL-WHAT A YEAR!

 

Not Interested in All the Details?  See 2020 Outlook & Recommendations

 

 2019 WAS UNIQUE IN MANY WAYS:

-The year started in the midst of a 35-day U.S. government shutdown that ended January 25, providing a negative backdrop to start the year.  Economic forecasts were downgraded, but this was soon forgotten (markets often have a short attention span) as the government resumed operations.

-The economy generated the lowest unemployment rate at 3.5% since December 1969, 50 years ago when Richard Nixon was President.

-Inflation remained below the Federal Reserve’s 2% target.

-Ongoing recession fears were stoked in late summer by an “Inverted Yield Curve” and then ignored and forgotten.  An Inverted Yield Curve is a phenomenon where long-term government interest rates are lower than shorter maturities.  This situation infers that longer maturities are low because investors are pessimistic on a longer-term basis, and it is typically a precursor to a recession.  Solid consumer spending negated this indicator, however, and markets continued upward.

-The year closed out by continuing the longest economic expansion on record.

-This was the only decade on record without an economic recession.

-Although consumer spending remained robust, manufacturing and capital spending remained weak.

-The year continued the longest bull market on record.

-For 2019, all major asset classes produced above-average returns.  This has never happened before according to Schwab.

SECTORS:

Biggest Winners:  The broad-based technology sector gained 47.9%, and the semi-conductor sub-sector was up 60.0%.  Big stock gainers included Apple up 85% and Microsoft up 55%.

Laggards:  Energy was the weakest sector, up only 4.7%.  The Exploration & Production sub-sector was particularly weak with a decline of -10.6%.  Continuing low oil prices negatively impacted drilling revenues, particularly for the “fracking” drilling companies.

IPOs:

Although the overall market did exceptionally well, some highly anticipated Initial Public Offerings-IPOs were disappointments.

Lyft-LYFT went public in March at $72 and ended the year at $43.02, down -40%.

Uber-UBER debuted in May at $45 and closed down -34% to $29.74.

Beyond Meat-BYND made headlines with their IPO that priced at $25 in April, it soared to $225 by July and then settled at $75.60 by yearend.  Nevertheless, it was up over 200% from its IPO.

-Other notable disappointments included Pinterest and Peloton.  Most of the year’s large technology listings traded below their opening prices.

 

U.S. SMALL CAPS:

US small capitalization stocks have trailed US big caps in the recent past, but the Russell 2000 Small Cap Index still advanced a very respectable 25.5% for 2019.  Although small caps have trailed large caps in recent years, small caps still have higher performance over the time of their long-term history.

 

FOREIGN DEVELOPED:

Foreign developed markets stocks hit their all-time-high of 2,186.65 on January 25, 2018, well in advance of record high levels for the U.S. stock market.  Although foreign stocks trailed U.S. stocks, gains were still respectable at 22% for the broad developed market MSCI EAFE index.  The European STOXX 600 index was up 23.2% and the Japanese Nikkei 225 index was up 18.2%.

 

EMERGING MARKETS:

Emerging markets were big winners in 2017 and the MSCI Emerging Markets index peaked at 1,273.07 on January 26, 2018.  Emerging markets have trailed other markets more recently but finished 2019 up 18%.  Part of the reason for the weaker emerging markets performance is that China is experiencing the slowest economic growth since they began reporting quarterly GDP in 1992.  Nevertheless, the mainland Shanghai stock exchange gained 22.3% in 2019.  Despite Hong Kong’s political struggles with China, the Hang Seng index still managed a 9.1% gain.  Other emerging market notables:  Brazil was up 31.6%, Mexico was up only 4.6%, and South Africa registered a -2.8% decline.

 

INTEREST RATES:

Interest rates continue to confound both investors and economists.  At the beginning of 2019 there was a broad consensus that rates would trend modestly upwards.  Instead, interest rates on the 10-year U.S. Treasury bond moved from 2.66% in January to 1.46% by September 4th.  Rates rebounded somewhat to 1.92% by yearend, but a sharp upward spike above current levels does not look imminent.  It may sound trite, but the phrase “Lower for Longer” has been an apt descriptor and it warrants consideration for the upcoming year.

 

THE LAST30 YEARS-VOLATILE BUT GOOD:

The Last 30 Years:  Much perspective can be gained from taking a longer-term perspective.  The last 30 years have been highly volatile but very good on a longer-term basis.

The Decade of the 1990s began with the emergence of the internet and culminated with the dot com mania.  By the end of the decade there was also the Y2K hysteria related to computer programs not being programmed to handle the transition for dates changing from 1900s to the 2000s (too many software programs supposedly lacked the first two digits of the year.)  Despite alarmist predictions, electric utilities did not encounter shut-downs and planes did not fall from the sky.  In the end, the real winners were the doom and gloom consultants who benefitted from a once-in-a-century opportunity to charge high fees.

The Decade of the 2000s:  While our computer systems handled the transition to the new millennium, we learned belatedly that our internet and “New Economy” fascination was unrealistically optimistic.  Consequently, we suffered a new millennium hangover and an inevitable Tech Wreck.

-The tech-heavy Nasdaq Composite index declined 78% from the March 10th 2000 peak to the October 9th bottom.

-The decade of the 2000s not only suffered from the tech debacle at the beginning of the decade, but also the financial crisis and the Great Recession at the end of the decade.

-The combination of these two downdrafts resulted in the S&P 500 generating a total return of a negative -0.95% for the entire decade.

-Ultimately the decade, known as the “aughts”, came to be characterized as the “Lost Decade.”

The Decade of the 2010s:  After the tech and financial crises of the 2000s, the 2010s followed with a spectacular recovery.

-the decade closed out with the longest economic expansion on record (and still counting.)  It should be noted, however, the current recovery at a 2.3% annualized growth rate is the slowest of all recoveries since 1950.  The average recovery growth rate since 1950 is 4.1%.

-This was the only decade on record without an economic recession.

-The 2010s also included the longest bull market on record and it is still going strong at year-end 2019.  In fact, 2018 was only negative year for the S&P 500 index.  The total return (including dividends) for the S&P 500 since the beginning of the bull market is 490%.

 

INVESTMENT PERFORMANCE:

The previous section provided a graph and high-level comments.  This section provides a table format and additional comments.

Table Below:

Long-Term Equity Performance:  Equity performance was strong but an examination of historic performance shows the importance of diversification.  Asset classes have experienced long stretches of both outperformance and underperformance.  It is important to avoid making investment decisions based solely on recent performance.

U.S. stocks have been the strongest performers over the last 30 years.  Although data is not listed above, foreign developed stocks outperformed US large company stocks in the decades of the 70s and 80s.

Emerging markets outperformed in the 90s and 00s but significantly underperformed in the 2010s.

Long Bonds WERE Great But:  The U.S. Treasury 20 Yr + Index is a long-maturity treasury index that is very sensitive to changing interest rates.  Historic performance has been strong because rates have declined to historically low levels and this forced bond prices to move up.  (This is the inverse relationship between interest rates and bond prices.  Although interest payments are fixed for the life of the bond, declining interest rates cause bond prices to rise.)  If interest rates move up to more normal levels, then bond prices will go down and the total return will be very negative.  (In the case of rising interest rates, bond prices go down.)  For example, if you hold a 10 year bond that pays 2% interest and then interest rates rise to 3%, then you would have to reduce the price of your previously purchased 2% interest bond to a low enough bond price so that the interest earned would match the current market-determined 3% level.

Junk Bonds:  The Bloomberg High Yield “Junk” Bond Index is very sensitive to the economy and defaults in a recession.  Consequently, this asset class performs well during economic expansions, but it underperforms heading into recessions.

 

2020 OUTLOOK & RECOMMENDATIONS:

Outlook Rationale:

Lessons to be Learned:  There are many lessons from both the recent past and also on a longer-term basis that impact the 2020 Outlook.

First, it is highly unlikely that 2020 performance will match the extraordinary 2019 gains.

-Although the U.S. SP500 large cap index WAS the place to be in 2019, it is unlikely to repeat this stellar performance.

-Remember, historic performance is not a good predictor of next year’s performance.

Market Fundamentals:

It is important to remember that market fundamentals are modestly positive, and don’t appear to be in bubble territory.

-Corporate earnings are a key driver of stock market gains.  Although 2019 earnings growth was slightly negative, earnings were up 22% in 2018.  More importantly, corporate earnings are projected to increase 9.6% for 2020 according to FactSet.

-Valuation is another consideration related to stock market performance.  Although the current trailing 12-month Price/Earnings ratio is relatively high at 20 times, it is less over-valued when looking at P/E ratios during periods of low inflation.

-The Price/Earnings ratio is certainly not as extreme as in 1999 when the “New Economy” mindset was the vogue.  The trailing PE in 1999 was 30X compared to 20X today.

-Earnings growth over the last ten years has actually accounted for two-thirds of annualized S&P 500 total return while multiple expansion due to rising P/E ratios accounted for one-third according to BCA Research and the Wall Street Journal.  The current consensus forward Price/Earnings ratio for the S&P 500 is a more reasonable 18X compared to the higher trailing 20X P/E.  As long as earnings growth stays strong, there is more support for equity markets.

-Higher Price/Earnings ratios are not a good predictor of shorter-term investment performance, but they do help predict future longer-term investment returns.  What this means is that current above-average valuation levels may not cause weak short-term investment performance, but these higher valuation levels are likely to cause below-average future long-term performance.  As a result, current higher valuation levels do not indicate an imminent market decline, but they do indicate that future long-term returns are likely to be lower than the historic 10% return level.

-Don’t assume that the big 2019 gains will lead to 2020 losses.  Analysis by Mark Hulbert, a Market Watch columnist, shows that when the Dow Jones gains over 20%, in a year, there is a a 65% chance that the next year will also be positive.  In other words, the market is highly efficient and making investment decisions on a single factor is generally counterproductive.

Wall Street Expectations:

Although institutional investors have a spotty track record in predicting future short-term market moves, the rationale for their predictions is useful.  Based on positive fundamental consensus expectations, Wall Street money managers expect modest 2020 gains.  According to the December 2019 Barron’s portfolio manager tally, the S&P 500 is expected finish yearend 2020 at 3,300, up 2.1% from the 2019 year-end close of 3,230.78.  Similarly, the CNBC Market Strategist Survey shows the S&P 500 ending 2020 at 3,330.

Reasons to track these big money investors include:

– They do good fundamental analysis and their consensus forecasts provide a reasonable baseline.

– It is not wise to categorically ignore the consensus forecasts.  No one is able to consistently predict short-term market moves, but the consensus forecasts indicate what is priced into the market and what might happen as market conditions change.

-It is important to remember that their investment horizon is typically much shorter, and individual investors have the benefit of being able to take a longer-term perspective.

-The FactSet consensus of money managers for the S&P 500 index shows 9.6% earnings growth for 2020.  If corporate earnings are reasonably close to this 9.6% level, then this provides significant market support.

Although these forecasts and outlooks have merit in a base-case scenario, there are reasons for caution.  Unexpected negative surprises happen and can cause significant short-term negative performance.  As a result, it is critical to stick with long-term objectives.

Recommendations for 2020:

Stay diversified.  Don’t be tempted to overweight your big winners.  It is certainly not the time to overweight yesterday’s winners.

Rebalance your portfolio-Your big cap portfolio exposure is likely overweight due to relatively strong performance and should be trimmed.  Funds taken from your large cap holdings could be rebalanced into US small cap, foreign developed and emerging markets.  Investors who rebalanced by trimming their technology holdings in the late 1990s had far better performance than those who blindly rode over the tech wreck cliff.

Don’t try to time the market and make big swings in portfolio weights.  Selling everything and

“going to cash” is not a prudent strategy and neither is “going all in” by abandoning your long-term objectives.  Don’t over-react to either the bullish polyannas or the doom and gloom Perma-Bear crowd.

Tactical adjustments.  Large market timing bets that take your portfolio asset allocation away from your long-term Investment Objectives needs to be avoided.  However, smaller incremental tactical adjustments could be considered.  For example, you could modestly underweight the overall equity weight, and modestly overweight the cash holdings weight.

-Recognize that volatility and bear markets (down over 20%) are a part of investing.  There have been18 bear markets since 1950, and they have all ended with subsequent bull markets.  Although they occur on average roughly every four years, they are notoriously difficult to predict (and profit from.) Since returns are often greatest leading up to a bear market and they are also very strong shortly after a bear market, a market timing strategy might easily miss these periods of significant gains.  Remember, time in the market is more important than timing the market.

-Avoid longer-maturity bonds.  Although longer maturity interest rates are not expected to spike upward, the longer maturity bonds are extremely volatile.  For example, the US Treasury 20-year bond had a total return of 23.4% from the beginning of 2019 through August 31 as interest rates dropped.  Since that time, interest rates have trended upward modestly and that index lost over 8% from September through December.  As a result, the 23% gain through August was reduced to 15.1% by yearend.  A helpful rule of thumb to project future long-term bond returns is to take the current bond yield as an indication of the future annualized performance.  For example, the current 10-year U.S. Treasury note has a yield of 1.92%, and this implies that you might expect a return of not quite 2% a year for the next ten years.  This would not likely be a good investment.  With the 30-year US Treasury bond trading at 2.3%, a return of 2.3% for 30 years would even worse!

To summarize, don’t react to isolated factors, but rather take a broad-based long-term perspective related to investments.  History going back to the 1930s shows a 6.5% S&P 500 earnings growth rate through a wide range of economic and market conditions, and earnings growth is a key driver of market performance.  This 6.5% expected return is less than the long-term historic average of 10%, but it takes into consideration the current relatively high valuation levels.  In addition, this level is supported by numerous successful long-term investors.  Finally, a 6.5% long-term expected return makes sense for reasons of conservatism.  An investor is better off planning for a lower return and then being wrong because the market did a little better.  Having a return expectation that is too high and then coming up short is a much worse outcome.  A diversified portfolio, a long-term perspective and a 6.5% equity return expectation should provide be a reasonable investment approach.  For bonds, current low interest rates mean that a 3% expected long-term return makes sense.  Combining long-term expected returns for a typical 60% equity/40% bond portfolio comes to a 5.1% return on an overall portfolio.

As always, there are no sure things in the investment world, but hopefully this content provides helpful perspective.

Back to Top:

Jeff Johnson, CFA

January 9, 2020

 

Charitable Giving Update And Comparisons-2019

As 2019 winds down, it is important to remember charitable commitments.  The first Cornerstone blog post in January 2018 covered charitable giving, and a key objective of that blog was getting the biggest bang for the (charitable) buck.  Whether consideration is given to charitable Multipliers, Cost/Benefit analysis, or Impact criteria, charitable giving provides immense benefits.  For example, what is the impact of $1,000 invested in education for children within a Christian environment in Haiti compared to consumption of an expensive $1,000 bottle of wine?  Charitable giving also gives the donor a greater sense of purpose and meaning compared to additional portfolio investment gains or consumer spending.  For additional content See original blog Charitable Contributions

Listed below is an update.

America is a very charitable nation:

Americans on a per capita basis voluntarily donate about seven times as much as Europeans and twice as much as Canadians according to the Philanthropy Roundtable.  Philanthropy Roundtable Statistics

Charitable Giving was up 0.7% in 2018:

Americans made $427.71 billion of charitable contributions in 2018.  This was up 0.7% from 2017, but down -1.7% on an inflation-adjusted basis.  This giving accounted for 2.1% of US GDP.

Giving went to the following major groups:

Religion remained the largest charitable category in the U.S. at $124.52 billion and 29% of total giving.  Giving to religion (Christians and all other faith groups) was down 1.5% from the prior year.  This decline is partly explained by negative 2018 stock market performance, but the 2017 tax law changes were another significant factor.  (More commentary below in the Tax Law Change section below.)  A longer-term factor is that religion continues to lose market share to other charitable categories over the last 30+ years.

Education (14%),

Human Services (12%),

Grantmaking Foundations (12%),

Health (9%).

Charitable Giving USA

Charitable Giving by Source:

Individuals contributed 68.3% of total giving at an estimated $292.09 billion.  Individual giving declined 1.1% in 2018 compared to the year before, and much of this decline can be attributed to the stock market decline and the 2017 tax law change.

Foundations increased contributions by an estimated 7.3%, to $75.86 billion in 2018.  Data on foundation giving are provided by Candid (formerly known as the Foundation Center).

Bequests totaled an estimated $39.71 billion in 2018, remaining flat with a 0.0% increase from 2017.

Corporations charitable giving is the smallest category at 4.7% of total giving.  Corporate giving for 2018 came in at $20.05 billion, up 5.4%.  Although the stock market was negative in 2018, corporate profits were up.

Charitable Giving USA

Other Charitable Statistics:

Giving by income level:  As one would expect, wealthy individuals give the highest $ amount, but the lower-income group (households making $25,000-$45,000 in current dollars, not the truly poor) gives more than middle-class Americans based on a percentage of income.  While only about a third of low-income individuals give any money at all, those that give are extremely generous and are highly motivated by religion.

Religious practice is highly correlated with generous giving.  Although religious givers (Christians and all other faith groups) strongly support religious causes, they are also more likely to support secular causes than the non-religious.

Red state versus Blue state:  “The electoral map and the charity map are remarkably similar” with red states correlated with higher charitable giving.  Or to quote the Chronicle of Philanthropy’s 2012 summary of its giving research, “the eight states that ranked highest voted for John McCain in the last presidential contest…while the seven lowest-ranking states supported Barack Obama.”

Philanthropy Roundtable Statistics

2017 Tax Law Change Impact:

One important change affecting individual 2018 giving is the drop in the number of individuals and households who itemize charitable and other deductions on their tax returns. This shift came in response to the federal tax policy change that doubled the standard deduction. More than 45 million households itemized deductions in 2016.  Various studies indicate that itemizing tax deductions may have dropped to roughly 16 to 20 million households in 2018.  Given that more individuals and households (using the higher standard deduction) received no tax benefits from charitable contributions, it is somewhat reassuring that individual charitable giving declined by only 1.1%.  This is a complex issue with many variables and it will take several years for a more definitive understanding of the tax law change on individual contributions.

Volunteering:

Approximately 30% of the adult population,77 million Americans, volunteer their time, talents, and energy to making positive contributions according to the National Philanthropic Trust.

Americans contribute $167 billion of their time to communities, assuming the 2017 national value of volunteer time is $24.69 per hour.

The top four types of organizations that use volunteers are: religious (32.0%); sport, hobby, cultural or arts (25.7%); educational or youth service (19.2%); and civic, political, professional or international (6.2%).

The top four national volunteer activities are fundraising or selling items to raise money (36.0%); food collection or distribution (34.2%); collecting, making or distributing clothing, crafts or other goods (26.5%); and mentoring youth (26.2%).

Charitable Giving Statistics

Sites for checking Charities:

Since we all want the “Biggest bang for the buck”, it is helpful to view websites that rate various charitable entities.  These sites help identify key factors including giving effectiveness, fund-raising costs and overhead costs.  Some good ones are as follows:

http://givewell.org/

https://www.charitynavigator.org/

http://charitywatch.org

http://guidestar.org

Center for High Impact Philanthropy-CHIP is the University of Pennsylvania’s multidisciplinary nonprofit center that focuses on maximizing social impact.  https://www.impact.upenn.edu/

Charitable Giving Tax Requirements, Considerations and Strategies:

Request a receipt if you make a donation of $250 or more to a single charity. But if the donation is in cash, you’ll need a receipt or supporting bank records, regardless of the amount.

-Tax Deductibility.  If your standard deduction exceeds your charitable contributions and other deductible expenses, then you likely won’t itemize deductions on your tax return.  Even though the standard deduction precludes charitable tax savings, your favorite charities still benefit, and this generosity likely greatly exceeds any income tax savings.

Long-term capital-gain property:  You can deduct the full fair market value of appreciated long-term assets (like stocks or mutual funds and Exchange Traded Funds) that you’ve held for more than one year.  In addition, if you donate stocks or other investments, you pay no capital gains tax.  Donating highly appreciated securities–instead of cash can be a very effective and tax-efficient way to support a charity. Generally, if your assets have appreciated in value, it’s best not to sell securities to generate the cash you need for a donation because you pay tax on the capital gains.  Contributing the securities directly to the charity increases the amount of your gift as well as your deduction.

If you are holding securities with a loss, it’s usually better to sell first. By doing so, you can take the capital loss for tax purposes and then donate the cash.  The tax aspects of charitable giving can be complex and it is good to discuss your personal situation with a tax professional.

Donor Advised Funds:  Given the fact that the 2017 tax law doubled the standard deduction, some individuals may consider “bunching” their charitable contributions to enable them to itemize deductions only in some years.  A Donor Advised Fund-DAF can be used to accomplish this bunching strategy whereby you contribute multiple years-worth of giving into one year in the DAF.  These bunched contributions can rise to a level that allows itemizing deductions and getting a tax reduction in that year.  This aggregated amount can be contributed to a DAF maintained by a financial institution like Schwab Charitable, Fidelity Charitable or many others.  A DAF contribution in a particular year may enable eligibility for itemizing deductions in that year and thus a deduction for the DAF contribution.  Then in subsequent years the donor can direct that the funds in the DAF be distributed to certain organizations over a number of years in the amounts and at the times desired.

Donations Directly from your IRA Account:  Individuals who have attained the age of 70 ½ are required to make Required Minimum Distributions-RMDs.  However, instead of making these RMDs and paying taxes on these IRA withdrawals, tax law allows qualified charitable contributions up to $100,000 to be directed from IRA accounts to a preferred charitable entity.  This allows a reduction of your taxable income if you do not itemize deductions (and thus do not receive a benefit for charitable deductions).

 

Charitable giving has many dimensions and broad-based benefits.  Hopefully this update and the original blog are helpful.  As always, your comments and feedback are appreciated.

Jeff Johnson, CFA

October 26, 2019