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

SEE ALL POSTS

Coronavirus Comments-March 1, 2020

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

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

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

Market Record, Panic, New Record-What’s Next?

The table above shows the strength of the U.S. stock market, and especially the large-cap S&P 500 Index.  Despite weakening global economic growth and continuing trade war fears, U.S. and foreign equity markets are up double digits so far in 2019.  Fixed income performance has also been strong based on falling interest rates and corresponding bond price increases.

 

The U.S. stock market set an all-time record last September, then it panicked on fears of an imminent global recession, and now it is at a new all-time high.  This volatility shows the market’s animal spirits working in both directions.  At this point, the gains are based on expectations for lower interest rates and trade talk progress with China.

President Trump continues to criticize Fed Chair Jerome Powell, but Powell recently said the central bank is “insulated from short-term political pressures”.  Regardless, the Federal Reserve looks certain to cut the Fed Funds rate by 0.25% in their July 31 Fed Open Market Committee meeting.  Second quarter earnings reports will also help determine second half performance.  It is interesting to note that strong earnings growth in 2018 and 2019 has helped keep the market valuation at moderate levels.  The current 16.7 forward Price/Earnings valuation is in line with the 16.6 average PE for low inflation (range of 0-2%) time periods since 1950.

Beyond Meat-BYND was a notable IPO.  The company sells plant-based burgers and is up over 360% since its May 2 opening price.  This is an interesting business model, but it also shows a fair amount of investor euphoria.

 

The Russell 2000 Small Cap Index is nowhere near the 2018 highs but it is still up 17% YTD.  The small caps haven’t rebounded like US large caps.  On a longer-term five-year basis, small cap stocks have trailed the large cap S&P 500 by nearly 4% annualized.  This under-performance is likely to be reversed in the future.

 

Trade and central bank monetary policy continue to be critical to the outlook for global stocks. A comprehensive trade deal between the U.S. and China is unlikely in the near-term, notwithstanding the June 29 “truce” between Presidents Trump and Xi Jinping. The hope is that there will be a resumption of serious negotiations between the two sides.  The European Central Bank recently indicated that the ECB will consider monetary easing.  In the UK, economic growth continues to lag due to Brexit uncertainty.  For example, the June Manufacturing Purchasing Managers Index came in at 48.0, down from 49.4 in May.  This is the lowest level since February 2013.

 

Emerging markets led all major markets in 2017 with a 37.3% gain but they fell 14.6% in 2018.  Emerging markets are up a respectable 10.6% so far in 2019.  Emerging markets are very cheap and will be a big beneficiary as the US reduces interest rates.

 

The 10-year US Treasury interest rate closed at 2.00% on 6/30/19.  Interest rates for longer maturity bonds have been relatively volatile in recent years.  For example, the 10-year US Treasury recorded an all-time low of 1.36% on July 8, 2016.  Then it moved up to a 3.23% closing yield on October 8, 2018.  Since then, the 10-year interest rate has trended downward again.  Although longer-maturity interest rates may move up modestly, muted expectations for economic growth means that the phrase “lower for longer” looks appropriate.

The strong high-yield bond performance, so-called junk bonds, is largely the result of less fears of an imminent recession and the corresponding bond defaults.

 

What To Do Now:

It is nearly impossible to consistently call short-term market moves, regardless of whether you are a big-money institutional investor, a CNBC talking head, or an individual investor.  It is more important to ignore the daily “Breaking News” and maintain your focus on your long-term Investment Objectives.

The large market moves, however, do require the disciplined practice of rebalancing your portfolio.  With US stocks leading the market, it is an opportune time to take your US equity holdings down to 70% of total equity holdings.  US large cap stocks in particular should be rebalanced into foreign developed and emerging markets.  Your overall equity weight is also likely above your investment objective and this necessitates moving holdings into fixed income and cash.

The current market strength provides an excellent time to make charitable stock gifts.  If you are retired, this is also a great time to refill your cash bucket.

This is clearly not a time to abandon your Investment Objective.  If you have an investment adviser, then find out your portfolios’s asset allocation compared to your Investment Objective.  If you don’t have an adviser, then you need to determine your current asset allocation. See DIY  Regardless, you need to prune any high-cost funds in favor of low-cost index mutual funds and ETFs.

Remember, high market levels promote euphoria, or at least complacency and these higher levels usually have more downside risk than negative markets.

Jeff Johnson, CFA

July 13, 2019

 

 

Educational Investment Seminar-Take Aways

This past March I held an educational investment seminar based on my career experience as an institutional and high net worth investor. The seminar content was also based on my Cornerstone Investments website. Since I am retired, this was simply a labor of love to provide investment and financial planning guidance and recommendations. There was no revenue to me and there was no effort to get business or clients, but rather an effort to provide independent and objective advice. Although the bulk of the seminar content covered typical investment and financial planning items, I also included sections on charitable giving and impact investing from a Christian perspective.   CornerstoneInvestmentsLLC

See Topic Content Here.

(The content is also listed further down this post.)

This was not a typical investment seminar with a fancy “gourmet” dinner and a pitch for an annuity or a stock strategy guaranteed to make you rich. Instead of a typical 2-hour dinner/presentation with a maximum of 6 Powerpoint slides, we started on a Friday evening and then continued Saturday morning. The seminar included a 77-page course book, and I tried hard to get through as many slides as possible. Not really. Actually, the plan was to cover items in the book that had broad interest. Ultimately, we covered about half of the content of the book. The seminar was held at my home church (Peace Church, 2180 Glory Drive, Eagan MN.) Attendance included 16 individuals with ages ranging from the 40s to 80. Most attenders were from Peace but there were several others as well. This proved to be a good-sized group that allowed time for discussion during the formal presentation and for additional comments during breaks.

Although there was no revenue to me, there was a recommendation to make a charitable contribution to the Peace Church General Fund. It felt good that the event generated $840 for the General Fund. “Professional” was a key seminar objective. My wife, Carol, has an IT background and she designed the professional marketing materials and formatted the course book for the seminar. She also played funny and engaging YouTube videos to provide light moments after complicated topics. Although there was no fancy dinner, there was plenty of good healthy food and ample leftovers that went to our Lao congregation for their Sunday morning lunch.

Although a broad group like this had different levels of interest and knowledge, we primarily focused on topics of common interest. Nevertheless, some topics that were covered had an interest level ranging from “High” to “Extremely Low.” For example, stock valuation elicited a range of reactions from enthusiastic to “when is he going to end?”

It was certainly a busy Friday night and Saturday morning. The Q&A portions were particularly beneficial as participants and I shared experiences and perspectives. Feedback showed a need for less jargon and more definitions. Another comment related to action steps on how to get started investing with the first $5,000. Some thought topics were covered too quickly, but there was a broad consensus that the content was applicable to real-world situations. I was told that I needed more of Carol’s funny YouTube videos, but I was not told what to cut out. Referrals were also provided for estate planning and a couple local advisers. Unsurprisingly, Pastor Tim and the Deacons welcomed the unbudgeted additional funds! On an overall basis, the evaluation responses were very positive and there were numerous requests for additional course books that necessitated a second printing. The word-of-mouth channel generated multiple requests to do it again. The feedback was constructive and it should be helpful as I consider a seminar targeted at millennials.

Highlights of Topics with the Most Interest:

Advisers/Brokers, Robo-Adivsors, Do-It-Yourself and Fiduciary:
This part of the seminar generated the most interest and discussion. Although many people might prefer a root canal to dealing with investment and financial planning items, there was a clear understanding of the need for a rational approach to retirement, education and other priorities. Most individuals would not attempt brain surgery on themselves, and they take their car to a local professional for overall maintenance, but they still remain uncertain about investment services. Here are a few key points:

The Do-It-Yourself (DIY) approach, sometimes called Self-Directed, is possible with a disciplined approach but it is not recommended for most individuals. Do It Yourself

-I think that most individuals need a trusted adviser that is a fiduciary. This service can be provided through either the traditional Registered Investment Advisor-RIA model or the robo-advisory services model.  See Outside Advisors

-I believe the new Robo-Advisory services that include access to an adviser are services that provide the right solution for many, and I also believe that these services will become increasingly popular and effective. See Robo Advisors

-Some brokers provide good service, but there is reason for caution for brokers due to potential conflicts using the commission-based model. See Brokers

Indexing:
Indexing is a an increasingly common and effective investment strategy. Indexing essentially uses low-cost index funds and it is generally best for most investors, whether large or small. Indexing is characterized as a passive form of investing that seeks to replicate all the stocks and their weights in an index like the S&P 500 index without attempting to pick outperforming stocks. Passive indexes stand in contrast to Active Investing. Active investing involves mutual fund portfolio managers who pick individual stocks with the expectation of generating a higher return than their benchmark or index. Most studies conclude that a passive index strategy generates higher returns than active strategy. See Active & Passive Investing.

Rebalancing:
Rebalancing a portfolio is necessary to keep the investment holdings in your portfolio at the appropriate weights. Since the various investment holdings within the portfolio generate different percentage returns over time in volatile markets, the overall portfolio increasingly deviates from your overall investment objective. As the portfolio gets increasingly skewed away from your investment objective, the portfolio is ncreasingly likely to generate lower returns and higher risk. Link in Terms. See Rebalancing

Financial Planning Accumulation Phase:
Analysis from Fidelity and JP Morgan show investment guidelines and mileposts for individuals at different ages and investment levels. For example, the analysis provides guidelines for investment levels for a 40 year-old seeking a specified portfolio level at retirement. See Asset Accumulation/Retirement MilePosts

The 4% Rule of Thumb for Retirement:
The 4% rule for retirement withdrawals is widely cited within the financial press and the financial planning community/industry. Although every situation is different, the 4% rule is a good starting point. However, I believe that a 4% withdrawal rate is too high due to current low fixed income interest rates and higher equity valuation levels. As a result, a 3.5% withdrawal rate offers more long-term security.

Social Security Claiming Break-Evens:
The Social Security section covered different social security claiming strategies based on analysis from Morningstar. Examples showed breakeven age levels for claiming social security at age 62 and at age 70. See Social Security into Website.  See Social Security

Charitable Contributions:
A primary objective of my Cornerstone Investments website is to bring a Christian perspective into the investment process. As a result, charitable contributions and stewardship are key factors. Items covered in the seminar focused on the benefits of giving to the local church, local missions and international missions. A key point of the seminar focused on economic studies showing the benefits of early-childhood education. Economic analysis also showed child sponsorship in foreign countries as having the biggest bang for the buck. Finally, websites were listed that rated charities based on their effectiveness, administrative costs, etc. Charitable Contributions

Values-Based Investing:
Values-based investing became prominent in the U.S. in the 1980s as Socially Responsible Investing sought to restrict investments related to the anti-apartheid movement in South Africa. In addition, Faith-Based investing developed based on religious convictions and the strategy generally avoids sin-stocks centered around alcohol, pornography, tobacco and gambling. Abortion, weapons and nuclear power are other common screens. Many faith-based investments also consider workplace issues and environmental factors.

Environmental, Social and Governance Investing-ESG is becoming increasingly common. ESG includes:
-Environmental-Climate change, emissions and waste, and resource efficiency.
-Social-Diversity, human capital & safety, product integrity and supply chain management, and community relations.
-Governance-Board & executive diversity, corporate structure, accounting & transparency, executive compensation.

Various mutual funds and ETFs were included in the analysis. The Vanguard ESG US Stock-ESGV, is a Cornerstone recommendation and a personal holding for Carol and I.  See Values-Based

Other Topics:
Other topics covered are listed in the Cornerstone website including Investment Objectives, Budgeting, Annuities, Fees & Expenses, Historic Investment Returns by Decade back to the 1920s, Expected Future Investment Returns, Stock Valuation and Markets & Economics. These topics are included in the CIA website.

Final Comments:
This seminar was an effort to Major on the Majors and to provide independent and objective investment advice. The Cornerstone website has even more content. Moreover, there are many professionals who can provide services for complicated and unique needs and objectives. Needless to say, I hope that this blog post and the links are beneficial for readers. Comments to this blog are always appreciated and helpful. At this point, I am considering a seminar targeted for millennials. And who knows, maybe the presentation will be updated and presented at Peace Church again.

Jeff Johnson, CFA
May 22, 2019

A Wild Year, A Great Decade and a Market/Economic Disconnect

A Wild Year:

The year started optimistically with an expectation of continued synchronized global growth, benefits of U.S. tax cuts, and a forecast for 20% earnings growth.  Based on these optimistic assumptions, the markets shot up to an all-time high in January, then plunged in February, then set a new all-time high record in September, then cratered by Christmas Eve and then finished with a modest, belated year-end Santa Claus rally.  The year looked schizophrenic and December was the worst December since 1931.  The wild seesaw swings makes one wonder if the so-called investment pros have convictions that last longer than 10 minutes.  Through it all, it is hard to believe that the S&P 500 total return was only down -4.38%.

 

Major Benchmark Performance: Last
December Year-To-Date 10 Years
US Large Cap-S&P 500 -9.03% -4.38% 13.12%
US Small Cap-Russell 2000 -11.88% -11.01% 11.97%
Foreign Developed-MSCI EAFE -4.85% -13.79% 6.32%
Foreign Emerging Mkts-MSCI EEM -2.66% -14.58% 8.02%
US Bonds-Barclays Aggregate 1.84% 0.01% 3.48%
Long Treasury-20 Yr+ US Treasury Bonds 5.62% -1.98% 3.37%
High Yield-BA Merrill Lynch HiYld Bonds -2.19% -2.26% 10.99%
12/31/2018

Some Notable Highlights/Lowlights:

First, the FAANGs were De-Fanged.  Facebook, Apple, Amazon, Netflix and Google (the FAANGs) were darlings for many years.  Apple’s market value briefly exceeded $1 Trillion, but it took a tumble when iPhone sales and pricing didn’t match lofty expectations.  Facebook took the biggest slide (down over 39%) as the company faced slowing growth and increasing security/data privacy issues.

The “crypto craze” also imploded as BitCoin fell 80% from over 19,000 last December to 3,747 by year-end 2018.

Ultimately, most asset classes declined and there was nowhere to hide.  As interest rates rose and stocks declined, the decade-long stock mantra “There Is No Alternative”-TINA lost its luster.  By the end of the year, the cash is trash crowd was de-throned, and the cash is king stalwarts were rewarded.  Market psychology turned sour and the “buy the dips” trade was replaced by “sell the rallies.”

The Best & Worst Sectors:

U.S. economic growth exceeded expectations and resulted in the best growth rate in over a decade, but only two sectors were able to achieve positive performance:

-Health care was up 4.6% and utilities were up 0.5%.

Meanwhile the biggest losers were:

-Home builders which were down -35% as rising mortgage rates crimped housing sales.

-Energy fell -20.6% as crude oil fell -26% to $45/barrel by yearend.

The Best and Worst Regions:

Although most international markets were down, Brazil was a surprise winner with a 15.0% gain.  This was based on the election of President Jair Bolsonaro and the prospect of a more business-friendly environment.

The Chinese Shanghai Composite was the biggest loser at -24.6% due to the looming trade restrictions and a slowing economy.  Germany’s DAX was down -18.3% as tariffs hurt their automakers and other global exports.  Finally, Brexitmania uncertainty caused the UK FTSE 100 to drop by -12.5%

A GREAT DECADE:

Despite the December 2018 carnage, the current decade proved to be very respectable.  This is especially true when we think back to the intra-day low of 666 (yes, 666) in March 2009.  In reality, 2018 was the only negative year in the last decade for the S&P 500.  Moreover, the 10-year return was an above-average 13.12%.

 

A MARKET/ECONOMIC DISCONNECT:

The sharp December market decline was largely precipitated by a fear that the Federal Reserve was raising interest rates too quickly, and by a fear of an imminent recession.  A trade war with China was another wild card that could make any recession even worse.  The rise of algorithmic trading also exacerbated the downside volatility.  According to the Wall Street Journal, roughly 85% of all trades are now completed based on algorithms, quantitative models and passive trading.  These trades are on autopilot and they essentially sell more when markets are going down and buy more when markets are going up.  This amplifies both downside and upside market moves.  Historically, markets traded more on fundamentals of the economy and individual companies.  Finally, the lower stock prices caused a wave of tax-loss selling.

Meanwhile, economic data and corporate earnings reports were far stronger than what was happening with the markets.

-The economy is on track to grow at a 3% rate this year, the highest growth rate since before the Great Recession.

-Corporate earnings are on track to grow by a hefty 20% for 2018.

-Employment is at the highest level since the 1960s.

-Consumer spending is strong, and MasterCard just reported U.S. retail sales surged this holiday season (Nov. 1 through Dec. 24), rising 5.1% from last year’s level and the strongest growth rate in six years.

-Market valuations have become cheap.  Although stock market valuation levels were elevated at the beginning of the year, the combination of unexpectedly strong earnings and lower prices means that valuation levels are cheaper than average historic levels.

Looking to 2019, there are signs that growth rates are moderating:

-Europe and China are clearly experiencing economic growth rates that are slowing.

-Although 2018 corporate earnings came in at a blistering pace of 20 percent, earnings for 2019 are still projected to be a respectable 7.9% according to FactSet.

-GDP growth, meanwhile, likely will fall from its 3 percent pace this year, but most economists are still looking at gains in the mid-2 percent range for the year ahead.  If this growth rate turns out to be correct, then it would be the second strongest GDP growth in the past decade, after only 2018!

It is noteworthy that economic data and forecasts can be wrong, and a downside scenario is clearly possible.  Further, the talk of recession could be a self-fulfilling prophecy.  When the drumbeat of negative commentary becomes excessive, it impacts consumer and business confidence.

Finally, it needs to be said that Corrections (down between 10 and 20% from the previous high) and Bear Markets (Down more than 20% from the previous high) are normal.  The post-war period saw 31 corrections and 11 bear markets.  the average decline from the peak to the bottom has been 18.7%.  Within that context, the 2018 market decline was typical of the risk inherent in the overall stock market.

WHAT TO DO NOW:

No one knows for sure how the market will perform for 2019.  There are too many variables and too many unknowns to make precise forecasts.  Nevertheless, market/economic fundamentals and history provide guidance:

-History shows that large downdrafts like we saw in the 4th quarter are likely to be followed by above-average performance in subsequent 1, 3 and 5 year time periods.

-Current valuation levels are modestly below long-term averages, and these cheaper valuation levels are usually followed by periods of stronger performance.

-Although it is never easy, it is helpful to remember the sage advice from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

So, don’t be a seller at these levels.  Do not abandon your long-term strategy based on these short-term price moves and headlines.  Rebalance your portfolio so that you maintain target weights for the various asset classes.  Finally, remember that the long-term averages were filled with numerous unforeseen declines and gains.

Jeff Johnson, CFA

January 3, 2019

Investments: Faith-Based & Environmental, Social and Governance

GOOD INVESTMENT RETURNS & POSITIVE IMPACTS:

Wouldn’t it be great to achieve your investment goals while changing the world for the better?  What’s not to like?  Faith-Based and Environmental/Social/Governance-ESG investments provide a Values-Based strategy to structure investments to be consistent with personal values and to achieve positive impacts.  Examples of positive impacts would include less tobacco and a cleaner environment.  We would certainly not want our investments to support pornography or companies that cause toxic releases into our environment.  For example, it would be desirable to avoid situations like the notorious Union Carbide chemical gas plant toxic release in Bhopal India that killed nearly 3,800 people.  More recently Volkswagen was caught in a scandal where they were cheating on emissions standards for their diesel-powered vehicles.  Currently, Under Armor is receiving bad publicity for corporate reimbursement of employee expenses at strip clubs.  Although it is impossible to know all the bad actors in advance, there are increasing investment opportunities to help match your personal values with positive impacts.  This blog article provides information to help guide your investment decisions to align your investments with your values while helping achieve a greater positive impact.  The Stewardship and Investment Impact gives additional information.

DEFINITIONS:

Investors and the media tend to use various terms and titles interchangeably and there are no set standards, but hopefully the definitions listed below will be helpful.

Values-Based investing falls into two broad categories:

  1. a) Faith-based and
  2. b) Environmental, Social & Governance-ESG. Sustainability is often associated with ESG investments.

Faith-Based investing is based on religious convictions and the strategy generally avoids sin-stocks centered around alcohol, pornography, tobacco and gambling.  Abortion, weapons and nuclear power are other common screens.  Many faith-based investments also consider workplace issues and environmental factors.  Environmental issues are sometimes characterized as evangelical environmentalism or as “Creation Care.” concerns.  Creation Care holds that the earth and its produce and inhabitants belong to God, not to humanity and it is humanity’s role is to be a good steward.  For example, the National Association of Evangelicals encourages restrictions on consumption that are destructive or polluting.

Environmental, Social and Governance Investing-ESG includes:

-Environmental-Climate change, emissions and waste, and resource efficiency.

-Social-Diversity, human capital & safety, product integrity and supply chain management, and community relations.

-Governance-Board & executive diversity, corporate structure, accounting & transparency, executive compensation.

Impact Investing seeks a positive, measurable impact while hopefully achieving a market rate of return.  Faith-based and ESG funds generally include Impact Investing as part of their investment objectives.

Screens are used in investment fund construction/maintenance by fund managers to eliminate certain companies with negative attributes and add companies with positive attributes.

Socially Responsible Investing-SRI is a term that goes back to the 1960s to describe investment funds that were based on social screens as a key part of their investment objectives.  SRI is essentially the forerunner of ESG.

Three general investment strategies to achieve positive impacts:

-First, negative and positive screens are used.  An example of negative screens would be seeking to bar alcohol and tobacco.  An example of positive screens would be to favor companies that have environmentally safe records, good affirmative action policies, community involvement or high charitable giving standards.

-The second strategy involves shareholder activism.  Fund managers can solicit shareholder votes and use proxy statements to advance ethical business practices, such as diversity, fair pay, and environmentally friendly policies.

-The third strategy, direct investment, is used by institutional and large individual investors (like Bill Gates) to invest in companies or technologies to achieve their desired impacts.

HISTORY:

Values-based investing goes back to the 17th century when the North American Quakers refused to profit from weapons sales and the slave trade.  The term “Socially Responsible Investing”-SRI-emerged in the  1960s by shunning sin stocks and then weapons stocks during the height of the Vietnam war.  Luther Tyson and Jack Corbett, associated with the United Methodist Church, worked with investment managers Paul and Anthony Brown to launch Pax World Fund in 1971.  Pax World used social as well as financial criteria in making its investment decisions.  By 1982 The SRI strategy participated in the anti-apartheid movement by banning investments in companies operating with South Africa. Ultimately apartheid ended in 1993 and Nelson Mandela was elected president.  After the anti-apartheid movement was successful, SRI investors focused on human rights, military, labor and the environment.  Christians, and particularly Southern Baptists, were a significant part of the SRI movement.  Although the term SRI is still used, ESG is more common today.

INVESTMENT PERFORMANCE:

Although there is a perception that there is a trade-off between achieving either good investment performance or good impacts, numerous studies indicate good performance is correlated with good outcomes.

-An examination of 25 studies by Morningstar showed that there was no performance penalty.  Between 1990 and 2016 Morningstar found that the MSCI KLD Social 400, a sustainability index, outperformed the S&P 500 index by 0.81%/year.

-The CFA Institute reports that “Innumerable studies have taken various approaches to assess the correlation between high levels of ESG commitment and performance.  Overall, they conclude that there is no performance penalty for ESG integration and it is possible to achieve risk-adjusted returns similar to a traditional portfolio.”

-DePaul University professor Daniel Koys and others completed research that indicates that providing better pay, ongoing training, and making employees feel secure-helps companies achieve financial goals.  The rationale is that if companies takes care of their employees, then the employees will be motivated to take care of the customers.

It should be noted that past performance provides no guarantee of future performance, but it is encouraging that past performance has not come at a large investment performance penalty.

CORNERSTONE VALUES-BASED INVESTMENT RECOMMENDATION:

I have completed significant due diligence and analysis related to numerous fund families and over 100 specific funds.  Based on this research, the Vanguard ESG US Stock ETF-(Ticker ESGV) is recommended for individuals interested in a values-based investment holding.  This fund holds a diversified mix of US stocks ranging from large cap to small cap and it provides a mix a faith-based and ESG exposure.  Vanguard’s website says: The fund’s index excludes companies involved with tobacco, alcohol, adult entertainment, firearms, gambling, nuclear power, and unfair labor practices.  In addition, The fund’s index includes companies with superior environmental policies, a strong hiring and promotion record for minorities and women, and a safe and healthy workplace.  Although the fund is new, it is patterned after the Vanguard FTSE Social Index Inv-VFTSX which has the highest 5 Star Morningstar rating (over the last 3, 5 and 10 years).  Although this is a Vanguard fund, it can be purchased through Schwab, Fidelity, and other major brokers.  (In fact, Cornerstone recommends purchasing this fund at Schwab, Fidelity, or elsewhere rather than at Vanguard due to Vanguard’s persistent client service problems.)

 

It needs to be said, that each person has their own values, and a fund that is attractive to one individual may not be attractive to another individual.  Further, not all attributes of a fund may match a person’s values.  Nevertheless, this Vanguard fund looks to offer a reasonable fit for many investors.  Finally, if you have an adviser, you could discuss this fund to see if it fits in your current portfolio.

OTHER INVESTMENT FUND OPTIONS

There is no clear delineation between faith-based strategies and ESG strategies.  In fact, many faith-based funds incorporate significant ESG criteria.  Moreover, many ESG funds have criteria that incorporates aspects of faith-based funds.  To help differentiate between faith-based and ESG investments, I defined faith-based as those funds that proscribed alcohol, adult entertainment and gambling, (regardless of whether or not they also used ESG).  Values-based funds not using these faith-based screens are categorized as ESG.

Values-based investing is growing rapidly and there are many fund families and individual funds to consider.  Examples are listed below to provide greater information and context.  The examples are not at all comprehensive, but they are reasonably representative of the options available.  Obviously, this investment space is large and there are many investments that are not included.  The examples below are not investment recommendations, but are listed to help show what is available.  If any holdings from the examples are being considered, then there should also be a careful determination of which share class is appropriate.

Faith-Based Examples:

Ave Maria funds represent Catholic beliefs.  The Ave Maria Value Fund-AVEMX is their most prominent example.

Eventide Funds constitute a broad mix of faith-based and ESG criterial.  The Gilead Fund-ETILX has been a strong performer.

GuideStone Funds.  Affiliated with the Southern Baptist Convention.  The GuideStone Equity Index Investor-GEQZX has been a strong core holding.

iShares MSCI KLD 400 Social ETF-DSI.  The MSCI KLD 400 Social Index excludes companies operating in the weapons, alcohol, gambling, nuclear power, adult entertainment, and general ESG criteria.

Praxis Funds.  Mennonite fund family that traces its roots to the Anabaptist movement in the 1500s.  The Praxis Growth Index I-MMDEX has been a strong growth fund holding.

New Covenant Funds are based on the social-witness principles of the General Assembly of the Presbyterian Church (USA).  The New Covenant Growth Fund-NCGFX is a main fund.

Timothy Plan.  The Timothy Plan offers a broad-based fund family based on Christian screens.  The Small Cap Value A Fund-TPLNX (TPVIX I share) was their first offering  in 1994 and it remains their top performer.

Vanguard Funds-The Vanguard ESG US Stock ETF-ESGV is a Cornerstone Investment recommendation, and it is similar to the FTSE Social Index-VFTSX.  The Vanguard ESG International Stock ETF-VSGX provides international exposure.

ESG Examples:

Calvert.  Calvert was an early leader in the SRI movement and remains a key player in ESG investing.  The Large Core Responsibility Institutional Fund-CISIX remains a core holding.

Fidelity US Sustainability Index Fund-FITLX-Index that targets highest ESG-rated companies.

MSCI USA ESG Index-SUSA  The MSCI USA ESG Index uses an optimization approach to maximize exposure to companies with strong ESG characteristics.

PAX World Funds-PAXWX.  This is the original PAX fund and it is a balanced fund that maintains a mix of approximately 60% equity and 40% fixed income.

TIAA-CREF has been doing responsible investing for 40 years and the Social Choice Equity Fund-TISCX institutional and TICRX retail funds represent a broad-based ESG strategy.

 

Let me know what you think:

This blog barely scratches the surface of values-based investing and Cornerstone maintains significantly more information.  Feel free to contact me at jjohnson@CornerstoneInvestmentsLLC.com.

 

Jeff Johnson November 9, 2018

 

 

Investment Guidelines 101-(Are Financial Advisers Worth It?)

</aInvesting and Planning-Worse than a Root Canal?

Some things in life really matter-a lot.  Financial resources for food and housing matter much more than your choice of socks or lunch today.  Adequate retirement resources are critical to ensure that you don’t need to work on your last day on earth.  (The joke is that you don’t want to have to cut your cash flows so closely that the last check that you write bounces.)  The reality is that people experience far too many mismatches between spending and portfolio income, and the retirement years are not so “golden.”

Whether the 1%, middle income or lower income, good decisions and implementation are critical.  Like everyone, you have investment and financial planning needs and you probably wonder about the best course to meet these needs.  If you don’t have any adviser, then should you get one?  If you have an adviser, then is this person meeting your needs?  After all, your role as the proverbial Walmart greeter should be because you like getting out and meeting people, not because you are short of cash.  On a more serious note, you want the financial flexibility to fund college (whether for yourself, your kids or your grand-kids) and you also want flexibility related to healthcare choices and other living expenses.

Finding answers can be overwhelming for some, and pure drudgery for others.  A typical response for many is to simply procrastinate.  But the needs don’t go away and the adverse consequences of procrastination compound exponentially over time.  Nevertheless, it seems some would rather have a root canal than have to deal with these matters.

 

CORNERSTONE Criteria and Guidelines-A Roadmap:

The objective of this Cornerstone blog is to provide some basic criteria and guidelines.  The blog gives both a high-level overview with general information, and also links to provide much greater detail.  People and circumstances are unique so there is no simple cookie cutter answer, but the intent is to provide objective content to help meet your needs.  The information should help determine the type of professional counsel that you may need.  It may also help evaluate costs and benefits of any current advisers.  Hopefully the content is worthwhile so that you don’t have to fall back on your brother-in-law (who sold used cars before getting into investments.)

 

INVESTMENTS:

At a basic level, you need a strategy and tactics so that your savings can be invested in a way to meet your needs.  This involves a determination of your Investment Objectives and Risk Profile.  See Investment Objectives .  It also involves an Asset allocation Plan to help meet your objectives.  See the  Cornerstone Asset Allocation example .  This plan should utilize primarily mutual funds and Exchange Traded Funds-ETFs rather than stocks of individual companies.  The Asset Allocation Plan provides diversification and rebalancing, and it involves the appropriate mix of:

  1. a) equity and fixed income,
  2. b) domestic and foreign,
  3. c) large and small capitalization,
  4. d) Other assets. There are many other asset classes that can comprise your Asset Allocation Plan as the portfolio size increases.

Major Investment Options:  Although the development of Investment Objectives and Asset Allocation Plans may seem daunting, the good news is that there are many potential strategies and options.  Moreover, technology has made investing easier and less expensive, and online websites are excellent.

Investment options are as follows:

  1. a) Do It Yourself (DIY).
  2. b) Robo-Advisers.
  3. c) Outside Advisers-Registered Investment Advisors.
  4. d) Outside Advisers-Brokerage/Commission.

Do It Yourself:  For many individuals, the default is the DIY model.  DIY is common because most people aren’t interested in investments, they don’t know where to go, they don’t know who they can trust and consequently they simply take whatever comes their way.  The DIY approach typically produces mediocre outcomes and it is not recommended unless you commit to a disciplined approach.  If you follow a disciplined approach, however, the results can be excellent.  A major DIY risk is an over-concentration in risky assets in bull markets and then fear-driven selling during bear markets.  This is called Buy High and Sell Low.  See Do It Yourself .

Robo Advisors:  A better strategy for most is a modified DIY that utilizes Robo Advisers.   “Robo Advisor” is a generic term for an investment platform that offers investment advice based on computer algorithms.  These algorithms are designed to assess your overall investment risk/return profile and then recommend an investment portfolio.  These Robo Advisors then monitor your portfolio over time and make adjustments to rebalance the portfolio to stay aligned with your strategic allocation as the market changes over time.  These programs are capable of producing a disciplined investment approach, and they are typically a very low-cost approach.  A major issue regards the lack of human contact and counsel in the event of a large market decline.  For example, would you feel comfortable trusting a computer algorithm in another severe market downturn like we saw in 2008/early 2009?  Robo Advisors are also impersonal and lack the intuition and personal touch of an experienced adviser.  To address these concerns, some Robo services are incorporating supplemental services that include contact with a live person.  See  Robo Advisers.  Cornerstone strongly believes that these Robo Advisor platforms are an excellent choice for individuals who are comfortable with technology and who do not need face-to-face interaction.

Registered Investment Advisers:  For many individuals, a RIA is the best solution.  These advisers typically provide both investment advice and financial planning services.  RIAs can provide advice that is tailored to an individual’s unique needs and circumstances.  A fee-only RIA offers fiduciary advice (See Fiduciary below), and compensation is based on a fee that is typically 1% of Assets Under Management-AUM for a $1 million portfolio.  Fees vary based on portfolio size and are lower for larger portfolios due to economies of scale.   Some advisers may charge both an AUM fee and a planning fee.  Some RIAs charge a flat fee and some charge based on an hourly fee.  Hourly rates for financial planners often range from $150 to $300.  There are many considerations in selecting and working with an RIA.  See Outside Advisers .  RIAs use both Passive and Active investment styles, and Cornerstone recommends RIAs that utilize the passive/index investment approach Passive/Active Investments .

Note:  the RIA description above is generalized.  While many RIAs are fee-only and they handle both client investment portfolios and financial planning services, there are also pure financial planners who are fee-only, but they do not handle investments.  There are also RIAs that call themselves “Wealth Management” firms.  Some Wealth Managers have the capabilities to handle high-net-worth clients with complex needs, but many other so-called wealth managers are less skilled and they use the wealth management term as a marketing ploy.  Finally, there are dually-registered RIAs who receive both fees and commissions and are best described as fee-based.  See  Outside Advisers  .

Brokers:  Brokers constitute another major category for outside investment services.  Traditional stock brokers, insurance agents and commission-based advisers have business models where they are compensated for commissions on trades.  Some of these individuals offer both investment services and financial planning services.  Some of these businesses may also offer investment advice for a fee instead of commissions.  There are some highly skilled individuals offering excellent advice for a commission, but there are also many who do not.  Whenever a commission is involved, there is a potential embedded conflict of interest.  There is always a question about whether the trade benefits your portfolio or whether it is more beneficial to the broker.  There can also be questions related to doing more trades to generate more commissions.  Brokers also tend to use more higher-cost actively managed products that tend to underperform.  It needs to be said that commissions may be an economic choice for very small portfolios.    Outside Advisers  

 

Key Investment Considerations:

Fiduciary Standards are a key consideration if you choose an outside adviser.  Fiduciary Standards require that an adviser act in the best interest of the clients.  Stated simply, a fiduciary places your interests above their interests.  Cornerstone is generally cautious about the brokerage business model because brokers are not fiduciaries and current laws and regulations hold brokers to a lower standard than RIAs.  Whereas RIAs need to act as a fiduciary in the best interest of the client, brokers must only provide investments that are “suitable”.  As a result, brokers and may use products with high commissions rather than an alternative with lower costs.  RIAs with dual registrations may have the same potential conflict of interest because they can offer commission-based products.  Historically, partnerships and Variable Annuities are other examples of investment products that have high commissions and lower investment returns.  The Department of Labor has proposed rules that require brokers to have a fiduciary standard similar to RIAs for retirement accounts but courts have struck down this provision.  At this time it is difficult to know what fiduciary standards may develop from the various regulatory agencies and the courts.

Passive/Active Investments.  Another key consideration involves Passive versus Active investment management.  Your Investment Objectives and your Asset Allocation Plan can be structured, implemented and managed in a number of ways.  When considering your options, it is important to understand the distinction between Passive and Active investments.  Passive investments use low-cost index funds, whereas Active investments utilize a higher-cost strategy to find investments that “beat the market.”  Research shows that Passive Index investments typically outperform Active investment managers.  At its worst, active management pitches hot products like Bitcoin at its peak.  See Passive/Active Investments .

Adviser/Broker Compensation:  If you are considering an outside adviser, or you already have an adviser, then you need a clear understanding of their compensation and all the costs and expenses included in your portfolo’s investments.  Unfortunately, most individuals do not understand the compensation and costs/expense structure in their working relationship with their adviser.  Many advisers and brokers do not provide the necessary transparency, and they may make you feel like you don’t trust them when you inquire.  It’s your money and it’s their job to provide full disclosure regarding these costs.  When advisers are vague, or when they say investment costs are not something that they can control, then simply move on.  Life is too short and the consequences may be too large.

 

FINANCIAL PLANNING SERVICES:

Financial Planning services provide practical guidance and tactics to meet a wide range of individual financial needs.  Financial planning needs are generally very basic for people just getting started with jobs and careers.  Your needs may be as simple as a monthly budget and a payroll deposit into an investment account.  Over time, however, life gets more complex and there is an increasing need for financial planning services.  Financial planning services may involve complex tax and estate planning strategies for a corporate executive.  Although the DIY approach for financial planning works, there is often a point where professional help is essential.  Cornerstone has links that cover basic topics, but cost-effective financial planning services are available through many Robo Advisor programs, and more comprehensive services are available through RIA firms.  Good financial planners have the experience and judgment to be able to provide good objective advice.  For example, telling clients they are spending too much, or investing too little, or taking too much risk.

Financial planning examples include:

Cash flow budgeting to provide guidance for monthly income and spending.  Mint is a free personal finance tool to create a budget and Quicken is another excellent product.  Finally, a simple Excel spreadsheet can handle simple budgets.  See Cash Flow Budgeting.

Managing debt is critically important and includes items like consolidating credit cards, paying off student debt, securing a mortgage and establishing flexibility for refinancing a mortgage.

Retirement Investments are a major financial planning service.  This involves assessing the amount of money to invest for an expected lifestyle.

This involves determining:

a) guidelines for financial planning life stages, contribution rates and withdrawal rates.

Financial Planning Life Stages and Link.Life Stages

b) Assessing progress towards achieving retirement goals. It is good to examine several models to get a more robust perspective on achieving your retirement goals. Cornerstone includes models from Fidelity, JP Morgan and T. Rowe Price.  Cornerstone has also developed a sophisticated model that allows you to input your own data and generate your own scenarios.

See Asset Accumulation/Retirement Mileposts Link.  Asset Accumulation/Retirement Mileposts

College costs and funding are increasingly expensive, and strategies are essential to prepare for this high cost/high reward expenditure.  See Investment Products link. College Funding

Tax preparation, planning and strategy is another key financial planning service.  Cornerstone maintains basic tax considerations in the Taxes Link.  Turbo Tax offers easy-to-use software for tax preparation for easy and moderately complex tax returns.  Some RIAs incorporate tax preparation in their planning services, and this is beneficial because it integrates tax loss harvesting and tax planning into the investment process.  CPA services are also available for moderate to complex returns.  See Tax Link.Tax

Insurance coverage is another consideration to meet various potential adverse risks.  Once again, online services provide easy, cost-effective comparisons and Geico and Progressive are two good online examples for auto and homeowner coverage.  Online services are also available for term life insurance.  Finally, health care insurance is critical, but this is complex and requires specialists in this field.

Estate Planning becomes increasingly important as individuals become older and as they have a wide range of assets and larger portfolios.  It is ironic, but there is a large need for people to get good advice to transfer and divest the assets that they accumulated during their lifetime.  This involves wills, trusts and other complex strategies and Cornerstone recommends specialized legal advice.  It should be noted that some RIAs incorporate estate planning into their overall financial planning advice.

 

FINAL WORD/FEEDBACK:

This summary was designed to educate and to provide an objective overview of typical needs based on my career observations.  It is certainly not all-encompassing and it definitely benefits from feedback.  Feel free to Reply with all comments, recommendations and corrections.  jjohnson@CornerstoneInvestmentsLLC.com.

 

June 22, 2018