What’s Next for the Economy and Markets?

crystal-ballTough question. A more relevant question would be: “How do I obtain long-term investment success?” We’ll discuss both today.

First, the economy and the markets are not correlated over the short-term. Last week’s overall market selloff again demonstrates this. Yes, over the long-run, there is a correlation between GDP growth and corporate earnings. But data demonstrates that over the short-term, there is no correlation.

Second, it is imperative to filter the noise of the media and put the current situation in broader context, than to guess about the future. Our economy is still recovering from the 2008 credit crisis. Similar crises were followed by weak GDP and job growth. The Fed confirmed last week that we are following this historical pattern. Since September 2012, when the latest QE program started, the unemployment rate has fallen from 7.8% to 7.6%. The Fed expects GDP to increase 2.3-2.6% this year. Inflation is up only 1.05% year over year.

Of course, these results, and the stock markets, have been influenced by easy money policies. Since 2008, the fed funds rate has been near zero. Hence, the Fed has employed additional policies to boost the economy. The most significant has been QE. The Economist on Friday described Chairman Bernanke’s tough assignment: “In a zero-interest rate environment, the central bank can influence monetary conditions more through words than through actions.” Mr. Bernanke’s comments last week, which pointed to the path that actions were “data dependent” were interpreted (perhaps incorrectly) by many investors to mean greater “hawkishness” (tapering was about to start). Virtually all markets tumbled.

The economic data doesn’t support a change in the bond-buying policy. Unemployment is still at 7.6%, labor participation rates are near 29 year lows, inflation expectation are falling, and perhaps, most importantly, there has been no substantial improvement in job growth:

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Yet, despite the weak pace of overall growth, the recovery in the last four years seems to be getting smoother. The housing market is up, the energy sector is booming, auto sales are improving, household finances are looking healthier and consumer confidence is at a five-year high. The Fed has increased its 2014 growth forecasts to 3% to 3.5%, from a March forecast of 2.9% to 3.4%. So, we’re making progress, but will it continue? And, if so, when will tapering start?

We agree with Yogi Berra, who said: “It’s tough to make predictions, especially about the future.” We humans are not so good with making accurate predictions. However, these days, you can generally find an opinion to confirm almost any point of view. In fact, studies have shown that the most confident, specific forecasts are a) most likely believed by readers and viewers, and b) least likely to be correct.

We prefer to focus on the long-term. People seem to lose sight of their financial future in the midst of all the noise. Most of us have a long-term investment horizon- perhaps 20, 30 years or more. During that time, we can expect bull and bear markets, volatility and short-term market swings. Emotional reactions to short-term events and media noise can cause you to miss market rallies and doom you to long-term investment failure.

You need a disciplined investment strategy and perhaps a full-time professional investment adviser to help you with it. Your asset allocation needs to represent the three asset classes; stocks, bonds and alternatives, with further diversification within each asset class. Your portfolio needs to be reviewed continually and rebalanced regularly. You need to make your capital work for you all the time, and not leave money sitting in cash. Over time, asset allocation, diversification, rebalancing and mean reversion will all work in your favor.

So, we won’t focus on predictions. Instead, what we will do is to help you establish and maintain a long-term probability-based investment approach that should reap dividends and investment success for you for years to come. Give us a call. We’d be happy to chat.

Media Scare Tactics: The Coming ‘Bond Bubble’

Is the media scaring you about the so-called coming ‘Bond Bubble’? Block out the noise and focus on what matters: asset allocation.

With all the hoopla going on about fixed income being the possible next “bubble”, I thought it prudent to talk about asset allocation. Fixed income is just one part of a well-balanced portfolio. At DWM, we believe in multiple asset classes including traditional asset classes like fixed income and equities, along with alternatives.

You do not want to all-out avoid or shun an asset class. We’ve seen people that have been out of equities since 2008 and they’ve missed one of the biggest bull markets in history.

You also do not want to load up in just one asset class. We saw people that were in 100% stocks going into 2008 that felt the full pain of a 35-50% drop. That’s a deep hole to dig out of.

The key is balance. A case can be made that everyone should have about at a minimum 20% allocated to each asset class. So how does one determine what percentage of equities, stocks, and alternatives their portfolio should have? DWM does this by identifying your goals, risk tolerance, return objectives, income needs, time horizon, and other special requirements. As every client is unique, so is each client portfolio. A younger client with a high risk tolerance may be 50% equities / 20% fixed / 30% alternatives. An older client with low risk tolerance may be 20% equities / 50% fixed / 30% alternatives.

Take a look at the graphic below which shows a sample individual investor portfolio versus an institutional portfolio from 2009:

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You can see that institutions have the majority of their assets allocated to alternatives. And because of it, they have had pretty good success. The individual investor is just starting to catch up, as access (or rather the previous lack thereof) to alternatives has changed. Until the last several years, only institutions and the extremely wealthy had access to alternatives. Furthermore, there were high minimums, lock-up periods, bad transparency, and high expenses that were not practical for the individual investor. But that is really changing. We at DWM have been using liquid alternatives for the last several years. More and more of these liquid alts come available almost every day.

In a time and age where the 30 year bond bull market may be coming to an end and a time when the equity market is being called “overheated”, alternatives may offer a complementing asset class that can give your portfolio better overall risk-adjusted returns. Alts can play many different roles in a portfolio from return enhancer to fixed income substitute to diversifier. They can provide investors insurance against declines to the traditional 60 / 40 model. They can mitigate downside risk and lower volatility.

Now, don’t get me wrong: there is no silver bullet. Not all alternatives are created equal, and not all are going to be consistent winners. But with a diversified portfolio consisting of all asset classes, you should have a much smoother, consistent ride which can ultimately lead you to better financial success.

The Underwater Beach Ball Effect

beach ball underwaterRemember as a kid holding a beach ball underwater, then letting it go? It’s fun. It’s also quite unpredictable as it returns to equilibrium.

The Federal Reserve is now facing the same task with long-term interest rates. Rates have been artificially submerged since the financial crisis in 2008. Can the Fed curtail their unprecedented monetary stimulus program without major fallouts to the economy and the financial markets?

On May 22nd, Chairman Bernanke told a congressional panel that he did not foresee an immediate reduction to easy money. However, hours later, the minutes from the last Fed meeting were released. These showed a growing number of governors want to start to “taper off” as early as next month. The markets have been rattled since then. The concern is: can the Fed “taper” off the quantitative easing without damage? It would be quite a balancing act. And, we, of course, are in uncharted waters.

Things had been going swimmingly since last September. The Fed has been buying $85 billion in bonds every month, lowering the long-term interest rates and boosting economic growth. The strategy appears to be working. The economy is growing, unemployment is shrinking, the housing market is recovering and the stock market has been soaring. The Fed had promised to keep the program going until there was a “substantial improvement” in the job market. We’re getting close. However, the markets have been spooked for the last seven trading days.

On Friday, U.S. Treasuries posted their biggest losses in more than two years, pushing yields to twelve month highs. The 30-year mortgage rate rose to 3.81% nationwide. Fixed income investments of all types declined in value, particularly currencies and emerging markets.

The S&P 500 has been down over 2% since May 22 and other equity subclasses, such as international, small cap and emerging markets are down even more. Many of the liquid alternative holdings have been flat, however, global real estate is down significantly, and gold is up in the last seven trading days. It’s one of those short periods of time when almost every investment is down.

The good news is that the economy has in fact recovered sufficiently that the Fed is considering tapering off easy money. That’s great. However, at this stage, we have no idea of the timing or the results of tapering. Bond interest and stock prices are connected, though not in a simple way. If bond interest rates rise too rapidly or too high, they will raise the cost of credit for companies and stock prices will be hurt. However, if interest rates are able to return to, let’s say, 5% or 6% that might have little impact on stocks.

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So what’s an investor to do? Should you do something or nothing? During periods of stress and volatility we suggest you focus on what you can control and learn to roll with what is out of your control. For example, none of us can control what the Fed does, what the major media report as front page news, interest rates or market actions. What we can control is our long – term investing plan, our asset allocation and the wealth manager we use.

It’s especially important at these times to review your long-term financial goals, risk profile (risk tolerance, risk capacity, and risk perception) and asset allocation. Most portfolios need a diversified mix of stocks, bonds and alternative investments. And, they need an experienced, proactive, trusted wealth manager like DWM, who has protected and grown client assets through volatile periods, just like the one we may be encountering now. Give us a call.