Arrrrrrrrrgh!

sb frazzleLet’s all go ahead and be emotional and let out a big scream. Arrrrrrrrrgh! These stock markets are really frustrating. After a lackluster 2015, equity markets are down around 10% in 2016. Of course, a balanced account might “only” be down 5% in 2016, but that still doesn’t feel good. Aren’t markets supposed to rise in Presidential Election Years?

Generally, that’s true. Since 1933, the S&P 500 has risen 8% per year in election years.

The simple fact is that politics is likely having a big impact on the markets. Certainly, investors are concerned about the price of oil, slowing world economic growth and China. But, a major part of the anxiety is very likely being caused by the presidential race. It’s similar to the impact that the Ebola scare had on the markets in mid-2014.

Think of it. In a normal election year, whether we are Republican, Democrat or Independent, we find a candidate that we think can make a change for the better in the U.S. and perhaps the world. We support that candidate with the hope and the optimism that things will be better after the election. In part, this typical election year optimism has helped produce historically good returns. Hence, there appears to be both a correlation between election year and good results and a likely causation.

So, what do we have now? Two political outsiders whose popularity has been largely anti-establishment. Donald Trump’s and Bernie Sanders’s victories in New Hampshire were seen as a vote of no confidence in the nation’s economy and the political status quo. Yet, while their supporters are happy to show their anger at the current situation and hope for change, neither candidate has any proven track record of being able to accomplish on a nationwide level what they propose.

Investors of all kinds are skeptical and concerned. The two “establishment” candidates, Jeb Bush and Hillary Clinton, are struggling.   There is a real question as to what would happen if Trump or Sanders was elected. This has likely helped spook investors, big and small.

Remember, too, that Mr. Trump is, according to the NYT, strongest among Republicans who are less affluent and less educated. Mr. Sanders appeals to a wide variety of people and has raised millions of dollars of support without the aid of a Super PAC. In Tuesday night’s victory speech, he thanked his more than one million supporters who contributed an average of $27 to his campaign. Their supporters are not your typical investor or Wall Street firms. Hence, this optimism generated by both candidates from their supporters doesn’t translate to typical election year investor optimism.

Then we have the omnipresent media. Every day we are besieged by the newspapers, TV and other sources filled with political content, much of which is pure useless trivia. Most candidates are all quite happy to drone on about the current problems and how they alone have simple solutions to fix everything. Educated people and institutions who represent the bulk of investors aren’t buying it. The result: a gradual, “grinding” downward slide that is worse than a fast panic-driven rout. It’s like everyone is bringing up the negative over and over and the “Group Think” pushes the equity markets down.

Brett was on a Goldman Sachs conference call yesterday discussing market volatility. They reiterated what Schwab, BlackRock and others have said. Yes, there continues to be concerns about China, credit/rates, oil, and expectations of monetary policy. They think there is a 15% chance of recession in the next 12 months. Which is good because any year on average is 24%. They summed it up this way, “There is a disconnect between fundamentals and what the market is saying. Take it easy, stay disciplined, stay diversified, and stay invested.”

We agree, the markets may continue to be choppy for 2016, particularly if a viable, experienced candidate, known and trusted by the investment community doesn’t move to the head of the pack. In the meantime, we suggest you let out a big scream and wait for the markets to swing back and catch up with the fundamentals. We know they will, we just don’t know when.

DWM 2015 Year-end Market Commentary

Uncertainty imageIf you had to summarize the markets in 2015 with one word, it would be “uncertainty”. Much of the reason for the poor performance of stocks, fixed income, and alternatives can be chalked up to uncertainty…uncertainty of what the Fed was going to do with interest rates, uncertainty to when oil supply and demand will come into balance, and uncertainty surrounding China’s economy. In last quarter’s market commentary, we wrote about having just finished an awful August/September stock market drubbing, only to see equity benchmarks almost fully recover in October. Unfortunately, the good vibes didn’t last long as another sell-off commenced in December after the Fed raised interest rates for the first time in over nine years. The end result: 2015 going down as the first losing year since 2008 for many investors.

Here’s how the major asset classes fared in 2015:

Equities: The MSCI AC World Equity Index registered -2.4%. Emerging markets really took it on the chin, losing 14.9%, as represented by the MSCI Emerging Markets Index as falling commodity prices and the strengthening US dollar hurt these countries’ economies. On paper, the big cap US market benchmarks appeared to do better with the S&P500 only down 0.7% before reinvested dividends, but that is skewed by the outperformance of some of the largest capitalized names like Facebook, Amazon, Netflix, and Alphabet (formerly Google). Remove those names and the S&P500 would have similar figures to the Russell 2000 Small Cap Index (-4.4%) or the Russell Mid Cap (-2.4%).

Fixed Income: Fixed income investors aren’t jumping for joy at this year’s end. The Barclays US Aggregate Bond Index was up just a tiny bit, +0.6%; but the Barclays Global Aggregate Bond Index declined 3.2%. It was worse off in the high yield aka “junk” market which finished the year -4.5%. This index was weighed down by energy companies where long term solvency has come into question given these extremely low oil prices.

Alternatives: In theory, asset allocation using a diversified approach helps investors over the long run. This was a very untypical year in that the three major asset classes (equities, fixed income, and alternatives) finished the year with very similar small negative results, with the Credit Suisse Liquid Alternative Index down -1.0% for the year. We wouldn’t expect that trend to continue for 2016. For more detailed info on alternatives, please see our blog from last month at http://www.dwmgmt.com/why-alts/ .

At the time of this writing, the stock market is not off to a good start in 2016, with the Dow tumbling more than 1000 points in the first week, as the uncertainty of the Fed, China, and oil continues. But let’s chat about those three items.

  1. The Fed and interest rates: The Fed has indicated that it wants to keep raising, but at a very gradual rate. The last thing they want to do is harm the economy or US or global growth. In fact, Fed officials expect that rates will still be below 3.5% in late 2018. So this is not the same thing as slamming down on the brakes when going 80mph.
  2. China’s slow-down: This is not a one-time 2015/2016 event. China is undergoing a necessary and positive adjustment, shifting from an economy based on heavy manufacturing towards one based on service. This will take years to convert so investors should simply expect these type of headlines and not fear them.
  3. Oil prices: Consumers are loving these lower prices at the gas pump, but it’s creating havoc in the global markets. There’s a disequilibrium: demand is up, but supply is up more, way more! Many energy companies are suffering. Imagine if your paycheck got cut in half or more. It’s very hard to live on severely reduced income. You still have the same fixed costs. So what do you do? You can borrow money and hope for prices to recover, but they may not and you may go bankrupt. This ballgame is only in the middle innings and could get uglier. Fortunately, for the US consumer, these lower oil prices means extra money in our pocket which most likely leads to spending and boosting our economy even more.

2016 isn’t another 2008 in the making. Major market declines typically occur when the economy is heading south. That’s not the case as the US economy is one of the world’s healthiest right now: there’s strong job growth, solid inflation-adjusted wage growth, and cheap gas prices. For diversified investors, there are opportunities in areas where selling has been overdone and market cycles start to reverse. It’s been a rough start in 2016, but a long-term investor remembers to stay the course, be disciplined, and be rewarded in the end.

Uncertainty is the one thing that is certain about financial markets.  Expect it, but don’t fear it.

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

REMINDER: Markets Don’t Go Straight Up!

Most equity markets were down 3% today, and most equity are markets down 5% this week! It’s the worst week for the Dow since 2011! The Dow is now in correction territory. What’s going on???

It’s been an unusual year. January and February were quite good. But not much has happened since then until this week’s market sell-off.

China’s apparent slow-down seems to be the main catalyst to what triggered this week’s ugliness, but we continue to have the uncertainty as to when the Fed will raise rates, if/when Greece will leave the Euro, and mixed second quarter earnings reports and economic news.

It is times like these that investors need to remember that markets don’t just go straight up. Markets don’t work that way- they go up and down! Not every calendar year can be an “up” year. As a long-term investor, you not only stay invested, but even may see this as an opportunity to buy more.

There have been over a dozen market pullbacks of 5% or more since March 2009. This is another one! Generally, when the market comes back, it does so quickly. So, it’s a fool’s game to try to time the market and jump in and out of it. No one has a crystal ball. Furthermore, we know that over time that staying invested is your friend. Studies show that just missing a few days of strong returns (which we could very well get next week or later this month), can drastically impact overall performance.

The market constantly over-reacts and then reverts back to the mean. Do not get caught up in emotion and sell and buy at the worst times. Unfortunately, humans are not wired for disciplined investing and usually trade poorly based on fear. They wind up selling at the lower prices (on fear) and buying at the higher prices (on elation) per the graph below.

Emotions

I’m sure many readers are nervous after this latest week with all this uncertainty in the air. However, if you use a wealth manager, like DWM, we can help you focus on what can be controlled:

  • Create an investment plan to fit your needs and risk tolerance
  • Identify an appropriate asset allocation target mix
  • Structure a well-balanced, diversified portfolio
  • Reduce expenses through low turnover and via passive investments where available
  • Minimize taxes by using asset location, tax loss harvesting, etc.
  • Rebalance on a regular basis, taking advantage of market over-reactions by buying at low points of the market cycle and selling at high points
  • Stay Invested

In closing, a pullback / correction like this one might actually be a very healthy thing because it may signify that the underlying assets’ valuation is getting back in line with fundamentals. So don’t get anxious over this latest short-term market volatility. By all means, there is a lot of “noise” this month. We’ve seen “noise” before and we’ll see “noise” again. Instead, remember that, over the long-term, the markets have rewarded discipline, through world events of all types. Check out the graph below, put your mind at ease, and have a great weekend. Let us deal with the “noise” and give us a call if you’re still feeling anxious next week.

Markets Have Rewarded Discipline

Ask DWM: What Does China Devaluing its Currency Mean to Us?

Barron's Chinese YuanGreat question. Thanks. China is a very big deal. Much bigger than Greece (see DWM blog 6/30/15). China is currently the world’s second largest economy, about 60% of America’s GDP. It is expected to surpass the U.S. in nominal terms in 11 years. And, by 2050, China is expected to have a population of 1.4 billion (vs. the U.S. at 400 million) and GDP 50% larger than the U.S. For the last 25 years, China’s economy has grown at a 10% annual rate. In 2015, the growth is expected to be 7%.

China devaluing its currency last week came as a big surprise to many. In our blog of July 29th, we featured an article about the Big Mac Index with the Economist’s report showing that, on an adjusted basis, the Chinese yuan was undervalued by 9%. Until last week, the Chinese government’s strategy has been to keep their currency within a narrow trading band against the dollar. And, then last week, the news came out of Beijing that the country will now link it more closely to market forces. There were two major reasons.

First, they are trying to keep their growth and employment high. As we discussed in that July 29th blog, the WSJ Dollar index has risen 22% in the last 12 months. Since last December, the dollar index was up 9% as was the Chinese currency, the renminbi, otherwise known as the yuan. This meant that the cost of Chinese goods for people in the Euro zone, Japan, or the UK was 9% more than it was at the beginning of the year. As a result, Chinese goods have become more expensive abroad, as American goods have. And, this is hurting the Chinese economy big-time in growth and employment. Exports dropped by 8% in July. Furthermore, China experienced a stock market crash in the last few months as well.

One of the key tools that countries use when they are experiencing a downturn is to devalue their currency. Typically, this is what allows countries to stay competitive in the market place by making it cheaper for their customers to buy their products. Being tied to the USD wasn’t working. So, last week, the Chinese government allowed the yuan to become more market driven and it declined in value by 2%. At this point, it is difficult to determine what the future value of the yuan will be. The 2% is not in itself a big deal, but it may lead to a 10% devaluation or more (Barron’s August 15th). However, the linking to market forces is a big deal and represents the second reason.

China’s government wants its currency to become globally pre-eminent. They want the renminbi to be recognized as a reserve currency, along with the USD, the euro, the yen and the British pound sterling. Two weeks ago, Christine Lagarde, head of the IMF, said that the renminbi was not quite ready for inclusion in the basket of securities the IMF uses for “special drawing rights” because China needed to make its currency more “freely usable.” And the policy change last week, by moving to a more market based valuation, is a step towards inclusion.

So, what does the devaluation and potential slowdown in China mean? In the long-run, it’s tough to say. In the short run, it’s another source of concern and uncertainty for investors. Uncertainty and doubt has been the mood of the markets since March, when strong economic data in the U.S. caused the Fed to start talking about increasing interest rates. That uncertainty was followed by the uncertainty about a possible ‘Grexit’. And, now we’ve got China. At other times, the devaluation might have been seen by investors as good news- that China now is using a competitive tool to stimulate growth. But, instead it was received as another uncertainty, which, together with the other concerns have caused stock markets to go sideways for over 5 months now.

Here’s a great example: Apple stock. On July 21st, Apple reported quarterly results that were “amazing”- revenues up 33% and earnings per share up 45%. Yet, investors focused on the lower demand for the iPhone and the smartwatch not meeting expectations. Apple stock has dropped 11% in the last four weeks.

It’s a frustrating time for investors. Some are quick to start extrapolating that the last five months of flat markets may extend for years. It’s a frustrating time for wealth managers, like DWM, as well. However, we know, as Barry Ritholtz pointed out in his Bloomberg column last week, time is our investing ally. People are often stuck in the short-term, focusing on recent events and projecting those out for the future. Just because the markets have gone sideways for the last five months, does that mean they will continue to languish indefinitely? Yet, despite its lack of growth the last five months, the world stock markets have been up over 15% per annum since March 2009. In the last 40 years, including the dot.com bust and the financial crisis in 2008/9, a diversified, balanced investment portfolio has likely increased more than 7% per year.

We know that in the long-term that the power of compounding is in our favor. Yet, that mathematical concept can be difficult to accept emotionally at times like this. It is now one of our chief jobs as total wealth managers to stress that it is important to stay disciplined, stay focused on the long-term, stay invested and not let emotions drive irrational behavior based on short-term events.

Big Macs, Gold, and Sugar

biggestBigMacBig Macs are a real bargain in China. On average, only $2.74 versus $4.79 in America. In Switzerland it will cost you $6.82, Norway $5.65, Euro area $4.02, Chile $3.27, Russia $1.88, and India $1.83. These values are from The Economist’s Big Mac Index, their annual survey to provide information on exchange rates.

The Big Mac Index was started in 1986 to provide a guide as to whether currencies are at their “correct level.” It is based on the theory of Purchasing Power Parity (PPP) which holds that in the long run exchange rates should move towards equalization of an identical basket of goods and services. Therefore, the Big Mac “raw” Index would suggest that the Chinese yuan was undervalued 43% to the dollar currently and will likely rise in the future.

However, the rise will likely be much less than 43%. This is because you would expect that a burger would be cheaper in poorer countries than in rich ones because labor costs are less. Hence, the Economist also compares the Big Mac price to GDP per person to get an adjusted index. When we use the adjusted index, the yuan is calculated to be 9% undervalued. India is estimated to be 34% undervalued and Switzerland 13% overvalued using the adjusted index.

The stronger U.S. dollar (USD) is very apparent in the raw and adjusted Big Mac Index. Over the last 12 months, the WSJ Dollar Index has risen 22%, mostly in anticipation of an interest rate increase by the Fed. The dollar’s gains are a burden for commodities, which are priced in USD and become more expensive for overseas buyers when the dollar gains in value. Gold and sugar are two commodities that have been dramatically impacted by the strong USD.

Gold hit a 5 year low last week propelled by a stronger USD, improving economic conditions, investor sentiment, and expectations the Fed will raise rates. Gold does well in response to unexpected crises (such as the financial crisis in 2008/2009), but not so for long-simmering troubles like the Greece situation. Furthermore, a diversified stock portfolio, as measured by a world index, has gone sideways (unchanged) for the last twelve months. And, with interest rates expected to rise and gold not paying any interest or dividends, investors have been moving out of gold. Furthermore, China and its citizens who have been big buyers of gold have tapered off their purchases. First, investors wanted to get into the roaring Chinese stock market instead, but as that market keeps sliding there is little liquidity to buy gold.

Of course, we think of gold as a kind of insurance policy. There’s a cost when things are good (markets are moving up) or moving sideways because gold is holding or losing value. But, when a crisis develops then this insurance helps mitigate the damage. A few percentage points of gold in your portfolio helps. Gold was up 2% in 2008 when stocks were down 35% or more.

In a similar way, sugar fell to a six year low last week. In the past year, sugar prices have fallen by 25%. Brazil has been supplying one quarter of the world’s 180 tons of sugar annually. The value of the Brazilian real has fallen 17% against the USD this year. As the value of the currency falls, it encourages producers and exporters to sell supplies on global markets, because it becomes more profitable for them when they convert the USD sales back into local currency.

Last week, Brazil’s cane growers announced they are in for an unusually large crop, increasing the worldwide supply. In addition, artificial sweetener production, including China’s Sucralose is expanding rapidly. As alternatives to natural sugar flood the global market, prices for real sugar declines.

I always look forward to the Big Mac Index. It is both fun and educational. The Big Mac Index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. It helps explain, in part, why gold and sugar hit 5 and 6 year lows last week. And the Big Mac Index lesson is much more easily digested than many of the economics lectures and papers many of us have had to endure. Here’s to McD’s, In n’ Out Burger, Five Guys, Shake Shack, and more. Keep ‘em coming.