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

Ask DWM: What Does the Fed’s Decision Last Week Mean?

FED logoThat’s a very important and good question.

Last week the Federal Reserve decided to hold rates steady. The uncertainty as to when they will raise rates has been extended to at least October and, if not then, to December or beyond. A Fed rate hike has been in the air since March when the Fed removed the word “patient” from its press release, signaling it could increase rates for the first time in nine years. Rates were reduced to zero in 2008 during the financial crisis and haven’t moved since.

This uncertainty has made markets very skittish. After a January and February when all asset classes were up, March through July was flat overall. Since the week after July 4th, the S&P 500 has alternated between weekly declines and gains for 11 consecutive weeks. China’s devaluation of the yuan in August (see the DWM blog) and the related concerns about its growth and that of emerging markets, caused a 6-7% pullback in stocks in August.

As we have pointed out previously, investors hate uncertainty. It’s interesting though. History shows us that equities typically do well during the tightening cycle (raising of rates by the Fed) and a year after the initial rate rise. (This is based on results in seven different time periods from 1983 to 2004). Hence, the uncertainty may be more disruptive to the markets than the actual tightening (raising of rates).

It’s valuable to look at the Fed’s decision and related statements in greater detail. They did acknowledge the U.S. economy is expanding at a “moderate pace” with “solid job gains and declining unemployment.” There is concern, however, about global growth. China, which has been growing at double digits, is now expected to be 6.8%. And other emerging market countries are struggling, particularly those whose income comes from oil and commodities. A decade ago, China accounted for 9% of the world GDP, now it’s 16%. Emerging markets overall now account for 57% of world GDP, up from 46% in 2004. We’re all interconnected, so lower worldwide economic growth impacts business earnings and stock valuations.

The other key factor is that inflation has failed to reach the 2% Fed target the last three years. Furthermore, the Fed doesn’t expect it to get there until 2018. What the Fed is trying to do is gradually raise rates at just the right time(s) before inflation hits 2% such that there will be a nice “soft landing” near 2% without the economy heating up and pushing inflation up too much and too quickly. At the same time, if the Fed raises rates too quickly and causes the economy to cool down, inflation could decline or even move to deflation, which we want to avoid.

Based upon the statements from the Fed officials last week and other recent data, it appears likely we may have lower worldwide economic growth and low inflation for at least a few years. Plus we will need to continue to endure the uncertainty of when the Fed will raise rates. October? December? Next year? What does all of this likely mean for investment returns?

First, nominal investment returns are likely continue to be lower than historical values. Historically, since 1970, stocks have grown at an annual rate of almost 9% while inflation has been a little more than 4% per year. Hence, there has been a 5% real return earned by risking money and investing in stocks. For the same time period, bonds returned 6%, or a 2% real return.

Mathematically, therefore, if inflation is 2%, it is very likely that a diversified all-equity portfolio might earn 7% and returns on a diversified bond portfolio might be 4%. And, if economic growth is low or stagnant, that pushes valuations down and lowers returns as well.

Nominal returns for all of us are under pressure from three sources; low inflation, slowing global growth and Fed uncertainty. We can’t control any of those. What we need to do is focus on real returns, not nominal returns. And, we need to make sure our financial planning and investment return expectations for the next few years are based on lower inflation and lower nominal returns.

We’re happy to chat about this important topic at any time. Give us a call.

Fed_lady_cartoon

Ask DWM: How Does the Likely Fed Rate Hike Impact Your Asset Allocation and Investments?

janet-yellen

Investors and markets are watching this week’s Fed meeting very carefully. Fed Chairwoman Janet Yellen and Fed officials appear to be moving toward raising short-term interest rates this year. Most expect September will mark the time of the Fed’s first rate increase since 2006. A key challenge for the Fed will be the communication of where future rates are going.

We all remember two years ago when Fed Chairman Ben Bernanke created a “taper tantrum” (and threw all markets in chaos for one month) when he signaled it was thinking about ending the QE program. Chairwoman Yellen wants to avoid that and has recently been emphatic that she expects rate increases to be slow and gradual once they start. In fact, in a March speech in San Francisco, she used the term “gradual” or “gradually” 14 times.

The U.S. economy is making progress, with strong job gains and rising wages. Auto sales are way up and factory machines are humming. Small business and consumer sentiment is up as are retail sales. The Producer Price Index rose slightly higher than expected. This data is likely too strong for investors or the Fed to ignore. So, yes, it looks like a rate hike will likely occur this year.

Of course, none of us can control when the Fed will raise rates, what rates will be longer term and how well the Fed communicates the future. We can, on the other hand, control our asset allocations and our investments. That’s where our focus should be.

Let’s revisit our annual DWM seminar in October 2013 entitled “Rising Interest Rates: Should I Be Concerned?” Here’s a quick summary of the key points that are still valid today.

  • The bond bull market may be over.
  • Bonds still play a vital role within an overall portfolio as do all of the asset classes.
  • Equities typically perform well in rising interest rate environments, with the “sweet spot” being when the 10 Year Treasury Bond rates are between 3% and 4%.
  • Use of multiple asset classes lead to non-correlation effects that ultimately lead to better long-term results.
  • One needs at least 15% in alternatives to make a difference.
  • Stay invested.

So, focusing on asset allocation, you should start by revisiting your risk profile. This includes risk capacity, risk tolerance and risk perception. Your risk profile is unique. You need to look at your long-term financial goals and plan and honestly assess how you are “wired.” It’s not as simple as looking at your age. We work with clients in their 80s who have an aggressive risk profile and clients in their 30s who have a conservative risk profile. Your risk profile will determine your asset allocation and therefore your portfolio mix of equities, fixed income and alternatives. In the long-term, your asset allocation is the primary (90%) determinant of the return of your portfolio.

2013 was a watershed year for fixed income. For three decades, fixed income had always been an asset class with low risk and good returns. The “taper tantrum” signaled the start of the end of the bond bull run making fixed income riskier and reducing the likelihood of 8% annual returns going forward. Given this change in risk/return characteristics within the fixed income area, the same risk tolerances score from prior years may not necessary lead to the same asset allocation mix. Hence, many DWM clients reduced their allocation to fixed income in 2013, some quite significantly.

At the same time, DWM fixed income holdings were re-positioned in an effort to reduce risk and potentially increase returns for an expected rising interest rate environment:

  • Reduced duration (when interest rates rise, bond with the longest maturities suffer the greatest drop in price)
  • Added international developed and emerging exposure
  • Added floating rate exposure with very low duration and ability to perform in rising markets
  • Continued diversification through low cost vehicles
  • Kept credit quality solid

So, with all the uncertainty regarding when, how high, and how often the Fed raises rates and how the markets will react to these changes, we suggest you focus on what you can control. If you haven’t already done so, now is a great time to review your asset allocation and your investment holdings. Our DWM clients know that is one of the highlights of our meetings with them, hopefully quarterly or even more often when appropriate. For others, we’re happy to help provide a second opinion. Just give us a call.

DWM Seminar Recap

Bond Interest Rate Graph
(Click above for full size image)

We just wrapped up our fall seminar series and based upon feedback it was a great success. Both venues – the Wolfe St Playhouse in Charleston and Emmett’s Brewery in Palatine – served as Graphgreat places to not only deliver an important financial presentation but also as a great place to just hang out and visit with one another.

In case you missed one of the October seminars entitled “Rising Interest Rates: Should I Be Concerned?“, here is a quick recap of what you missed:

The Bond bull market may be over.

  1. The last 3 decades saw declining interest rates. Because of the inverse relationship between rates and bond prices, this created a nice tailwind for bond prices.
  2. With interest rates recently bouncing off historic lows and expected to gradually increase as the Fed tinkers with tapering their Quantitative Easing Program, these tailwinds are becoming headwinds.
  3. This doesn’t mean that bonds will necessarily have negative returns but expected returns should be significantly lower than the 8.5+% returns they have exhibited since September of 1980 when 10-Year Treasury rates peaked at 15.8%.

Bonds still play a vital role within an overall portfolio as do all of the asset classes.

  1. As a diversifier which creates lower volatility to the overall portfolio- bonds not only have smaller corrections than equities but have consistently held up during equity market corrections.
  2. As a capital preservationalist.
  3. As an income provider.

Traditional and major index (like Barclays Aggregate) bond funds may not be the best way to go.  Make sure to ‘get under the hood’ of your bond portfolio and ‘check the fluids’.

  1. Duration (essentially the amount of time until a bond matures) – the bigger the duration, the more sensitivity the bond price will change. Because of this, consider reducing the overall duration of your bond portfolio.
  2. Consider adding floating rate exposure – one of the few subsectors within bond land that enjoys a rising interest rate environment given that they rely upon loans that reset in periods usually less than a year at the new current interest rate environment.
  3. High Yields – with default rates near historical lows, these securities can enhance an overall bond portfolio.
  4. Look to areas outside of the US – international developed and emerging bond markets can provide diversification and enhanced yields/returns.
  5.  Utilizing low cost ETFs and mutual funds for the above exposure helps eliminate company-specific risk.

Use of multiple asset classes lead to non-correlation benefits that ultimately lead to better long-term results.

  1. Non-correlation leads to a tighter range of outcomes for the overall portfolio
  2. Tighter range of outcomes puts a smoothing effect on your return profile
  3. Smoothing effect leads to smaller downsides
  4. Smaller downsides lead to better geometric compounding
  5. Better geometric compounding leads to BETTER LONG-TERM RESULTS
  6. Note: Investor psychology studies and personal experience remind us that not everyone is a fan of non-correlation when stocks are roaring, but the fact is one cannot count on 20%+ stock returns year in and year out. Not to mention that the 30yr+ bond bull market may be over.  One must look elsewhere for proper diversification, for real positive returns and for protection to the portfolio.
  • The world has changed…and will keep changing.
  • Don’t try to control the things you cannot, but take advantage of the things you can control.
  • The markets cannot be controlled, but Asset Allocation can be. Asset allocation is the primary driver of returns.
  • Make sure you are prepared for a rising interest rate environment or whatever environment is thrown your way by working with a wealth management professional firm like DWM.

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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.

focus

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.