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:

chart

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.

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.

Quantitative Easing: QE 4ever?

QE (2)We are all in the midst of one of the biggest global financial experiments ever conducted: Quantitative Easing. Since the world financial crisis in late 2008, the Fed and other central banks have employed this technique in an effort to stimulate the world economy. QE has certainly has had an impact. It has reduced home mortgage rates to all-time lows and helped push the stock markets to all-time highs. Yet, QE is not an elixir. QE can’t cure all the ills of a moribund world economy. Furthermore, QE could ultimately cause major damage to the U.S. and world economy.

Last week, a good friend and client suggested that an update on QE might be appropriate for our readers. Good idea DD; thanks for the suggestion.

Quantitative Easing is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy isn’t working. Historically, the Fed has principally stimulated the economy by lowering short-term (fed funds) rates and cooled down the economy by raising short-term rates. However, by late 2008, the Fed funds rate was as low as it could go-effectively at zero. The Fed needed another tool. QE, last used in the U.S. from 1932-1936, got the call.

QE has the same effect as printing money. The central bank buys treasury and agency bonds from commercial banks and other private institutions (using electronic transfers), thereby creating money and liquidity. The purchases raise bond prices and reduce their yields, thereby reducing long-term interest rates. Interest rates on 10 yr. U.S. Treasuries have fallen from roughly 3% to 2% since QE started. Lower treasury rates mean lower home mortgage rates, which has certainly helped the housing industry get back on its feet.

Many investors, uncomfortable with lower returns on fixed income, started loading up on stocks and riskier debt. Since the start of QE, there has been an 85% direct correlation between the amounts of money added to QE and the rise in the stock markets. During 1Q2013, the move to riskier assets intensified. The result -stocks hitting all-time highs. Furthermore, increasing stock values have been shown to affect both consumption and investment decisions, which helps the economy as well.

Other developed countries have also adopted QE to stimulate their economies. The UK started in 2009. The European Union started in 2011. And Japan, which used QE in 2001-2006, started a new round of QE last year. In total, about $10 trillion has been invested by central banks world-wide in QE programs.

There are two major concerns with QE. First, many believe that QE will ultimately cause inflation-perhaps hyperinflation. With the money supply expanding faster than the real economy, one would expect inflation to occur. This hasn’t happened yet. Fortunately, the U.S. dollar continues to be the world’s reserve currency. Hence, events in Cyprus and other parts of Europe cause investors to dump the euro for dollars. Certainly if China and/or Saudi Arabia would ever drop the dollar or dump U.S. Treasuries, we could certainly see a run on the dollar and perhaps hyperinflation. However, that scenario, if it does occur, is likely years or decades away.

The second concern of QE is the impact when it starts to unwind. At their FOMC meeting in March, the Fed signaled that it would keep its ultra-easy money policy for now. They will continue this at least as long as the unemployment rate is above 6 ½%. As it approaches this level, it is expected the Fed will taper off QE. However, Chairman Bernanke made it clear that the Fed would discontinue QE long before it would raise the fed-funds rate. And it promised to keep the fed-funds rate at current levels until 2015.

So, the net effect is that once there is a substantial improvement in the economy, QE will stop. This will likely result in higher interest rates and higher inflation- both of which could slow economic growth. As a result, some are calling for the Fed to start unwinding QE now. With the unrest in Europe and around the world currently, perhaps the impact of unwinding of QE now would be less damaging to the U.S. economy than it will be in the future.

Rest assured, DWM is following QE very carefully. This experiment has already had a huge impact on the U.S. and world economy and undoubtedly will for years to come.