DWM 3Q19 Market Commentary

“Fancy a cuppa’?” “Anyone for tea?” Even though our beloved Chicago Bears were “bloody” unsuccessful in their visit to London this past weekend, I’m “chuffed to bits” to put a little “cheeky” British spin on this quarter’s market commentary… Let’s “smash it”!

After a volatile three months, the third quarter of 2019 is officially in the history books. The S&P500 finished only 1.6% below its all-time high, bonds rallied as yields lowered, and alternatives such as commodities and real estate rallied. It’s been a rather “blimey” year for investor returns so far, but there’s a lot of uncertainty out there about if these “mint” times can last. Let’s look at how the asset classes fared first before turning to what’s next.

Equities: Equities were about unchanged for the quarter, as evidenced by the MSCI AC World Index -0.2% reading for the quarter.  Domestic large cap stocks represented by the S&P500 did the best relatively, up 1.7%, but underperformed in the final weeks of the quarter. Recent trends show that traders are gravitating toward stocks with cheaper valuations instead of pricey, growth ones. International equities* underperformed for the quarter, down -1.8% but had a strong showing in September. Even with this so-so quarter, stocks, in general, are up over 15%** Year-to-Date (“YTD”)! Yes, “mate”, this bull market – the longest on record – continues, but at times looking “quite knackered”.

Fixed Income: The Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index ascended even higher, up 0.7% and 2.3%, respectively for the quarter and now up 6.3 & 8.5%, respectively YTD. “Brilliant!” Yields continue to fall which pushes bond prices up. But how far can they fall? The 10-year US Treasury finished the quarter at 1.68%, a full percentage point below where it started the year. For yield seekers, at least it’s still positive here in the States as the amount of negatively yielding debt around the world swells. Sixteen global central banks lowered rates during the quarter including the US Fed, all of them hoping to prop up their economies. As long as they’re successful, all is good. But what if our slowing US economy actually stalls? We could be “bloody snookered”…

Alternatives: The Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, showed a +0.3% gain and now up 6.1% YTD. Lots of winners in this space. “Lovely!” For example, there is a lot of money flowing into gold***, +4.4% on 3q19 & +14.7% YTD, as it is seen as a safe haven. And real estate, +6.3% 3Q19 and +23.5% YTD, has rallied from investors looking for yields that are more than the bonds like those mentioned above.

Frankly, it’s been a pretty great year for the balanced investor who’s now looking at YTD returns that around double-digits. But it’s not all “hunky-dory”. The main worries are the following:

  • The US-China trade war continues affecting the global economy. Sure, since the US exports less than every other major country, this shouldn’t affect us as much. But given the uncertainty, many companies are choosing to hold off on capital expenditure until we get clarity on this issue. Reports earlier this week that US manufacturing momentum has seriously slowed down led to one of the worst fourth quarter starts for the stock market in years. Politics will continue to make it volatile.
  • The Fed’s path of monetary easing. It’s gotten “mad” – it seems every time there is bad news, it’s good news for the stock market because traders are betting on the central banks around the world to support the markets. Seems “dodgy”, right?!? So the Fed must play this balancing act, always wanting to keep the economy humming along. Quite frankly, there really is no economic reason for a rate cut right now if it weren’t for the trade conflict. Figure we’ll have at least one more cut, possibly two, in 4Q19 and hopefully that’s it. Otherwise, if they keep lowering, it means we have fallen into a recession.

It’s in a lot of peoples’ interest to get a trade deal done. If it does, markets will celebrate it. The longer a deal plays out, the more volatility we’ll see and the higher the risk of recession becomes. The US economy is not “going down the loo”, but it won’t continue to go bonkers with everything mentioned above as well as the Tax Reform stimulus fading away in the rear-view mirror as quickly as a Guinness at the Ye Olde Cheshire.

This all isn’t “rubbish”. Actually, there is a lot of turmoil out there. So don’t be a “sorry bloke”. In challenging times like this, you want to make sure you’re working with an experienced wealth manager like DWM to guide you through.

Don’t hesitate to contact us with any “lovely” questions or “brilliant” comments, and Go Bears!

“Cheerio!”

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

 

*represented by the MSCI AC World Index Ex-USA

** represented by the MSCI AC World Index

***represented by the iShares Gold Trust

****represented by the iShares Global REIT ETF

ECONOMY CELEBRATES 10 YEARS OF GROWTH: IS IT TIME TO PARTY?

Next week will mark the 121st month of the current bull market- the longest business cycle since records began in 1854. Based on history, a recession should be starting soon. Bond rates now form an “inverse yield curve” with shorter term rates above longer term, which typically signals a downturn. Business confidence is down. However, 224,000 American jobs were created in June and equities continue to soar, rising 16-20% year to date. Is it time to party or not?

The business cycle appears to be lengthening. The current expansion, coming after the worst financial crisis since the Great Depression, has been unusually long and sluggish. Average GDP growth has been 2.3% per year, as compared to the 3.6% annual growth in the past three expansions. The workforce is aging. Big firms invest less. Productivity has slipped. And, Northwestern Economics Professor Robert Gordon continues to assert that American’s developments in information and communication technology just don’t measure up to past achievements including electricity, chemicals and pharmaceuticals, and the internal combustion engine.

However, the changing economy may now be less volatile for a number of reasons. 1/3 of American’s 20th century recessions were caused by industrial declines or oil-price plunges. Today, manufacturing is only 11% of GDP and its output requires 25% less energy than in 1999. Services are now 70% of our GDP. Furthermore, the value of the housing market is now 143% of GDP, as compared to a peak of 188%. Banks have lots of capital.

Finally, inflation has been very low, averaging 1.6% in the U.S. (and 1.1% in the euro zone) per year during the current expansion. In earlier business cycles, the economy would surge ahead, the jobs market would overheat, causing inflation to rise and leading the Federal Reserve to put on the brakes by raising interest rates. Today, it’s different. Even though the unemployment rate is at a 50 year low of 3.7%, wage growth is only 3%. As the Economist pointed out last week in “Riding High,” American workers have less bargaining power in the globalized economy and are getting a smaller percentage of company profits, keeping inflation down. The Fed recently announced that it is less concerned about rising prices and more concerned about growth slowing and, therefore, will lower interest rates at its meeting next week.

Changes in the economy to slower growth, more reliance on services and lower inflation all contribute to longer business cycles. Yet, the changing economy, particularly globalization and technology, has also produced new risks.

Manufacturing that was formerly done in the U.S. is now outsourced to global producers. These chains can be severely disrupted by a trade war. This could produce a major shock- imagine if Apple was cut-off from its suppliers in China. Also, take a look at the impact that the prolonged grounding of Boeing’s 737 MAX is having on the U.S. economy. It’s hurting suppliers, airlines, and tens of thousands of workers, while $30 billion of the MAX sit grounded. Global supply chains are extremely interconnected these days.

IT is significantly linked as well. Many businesses outsource their IT services via cloud-computing to a few giants, including Alphabet (GOOGL).  85% of Alphabet’s $100 billion annual sales comes from advertising, which in the past has been closely correlated to the business cycle. GOOGL invested $45 billion last year, 5 times more than Ford. In fact, the S&P 500 companies invested $318 billion last year, of which $220 billion was spent by ten tech companies. The big IT companies are now facing regulatory issues worldwide. What would be the worldwide impact if GOOGL, Facebook or others get their “wings” clipped?

Also, finance issues could disrupt the expansion. Although housing and banks are in decent shape, private debts remain high by historical standards, at 250% of GDP, or $50 trillion. And, if the prime lending rate continues to decline, banks’ profits and balance sheets will likely weaken.

Lastly, politics is a big risk. There are the threats of trade wars with China and physical war with Iran. The big tax cut that pushed markets up in 2017 could now produce lower year over year earnings for companies. On Monday, July 22nd, Congressional leaders and White House negotiators reached a deal to increase federal spending and raise the government’s borrowing limit. This would raise spending by $320 billion, at a time when the annual deficit is already nearing $1 trillion, despite the continuing expansion.

Conclusion: Changes in the economy have produced reasons why business cycles are longer, yet more sluggish. Those changes have also added new risks for a continuing expansion and bull market. No one can predict the future. Focus on what you can control: Make sure your risk level is appropriate for your risk profile. Make sure your portfolio is prepared for the next downturn. And, yes, stay invested.

DWM 2Q19 Market Commentary

Carnival Pic

Summer is finally upon us! Weather is steamy, kids are out of school, and it’s the midst of carnival season. Merriam Webster has several definitions of carnival including:

  • An instance of merrymaking, feasting, and masquerading
  • An instance of riotous excess
  • An organized program of entertainment or exhibition

Sounds a little bit like the markets we’ve seen in 2019 so far: it’s certainly been an entertaining program with all asset classes parading higher. But does this Fun House continue or is it all just a House of Mirrors….

Equities: You win a small prize! Equities continue to be the most festive part of the fairground, with many stock markets up over 2-4% on the quarter and now up around 12-18% on the year! Domestic and large cap stocks continue to outperform value and smaller cap stocks, which is typical of a late-stage bull market, this one being over a decade-long!

Fixed Income: You can trade in that small prize for a medium prize!  Like a Ferris Wheel where one side goes up, the other side comes down; yields and bond prices operate the same way. With the 10-yr Treasury now down to around 2.06% at the time of this writing compared to 3.2% last November, it’s no surprise to see strong returns in bond land. In fact, the Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index popped another 3.1% and 3.3%, respectively for the quarter and 5.6 & 6.1%, respectively year-to-date (“YTD”).

Alternatives:  You can trade in that medium prize for the largest prize! The merrymaking continues as most alternatives we follow had good showings in 2Q19, evidenced by the Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, up 1.3% and now up 5.7% YTD.

It almost feels like you could go over to the Duck Pond and pick up a winner every time. There are indeed a lot of positives out there:

  • US stocks near record highs
  • A stock-market friendly Fed
  • Historically low unemployment with inflation that appears totally under control
  • Americans’ income and spending rising, leading to relatively strong consumer confidence

But this carnival has some roller coasters in the making given some riotous issues including:

  • US-China trade tensions most likely not ending with a solid deal anytime soon, which will fuel anxiety
  • A weakening European economy due to tariffs and other issues, which could bleed over to all markets
  • Slowing US economic growth here as the Tax Reform stimulus wears off
  • A relatively expensive US stock market, evidenced by the S&P500’s forward PE ratio now at 16.7 times versus its 25-year average of 16.2

It definitely wouldn’t be fun if the yummy funnel cake turns into spoiled fried dough…Yuck! We don’t know exactly when or what will happen, but we do know that at some point this bull market will indeed end. You cannot time the market so forget about getting out of the Cliff Hanger before the time comes. That said, you want to stay invested and continue to control what you can control. Don’t wind up being on the bottom end of a Whack-A-Mole game; make sure your portfolio is prepared for the next downturn, which includes making sure your risk level within is appropriate for your risk tolerance.

So don’t wind up being a carny clown. If you want to continue hearing “winner-winner-chicken-dinner!”, work with a proven wealth manager and you’ll be the one controlling the Zipper!

 

Zipper

DWM 1Q19 Market “MADNESS” Commentary

In basketball, March Madness is a big deal. For those of you who aren’t familiar with the term, March Madness refers to the time of the annual NCAA college basketball tournament, generally throughout the month of March. In the market, it may appear that “Madness” is never confined to any one month. If you really want to talk about Madness, just think about the last 6 months: The S&P500 was at an all-time high late September, only to throw up an “airball” and bottom out almost 20% lower three months later on worries that the Fed was raising rates too fast, only to “rebound” to have its best first quarter since 1998 as the Fed shifted its tone to a more dovish nature. Is it the NCAA or the markets in a “Big Dance”?!?

Yes, the investing environment now is so much different than our last commentary. Then, it certainly felt like a flagrant foul after a tenacious 4q18 sell-off that had gone too far. We advised our readers then to essentially do nothing and stay the course. And once again, rewards come to those that stay disciplined. With the market back within striking distance of its peak, it almost feels like its “cutting down the net” time. (“Cutting down the net” refers to the tradition of the winning basketball team cutting down the basketball net and giving pieces to team members and coaches.) But of course, the game of investing is not just four quarters like basketball. Investing can be a lifetime. So if you’re thinking about your portfolio like you would a basketball team, let’s hope its more like the Chicago Bulls of the 90s and not the 2010s! (Where’d you go, Michael Jordan?!?)

Like the Sweet 16 of the NCAA tourney, your portfolio holdings are probably like some of the best out there. But there will always be some winners and losers. Let’s take a look at how the major asset classes fared to start 2019:

Equities: The S&P500 soared to a 13.7% return. Small caps* did even better, up 14.6%. Even with a challenging Eurozone environment, international stocks** climbed over 10%. In basketball terms, let’s just say that this was as exciting as a SLAM DUNK for investors! Of course, with a bounce-back like this, valuations are not as appealing as they were just three months ago. For example, the S&P500 now trades at a 16.4x forward PE vs the 16.2x 25-year average.

Fixed Income: With the Fed taking a more dovish stance, meaning less inclined to raise rates, yields dropped and thus prices rose. The total return (i.e. price change plus yield) for most securities in fixed income land were quite positive. In fact, the Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index jumped 2.9% and 2.2%, respectively. Further, inflation remained under control and we don’t expect it to be a pain-point any time soon. But TIME OUT!: Within the last several weeks we have seen conditions where the front end of the yield curve is actually higher than the back end of the yield curve. This is commonly referred to as an “inverted yield curve” and has in the past signaled falling growth expectations and often precedes recessions. To see what an inverted yield curve means to you, please see our recent blog.

Alternatives: Most alternatives we follow had good showings in 1Q19 as evidenced by the Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, up 3.9%. Two big winners in the space were Master Limited Partnerships***, up 17.2%, and Real Estate****, up 15.2%. The pivot by the Fed in terms of their attitude toward rates really benefited the real estate space as new home buyers are now seeing mortgage rates almost a point lower than just several months ago. Unfortunately, not all alts did as well. Gold barely budged. And managed futures†, down 3.1%, were tripped up by the last six-month whipsaw.

So if you think of your asset classes as players on a basketball squad, one could say that pretty much every one had a good game, but the star of the show was definitely “LeStock”. Moreover, there was no buzzer beater necessary this quarter, as your team flat out won. In fact, most balanced investors after just one quarter are up high single-digits! A definite nice start to the year. You have now advanced to the next round, but where does your team go from here?

The game we saw in the first quarter cannot continue. With the Tax Reform stimulus starting to wear off, economic growth has to decelerate. In fact, companies in the S&P500 are expected to report a 4% decline in 1Q19 vs 1Q18; their first decline since 2016! World trade volume has really slowed down, so there’s a tremendous focus on a US-China trade agreement happening – if not, watch out! The good news is that the Fed seems to be taking a very market-friendly position, and unemployment and wage growth are under control.

As always, there are risks out there. But with the bull market on the brink of entering its 11th year of economic expansion, the end-of-the-game buzzer need not be close as long as you have a good coach at the helm. Just like within NCAA basketball, to succeed, you need a good coach on the sidelines – someone like Tom Izzo of the Michigan State Spartans who always seems to get his players to work together and play their best. The same way a wealth manager like DWM can help you put the portfolio pieces and a financial plan together for you in an effort to thrive and succeed.

So don’t wind up with a busted bracket. If you want a lay-up, work with a proven wealth manager and you’ll be cutting down your own nets soon enough. Now that’s a “swish”!

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

 

*represented by the Russell 2000

**represented by the MSCI AC World Index Ex-USA

***represented by the Alerian MLP ETF

****represented by the iShares Global REIT ETF

†represented by the Credit Suisse Managed Futures Strategy Fund

THE FINANCIAL CRISIS: 10 YEARS LATER

On September 15, 2008, Lehman Brothers imploded; filing a $691 billion bankruptcy that sent stock markets into a deep dive of 40% or more. The global financial crisis ultimately would destroy trillions of dollars in wealth- $70,000 for every single American. The deep financial trough produced the Great Recession.

Now, 10 years later, how are we doing and what lessons have we learned?

How are we doing?

Official economic statistics would say that the American economy is fully recovered. We are in a 9+ year bull market with a cumulative total return of 350%. The total combined output of the American economy, known as our gross domestic product (“G.D.P.”) has risen 20% since the Lehman crisis. The unemployment rate is lower than it was before the financial crisis. These key measurements, now a century old tradition, however, don’t tell the whole story. The official numbers are accurate, but not that meaningful.

For many Americans, the financial crisis of 2008-2009 isn’t over. It left millions of people-who were already just “getting by”- even more anxious and angry about their future. The issue is inequality. A small, affluent segment of the population receives the bulk of the economy’s harvest. It was true 10 years ago and is even more so today. So, while major statistics look good, they really don’t measure our country’s “human well-being.”

The stock market is now 60% higher than when the crisis began in 2007. While the top 10% of Americans own 84% of the stocks, the other 90% are much more dependent on their homes for their overall net worth. The net worth of the median (not the “average”) household is still 20% lower than it was in 2007, despite the record highs for the stock markets.

The unemployment rate, currently at 3.9%, does not take into account two major items. First, the number of idle working-age adults has swelled. Many of them would like to work, but they can’t find a decent job and have given up looking. Currently, 15% of men aged 25-54 are not working and not even looking; therefore, they are not considered “unemployed.” Second, many Americans are working at or near the federal minimum hourly wage- which has been $7.25 per hour since July 2009. Neither group is benefitting from low, low unemployment rates.

There is a movement to change these metrics to something more meaningful.   A team of economists, Messrs. Zucman, Saez and Piketty, have begun publishing a version of G.D.P. that separates out the share of national income flowing to rich, middle class and poor. At the same time, the Labor Department could modify the monthly jobs report to give more attention to other unemployment numbers. The Federal Reserve could publish quarterly estimates of household wealth by economic class. Such reports could change the way the country communicates about the economy. Economist and Nobel Laureate Simon Kuznets, who oversaw the first G.D.P. calculation in 1873, cautioned people not to confuse G.D.P. with “economic welfare.”

What lessons have we learned?

Mohammed A. El-Erian, the chief economic adviser at Allianz, the corporate parent of PIMCO, recently summarized, in the “Investment News,” some key lessons learned from the crisis.

Accomplishments:

  • A safer banking system due to strengthened capital buffers, more responsible approaches to balance sheets and better liquidity management
  • A more robust payment and settlement system to minimize the risk of “sudden stops” in counterpart payments
  • Smarter international cooperation including improved harmonization, stronger regulation and supervision and better monitoring

Still outstanding issues:

  • Long-term growth still relying on quick fixes rather than structural and secular components
  • Misaligned internal incentives encouraging some institutions who are still taking pockets of improper risk-taking
  • The big banks got bigger and the small got more complex through the gradual hollowing out of the medium-sized financial firms
  • Reduced policy flexibility in the event of a crisis because interest rates in most of the advanced world, outside of the U.S., are still near zero and world-wide debt is significantly higher than 10 years ago.

Yes, we’ve made some good progress in the last 10 years since the financial crisis. But, there’s still plenty of room for improvement.

Bull Market Runs Come in All Lengths

 

Bull_Market_Chart.png

Let me help you with the details of the above chart- though it is difficult to read, it’s quite important.   This graph from First Trust reflects the historical performance of the S&P 500 index from 1926 through June 2018. The blue represents bull markets; the red bear markets. It’s obvious that there is a lot more blue on this chart than red. That’s why we encourage you to “stay invested” through the ups and downs of the markets in a risk appropriate, diversified portfolio.

There are 8 bear markets shown. These represent periods of time when markets went down 20% or more. The longest and largest, from 1929-1932, was caused by the Great Depression. This bear market lasted 2.8 years and represented a cumulative decline of 83.4% overall; 47% per year. Ouch. Other bear markets have been much tamer. The average bear market period for the eight periods shown above lasted 1.4 years with an average cumulative loss of 41%. The bear market in 2008-2009 caused by the financial crisis lasted 1.3 years, with a 51% cumulative decline, 41% per year.

There are 9 bull markets shown. The longest and largest occurred after World War II from 1948 to 1963. This bull market lasted 15.1 years and represented a cumulative total return of 936%, or 17% per year. The average bull market has lasted 9.1 years with a cumulative total return of 476%; 21% per year. Some bull markets have been as short as 2.5 years and there have been other longer bull markets of 12.8, 12.9 and 13.9 years.  Our current bull market started in Spring 2009 and has lasted 9.3 years, with a cumulative total return of 350%; 17.5% per year.

At DWM, we are asked the question: “How long can this bull market continue?” This question seems to be based on a concern that a bull market comes with a pre-ordained expiration date; when it runs out of whatever made it go. However, selling equities because a bull market run is longer than average has been a great way to miss out on lots of gains. Remember, bull market runs come in all lengths.

While a bull market may be technically defined as a period of time after a 20% drop (bear market) has reached its end, it’s probably healthier to view a bull market from an economic perspective. Barry Ritholtz in a Friday Bloomberg article defined a bull market as follows: “An extended period of time, typically lasting 10-20 years, driven by broad economic shifts that create an environment conducive to increasing corporate revenue and earnings. Its most dominant feature is the increasing willingness of investors to pay more and more for a dollar of earnings.” This is exactly what we have seen in periods after WWII, the 1980 and 1990s biotech boom and now the maturation of internet, software and mobile companies.

Bear markets are typically brought about by recessions; often when the markets have gotten overheated (such as the dot.com bubble bust in 2000). Bear markets can also be brought on by a financial crisis, as we had in 2008-2009. Recoveries from financial crises are quite different from recoveries from depressions.   A post crisis recovery is marked by slow and erratic economic growth, weak wage gains and disappointing retail sales. Furthermore, investors, after being burned, remain skittish for years. The 2008-2009 crisis scarred consumers and left them more determined to sock away funds.

Case in point, the Wall Street Journal reported Monday morning that the personal savings rate is up to 7.2% from the 3.3% estimated previously. The new number exceeds the 6.4% average savings rate since 1990 and is almost three time the savings rate in 2005. The “wealth effect” that we saw in the mid 2000s that increased spending and dropped savings rates, is not happening now. This news, along with the reduction in corporate taxes, historically low unemployment and continued increased corporate earnings bodes well for a continuation of the current Bull Market despite ongoing negative factors.

Yes, we don’t know how long this bull market will run. And, we’re not going to try to time it. We do know, at some point, this bull market run will come to its natural end. Before it does, we may see more pullbacks (declines of 5% or more) or corrections (declines of 10% or more).   Remember this graph- lots more blue than red- and stay invested.

DOW 26,000-WHEN’S THE LAST TIME YOU THOUGHT ABOUT YOUR RISK?

With U.S. stocks at all-time highs, now is the perfect time to review your risk profile and then make sure the asset allocation within your investment portfolio matches it.  Equity markets have been on a tear.  In 2017, the average diversified US stock fund returned 18%, while the average international stock fund returned 27%.  In the first three weeks of 2018, the MSCI World Index of stocks has increased 5.6%. With low interest rates and inflation, accelerating growth and the recent passage of the Tax Cuts and Jobs Act, it looks like this streak could continue in 2018.

During the current nine year bull market, investor emotions about stocks have gone from optimism to elation and many investors now are not only complacent, but overconfident. Yet, with valuations soaring, we are approaching the point of maximum financial risk.  Certainly, at some point, we will have a pullback, correction or crash.

It always happens.  It could be a conflict in N. Korea or Iran or somewhere else.  It could be a worldwide health scare.  It could be higher interest rates negatively impacting our rising national and personal debt.  It could be something none of us even consider today.  History shows it will happen.  We need to be ready for it by having an asset allocation in our portfolios that matches our risk profile.

What exactly is a risk profile?  There are three components of your risk profile.  First, your risk capacity, or ability to withstand risk.  Second, your risk tolerance, or willingness to accept large swings in investment returns.  It’s the way we are hard-wired to respond to volatility.  Third, your risk perception, or short-term subjective judgment about the characteristics and severity of risk.

We classify your risk profile into one of five categories of risk: defensive (very low), conservative (low), balanced (moderate), growth (high) and aggressive (very high).  As a general rule, younger investors are more willing to take on a higher level of risk.  However, that’s not always true.  Investors in their 80s and 90s who know that they have ample funds for their lifetimes and beyond, and who can emotionally handle high risk, may have an aggressive risk profile, particularly when they plan to leave most of their money to the beneficiaries.  Everyone’s circumstances and emotions are different.  Profiles can change over time, particularly when there are life changing events, such as marriage, birth of a child, loss of job, retirement, changes in health or other matters.  Therefore, it’s important to regularly assess your risk profile.

Here’s the process:

 

Step 1. Quantify your lifetime monetary goals and compare those with your expected lifetime assets. During your accumulation years, how much will you add to your retirement funds per year?  How many years until retirement?  How much money will you need to withdraw annually during retirement for your needs, wants and wishes?  What are your sources of retirement income?  What’s your realistic life expectancy?  What market return is required to provide the likely outcome of success- not running out of money?  Do the goals require a high rate of return just to have a chance of success or is the goal so low risk that even a bad market outcome won’t cause it to fail?

Risk capacity isn’t simply the amount of assets you have; rather it is the comparison of those assets to your expected withdrawal rate from your portfolio.  A low withdrawal rate from your portfolio, e.g. 1% or 2% a year, means you have high risk capacity. A high withdrawal rate, such as 6% or more, means you have low risk capacity.

Step 2.  Evaluate your tolerance for risk.  What’s your comfort level with volatility?  Are you aggressive? Moderate?  Defensive? How does that compare to the risk needed in your portfolio to meet your goals?  If the risk needed to meet your goals exceeds your risk tolerance, you need to go back and modify your goals.  On the other hand, if your risk tolerance exceeds the risk level to meet your goals, does that mean you need to take on more risk just because you can or because you can afford it? You need to go through the numbers and make important decisions.

Step 3. Compare the risk in your portfolio to your risk tolerance.  Separate your assets into all three classes: equities, fixed income (including cash) and alternatives and determine your asset allocation.  A balanced portfolio might have roughly 50% equities, 25% fixed income and 25% alternatives.  An aggressive (very high risk) portfolio could have 80% equities and a defensive (very low risk) portfolio might have only 10-35% equities.  If your portfolio is riskier than your risk tolerance, changes need to be made immediately.  If your portfolio risk is lower than your risk tolerance, you still need to make sure it is of sufficient risk for you to meet your goals, considering inflation and taxes.

Step 4.  Rebalance your portfolio to a risk level equal to or less than your risk tolerance and sufficient to meet your goals.  Make sure you diversify your portfolio within asset class and asset style. Diversification reduces risk.  Reducing portfolio expenses and taxes increases returns. Alternatives are designed to reduce risk and increase returns. Trying to time the market increases your risk. Set your asset allocation for the long-term and don’t change it based on feelings of emotion. Stay invested.

Step 5.  Most importantly, regularly review and monitor your goals, risk profile and the asset allocation within your portfolio.  The results: Improved lifetime probability of financial success and peace of mind.

Bond Bull Market May be Over- Time for Revised Strategies

Source: James O’Shaughnessy / WSJ
Graph Source: James O’Shaughnessy / WSJ

What were you doing in 1981? A mere twinkle in someone’s eye? Attending school? Working? Married? Elise and I were buying our fifth house and taking on a 15% mortgage. The rate seemed pretty decent to us. 20-year Treasury bonds were yielding 15%, businesses were paying 21% for a “prime” lending rate, and inflation was in double digits. Many people thought we were living in Jimmy Buffet’s “Banana Republic;” where inflation and interest rates would continue at record highs for decades to come.

This was not to be. We had reached a turning point in 1981, where apparent trends started to reverse. In fact, inflation and interest rates decreased steadily for the next thirty-one years. Inflation has averaged less than 1.5% over the last five years and 20-year Treasury bonds yields reached a low of 2.11% last year. Now, it appears that we have a new, permanent change of direction-rates are beginning to rise. The thirty year bond bull market seems to have ended.

Until this year, bonds have provided a great place for investors to put a good share of their money. Performance has been very good and the risk has been low. Total return, as Brett pointed out a few blogs ago, is equal to the yield (interest paid on the bond) plus the change in value of the investment. Because bond prices increase when interest rates decline, bond investors have been rewarded with both their interest income plus an increase in market value for last thirty years.

From 1/1/2000 to 12/31/12, 20-year treasury bonds produced a total return of 7.6% per year. The S&P 500 had a total return of 2.4% over the same period. It’s no surprise that investors fell in love with bonds, not only for the excellent return but also for the lower risk and volatility. However, the experience of the last three decades in bonds is unlikely to continue.

It’s a shame, particularly for older investors.

Here’s a simple example. Let’s say that you own a bond paying 4% interest that matures in 5 years. If the interest rates for similar bonds decline by 0.50%,then the value of your bond is reduced by roughly 2.5% (0.50% decline x 5 years to maturity). Hence, your total return that year would be 4% interest income less 2.5% of price reduction. Hence, a net total return of 1.5%.

So, why would someone even own fixed income investments? The simple answer is that they still serve an important role in your portfolio. Fixed income has traditionally provided diversification and low volatility and should continue to do so. When equities rise, bonds won’t keep pace. But, when equities decline, fixed income historically advances. In addition, fixed income provides superior capital preservation qualities over other asset classes, including equities.

We believe in long-term investing and are known for not making “knee jerk” reactions. However, when there are major investment turning points, as we are seeing now, it is time to review portfolios with new proactive strategies in mind. This may include reduction of the allocation to fixed income, modifications within the fixed income asset class, and other techniques. Our DWM clients have seen a number of rebalancings focused on these matters in the last few months.

If you want to hear more, mark your calendars. DWM’s annual client educational update this year will focus on proactive strategies in a rising Interest rate environment. Our Charleston/Mt Pleasant event will take place October 23rd in the afternoon and our Palatine event will take place the afternoon of October 30th. We do recognize that the topic may, for some, be important but unexciting. That said, we can promise all attendees some pleasantries at the receptions that will follow. Be sure to watch for more details soon.