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.


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

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.

Greek Financial Crisis- Nothing New

GreeceGlobal stock markets fell sharply Monday. Investors don’t like uncertainty and that’s what this latest Greek financial crisis is providing. Can they avoid a full-blown default? Will there be a ‘Grexit’? Will it stay in the euro zone and keep the single currency?

The current Greek crisis has had many deadlines that have come and gone without any changes. Today, Greece is due to make a payment of $1.7 billion to the IMF for partial repayment of a bailout agreed to in February 2012. This Sunday, the people of Greece will vote on a referendum to accept or reject the austerity measures demanded by its creditors in exchange for further aid. Prime Minister Alexis Tsipras has encouraged the populace to vote “no” in order, he thinks, to try to negotiate a better deal with the country’s lenders. On July 20th, there is a $4 billion payment owed the ECB and then August 20th another $3.6 billion due the ECB. It will likely be a tumultuous next seven weeks for Greece and its citizens.

This is nothing new for Greece. Depending on your chosen starting point, this is year five or year 2600 of the Greek financial crisis.

  • Ancient Greece invented finance including banking, personal loans, capital levies and annuities. Back in the 6th century BC, according to Josh Brown in The Reformed Broker, they also invented the first financial crisis in recorded history. Greek citizens, en masse, had pledged themselves as slaves as collateral for debts they took out against their farms. Ultimately, much of the population was enslaved, both in the country or shipped abroad. The wiseman Solon solved the crisis by freeing his fellow countrymen from slavery by devaluing the drachma by one-quarter.
  • The banks of the day, which were the temples, generally did not lend to the city-states. However, the Shrine at Delphi and its Temple of Delphi made 4th Century BC loans to 13 Greek city-states and ended up taking an 80% “haircut” when the majority of them never paid back their loans.
  • Since Greece obtained its independence in the 1820s, it has been in default to its creditors roughly 90 of those years; about half. They defaulted in 1826, 1843, 1860, 1894 and 1932. In the late 1800s, the Greeks once again ended up under an unsustainable debt burden and the government suspended all payments on external debt in 1893. At that time, they created the “International Committee for Greek Debt Management” to appease foreign creditors. Sound familiar?
  • There are no countries in the modern world that have defaulted on their loans more often than Greece, except for Honduras and Ecuador.
  • The current financial drama began in December 2009, when credit rating agencies first downgraded Greek debt. Then, in May, 2010, there was a $146 billion rescue package loan, tied to a severe austerity requirement. The austerity program and rescue package failed and in October 2011, debt was restructured, with a 50% haircut.

That brings us back to today where Greece and the rest of Europe are at a nasty impasse. The odds of deal failure are quite high and ‘Grexit’ has become a real possibility. How bad would it be if Greece left the European Union? Maybe, not bad at all.

The world is ready for it:

  • More psychologically prepared than in 2009/2010 when the fear of contagion was very large.
  • More financially ready. Today, Europe has embraced its versions of QE- “whatever it takes.”
  • More economically prepared. Growth in the U.S. and Japan are doing much better. Parts of Europe are making progress. China keeps moving forward.
  • Removing this uncertainty could help the Eurozone. Some say that if Greece would leave, the bloc would be stronger. They call it the “ballast theory”- comparing the bloc to a hot-air balloon which would rise once Greece has been thrown overboard.
  • Contagion is always a risk, but probably not the risk it was when this all started.
  • Having a template for a country to leave the euro is likely a good thing.

Greece has a great cultural heritage. It has given the world some very important things. It’s a wonderful place to visit. Unfortunately, finance has not been its strong suit. Greek’s economy is about the size of Atlanta, Georgia. The world is prepared if there is a ‘Grexit’. Of course, no one knows how this drama will play out. Yet, everything should be fine with the exception of the volatility that this uncertainty brings to the stock markets.

We just need to stay focused on what we can control, particularly having a well-balanced and diversified portfolio consistent with our risk profile and staying invested.

Finally, we need to be ever grateful for being Americans and being able to celebrate our great country on July 4th. Happy Independence Day! Have a fun and safe weekend!

American flag flying in the wind

Gentlemen Prefer Bunds (German Bonds)

On March 10th, U.S. stocks declined for a fifth day.  The reason most often given was concern over Europe. Bond prices on most European bonds have declined, producing higher yields. Investors have flocked to safe havens, such as U.S. and German bonds, pushing those prices up and those yields sharply lower.

Spain’s ten year bonds are now yielding 5.8%. Spain is entering its second recession in three years, unemployment is at 23% and the government expects the economy to contract about 1.7% in 2012. The Spanish stock market is the lowest since March 2009. The concern is that austerity measures could have the effect of further depressing growth and creating a vicious cycle in which more budget cuts are needed to balance the books. Italy’s ten year bonds are not far behind, yielding 5.5%.

French business confidence has stagnated and factory output has dropped. Manufacturing production fell 1.2% in February and the Bank of France said its surveys suggest that GDP didn’t expand in the first quarter. On March 31st the Economist characterized France, Europe’s second largest economy, as “A Country in Denial.” Comparing them with Greece, the Economist indicated that “the Greeks know that free-spending and tax-dodging are over. But (France) has yet to face up to its changed circumstances.” Upcoming French elections demonstrate the reluctance to change. Front-runner Socialist Francois Hollande has promised to rollback most of the recent pension-age reforms and install a 75% tax rate on the wealthy. None of the candidates are offering radical reforms or austerity programs seen in other European elections recently. Yields on France ten-year bonds are currently 2.93%. But that could move up quickly and significantly right after the elections.

Germany is the one major bright spot. German ten year bonds are yielding 1.8% (as compared to ten year US treasuries yielding 2.04%.) Germany’s exports are up and its trade surplus surged in February. The above chart tells it all. German productivity has far outpaced the rest of Europe in the last eight years. Nominal unit labor costs have stayed almost level in Germany, while growing in Italy, Ireland, Spain, Greece and France. During this period, only Ireland has seen their costs drop, starting in 2008, as their labor accepted pay cuts and productivity increased. To get on par with Germany, all five countries would need a 30% pay cut to become competitive. It’s unlikely we can expect that to happen any time soon.

Greek Rescue Approved- But Europe Not Out of the Woods

Greek rescue

Today Europe finally reached a Greek Deal. Yet, doubt remains over whether Greece will be able to meet the terms of the accord and what the future holds for the euro zone.

The finance ministers agreed to the long-awaited 130 billion euro ($170 billion) deal that would start to reduce Greece’s debt to 120.5% of GDP by 2020. Private sector creditors will take a write-down on their Greek bonds of 53.5%. In return for the new cash, Greece signed up for cuts in pensions, minimum wage, health-care and defense spending, sales of assets and layoffs of public sector employees. However, even with this latest agreement, concern exists that Greece will not be able to meet its future commitments.

The Greek economy shrank by 7% in 2011, 5% of which was in the last quarter. Analysts expect further declines of at least 4% in Greek GDP in 2012 due to the required austerity programs. These structural reform measures, on top of Greece’s already 20% unemployment, will only deepen Greece’s recession. To make matters worse, businesses are not investing in Greece’s future until the euro is secure. Suppliers are not extending Greek firms credit, which is worsening the current liquidity shortage.

Elsewhere in the euro zone there are glimmers of hope. According to the Economist, Ireland has regained competitiveness, Spain’s new government has been able to reform long rigid labor laws, and Italy has passed a pension reform and is soon to propose labor reforms of its own. Yet, austerity in the short-term causes more unemployment and reductions in spending and GDP. Italy, Spain and Portugal are all expected to see a sharp drop in GDP in 2012.

By the end of February, European leaders are expected to agree on a new, higher “firewall” for euro countries that get into financial trouble. A permanent 500 billion euro ($650 billion) fund, the European Stability Mechanism is expected in July. This could bring much-needed momentum to the euro zone.

Yes, Europe has reached a Greek deal. Yet, the road to recovery for the euro zone will still be long and hard.

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