2020 was a year that investors will not soon forget and it’s clear, few of us were sad to say goodbye.
2020 was a year that investors will not soon forget and it’s clear, few of us were sad to say goodbye.
If you want to see, perhaps even enjoy, an exercise in futility, run a search in Google on this phrase:
As you’ll find, the search returns dozens of articles containing hundreds of predictions from market pundits about how they expected 2020 to unfold for the economy and the stock market. Some were bullish, some bearish. Some predicted a recession, others a continued economic expansion. Nearly all boldly predicted some “periods of volatility” for stocks – mostly due to 2020 being a presidential election year.
What you will not find in any of these articles is a single prediction that an unprecedented pandemic would shut down the world for months, tanking the global economy and sending the stock market down more than 30% in the span of just four weeks. Nor will you see any predictions of the historic recovery in stocks that followed.
To be fair, it’s hard to fault these failed fortune tellers from just 10 months ago. It wasn’t until December 31, 2019 that China first notified the World Health Organization of a mysterious, pneumonia-like virus emerging in the Wuhan region of China. It would be another month before U.S. health officials confirmed human-to-human transmission of the new virus. And it wasn’t until February 11 of this year that this novel coronavirus was given a name: Covid-19.
Yet, while we can’t blame any market pundit for their failure to predict the seismic impacts of a pandemic no one could have seen coming at the time – that’s also the point.
PREDICTIONS CREATE CURIOUSITY
In retrospect, predictions about the short-term direction of the stock market seem harmless enough. Whether they turned out to be right or wrong is little more than a curiosity. But in the present, when the future is a murky mystery, they have impact. We are bombarded with predictions from the so-called experts about the stock market on a daily basis, and in real time they often seem compelling. They are blasted constantly across web sites and news networks and into the consciousness of the investing public. Rightly or wrongly, many investors view these predictions as guidance; it influences their worldview, and, as a result, their decision making.
This dynamic was on full display in the midst of the stock market plunge in February and March of this year, when all the experts who didn’t predict the pandemic a few months earlier were rushing, undaunted, to issue new predictions. They warned of deeper market drops yet to come, and a plodding “u-shaped” recovery for stocks that would take years to climb out of once the bear market finally ended.
STAYING IN YOUR SEAT
Unfortunately, investors heeded these warnings and headed for the exits. According to Morningstar, Inc., they pulled $326 billion from mutual funds and ETFs in March – more than three times the amount of outflows the industry saw in October 2008. In the same month, investors plowed a record $685 billion into money-market funds – just in time for the massive stock rally.
It’s a story as sad as it is predictable, because we’ve seen it happen repeatedly in the past three decades. We can only hope that one day individual investors will finally realize how baseless these short-term market predictions are, and how much their net worth declines whenever they heed them.
It seems the rapid recovery in stocks since late March has been met with more skepticism than optimism. How could stocks have been on such a staggering upward climb since the early stages of the pandemic, with the economic impacts of the shutdown just beginning to be felt and the ultimate human impacts of Covid-19 far from certain? The rebound is generally attributed to stocks being propped up by the enormous relief packages enacted by Congress and accommodative fiscal policy from the Fed.
Indeed, there’s no denying that the stock market typically responds favorably to spending bills and easy money policies. But it’s also interesting to look under the hood, so to speak, and take a closer look at the stocks that have powered the S&P 500’s almost 50% gain since the market bottom on March 23.
As we saw through early July of this year, the S&P 500 index’s performance in 2020 has been heavily skewed by the 50 largest stocks in that index – and especially by the 10 largest stocks. Beyond that (as of the July date used in our analysis), the remaining 450 stocks in the index had negative returns, with the bottom 50 stocks down nearly 40% on average. It seems the index remains skewed in a similar state.
In fact, an even deeper dive into the S&P 500’s performance this year shows the rebound has been attributable to five technology behemoths: Amazon, Apple, Alphabet (Google parent company), Microsoft and Facebook:
Because these five stocks account for 22.6% of the S&P’s total market capitalization, their outsized performance has buoyed the index in 2020 despite the vast majority of its component stocks being in the red.
While the performance of those five big tech stocks has been impressive so far in 2020, they also carry significant risks going forward – namely in the stratospheric valuations these stocks now carry. As seen in the prior chart, the weighted average price-to-earnings (P/E) ratio of those Big 5 tech stocks was 50.1 as of August 10, compared to 22.2 for the remainder of the S&P 500. By comparison, small value stocks had an average P/E ratio of 12.20 as of June 30.
None of which is to say that any or all of these bellwether tech stocks are headed for a decline – just that their present valuations will require huge earnings going forward to justify their recent performance. Investors who are heavily concentrated in them are bearing the risk that comes with those lofty valuations – knowingly or unknowingly.
As always we are here to help.
CAM Investor Solutions
It is no secret 2020 took the world by surprise and will be the year we all remember. It also seems investors have learned there are many things we certainly cannot control. However, when it comes to financial planning, and in particular tax and retirement planning, there are significant opportunities we all should consider now since they may not be available for long. If you haven't considered Roth conversions before, 2020 may be the year.
Why 2020? It's because we have historically low tax rates and some have suggested they could rise in the near term. Taxes could also rise due to the increasing budget deficit, increased stimulus spending and highest deficit since World War II. For those whose employment has been impacted by the Covid-19 pandemic, this may present planning opportunities. And the obvious may be that higher tax rates put tax-deferred retirement savings at risk; so some of us may want to pay off the "debt" at the lowest possible tax rates.
Assess overall market conditions and factors to determine if a Roth IRA conversion makes sense.
Determine which group of assets and/or asset class to convert.
Work with Advisor or CPA to determine the amount to convert.
Determine how you will pay the income tax on the conversion.
Compare other viable long-term tax planning strategies.
Evaluate your need for a 2020 tax conversion. One option is to perform a series of smaller annual conversions over time. This fills up the lower tax brackets each year and manages the tax liability. Also, be sure funds are available to pay the taxes.
A second option is to convert larger amounts in 2020. By now, you should have a reliable estimate of 2020 income. If the pandemic caused business losses, a job status change from retirement or unemployment, or a large change to income, this year may allow for a larger conversion.
This popular planning strategy can allow you to pay lower tax rates today and allow the funds in your Roth IRA to grow tax-free. It can also allow for the potential for 100% tax-free withdrawal from your Roth in the future.
While a Roth IRA conversion can remove some risk of uncertainty to your planning process, keep in mind your Roth is not subject to required minimum distributions (RMDs). Smaller RMDs can reduce tax liability and increase sustainable lifetime income.
The benefits can be significant, but this strategy is not for everyone.
As always we are here to help.
CAM Investor Solutions
It’s natural for investors to look for a connection between who wins the White House and which way stocks will go. But as nearly a century of returns shows, stocks have trended upward across administrations from both parties.
Shareholders are investing in companies, not a political party. And companies focus on serving their customers and growing their businesses, regardless of who is in the White House.
US presidents may have an impact on market returns, but so do hundreds, if not thousands, of other factors—the actions of foreign leaders, a global pandemic, interest rate changes, rising and falling oil prices, and technological advances, just to name a few.
The anticipation building up to elections often brings with it questions about how financial markets will respond. But the outcome of an election is only one of many inputs to the market. Below is a link to an interactive exhibit that examines market and economic data for nearly 100 years of US presidential terms and shows a consistent upward march for US equities regardless of the administration in place. This is an important lesson on the benefits of a long-term investment approach.
Follow this link to learn more about each presidency: Interactive Exhibit - Markets Under Each Presidency
As always, we are here to help.
CAM Investor Solutions
Vanguard founder John Bogle once famously advised investors on how to handle stock downturns: “Don’t just do something,” he said. “Stand there!”
It is a wry and wise way of turning the conventional wisdom about what to do in bear markets on its head. When panic grips the stock market – as it did in February and March of this year – the gut instinct of investors is to do something. Sell. Flee. Run. Protect. Move. All of these survival instincts that lurk in the back of our brains during calm markets come rushing to the front when stocks swoon and we fear our financial security is in jeopardy.
The great irony of investing, though, is that our instincts are almost always wrong. Emotion is the enemy that leads us down stray paths and into a place of chaos and confusion. Creating a successful long-term investment strategy is all about process; it is a logical and methodical exercise that requires planning, prudence and discipline. And when our survival instincts kick in, our anxious brains don’t want to hear anything about planning or prudence or discipline.
Overcoming this urge to take action is made doubly hard by the endless stream of bad advice that permeates the airwaves and websites when the market plunges. The talking heads tell us to “take some money off the table” and “shift assets into defensive stocks” and various other bear-market tropes that are all just market timing masquerading as sound investment strategy.
The Importance of Having an Investment Philosophy
Alas, the majority of the investing public heeds this bad advice and flees the stock market for the perceived safety of bonds and cash, only to miss the ensuing recovery that occurs when everyone least expects it. We saw this vividly this past February, when U.S. equity funds saw $17.5 billion in outflows, while money-market funds saw $31.4 billion in inflows. (Source: Morningstar, Inc.). Predictably, and sadly, those investors were on the sidelines when stocks staged their dramatic turnaround beginning in late March. In a span of just 10 weeks, from March 23 to June 8, the Dow Jones Industrial Average gained a stunning 48.30%, but all of those investors who fled to cash missed out on the recovery.
Typically, these investors only dip a toe back into stocks when they perceive things to have calmed down. But by then the recovery has passed them by, and they only experience a long period of stagnant returns or, worse, another market downturn. This is known in the investment business as “getting whip-sawed” and it is all-too-common an experience for many investors. As a result, they conclude that the stock market is rigged or somehow stacked against them, ignoring the reality that it was their own behavior – not the stock market – that caused them to incur steep losses.
This wrong but widespread belief can be seen in numerous articles that have cropped up in recent months. One particularly egregious example we saw last week carried the headline, “The Stock Market is a Ponzi Scheme.” It pointed to various deceptions and frauds that have caused companies and investment products to fail, wiping out their shareholders in the process.
There is no denying that frauds and deceptions come and go in the financial markets. In the past two decades we have seen accounting frauds at WorldCom, Enron and several other huge conglomerates that have bankrupted the companies and wiped out their shareholders in the blink of an eye. Just in the past few weeks, a $2 billion fraud was revealed at Wirecard, a global payment processor, that sank the company and its stock.
The skeptics love to point to these unfortunate incidents as proving their assertion that the market is rigged and unfair to individual investors. What they fail to point out, though, is it was only the investors who were concentrated in these stocks who lost everything; for well-diversified investors, they were merely a blip on the radar, because the broad stock market isn’t impacted over the long run by the fates of individual companies. In fact, it is the nature of a free-market that companies are constantly coming and going within the ecosystem.
The buzzword in the start-up world these days is “disrupt” – meaning that small tech companies are seeking to disrupt larger, entrenched companies and industries that are vulnerable to innovative new technologies and strategies. Uber, Airbnb, and Venmo are but three of the more high-profile start-ups that have disrupted entire industries and the legacy companies within them. Meanwhile, venerable old-line companies with huge capital requirements such as Hertz and Neiman Marcus have filed for bankruptcy in recent weeks as their business models became unsustainable during the COVID-19 shutdown.
This dynamic of innovation displacing stagnation has been going on since free markets began; it should be embraced, not feared, because it is the fuel that propels the stock market ever higher in the long run.
Diversification is the way to capture those higher returns without betting on the fates of individual companies. And with an estimated 630,000 public companies in the world, there is simply no reason to take on that unnecessary risk.
Unfortunately, most investors don’t differentiate between market risk (the risk that is inherent to stock investing) and security risk (the risk you assume when investing a large sum in an individual stock or investment product). Market risk diminishes over time; the longer your holding period, the lower your risk of losing money. Security risk, however, does not. A company whose stock has outperformed the broad market for twenty years could still go bankrupt for unforeseen reasons and wipe out their shareholders in the process.
The Zoom Effect
We will close with a recent, and humorous, example of security risk. When the world went into shutdown-mode in March, video conferencing quickly became a part of everyday life for millions of people, and the phrase “Zoom call” became a part of our lexicon.
No surprise, then, that investors rushed to load up on the stock of Zoom Technologies. After all, if almost everyone is using a company’s product, it stands to reason the stock will soar, right?
And soar it did. Unfortunately for those who piled into the stock, it was the wrong company. Zoom Technologies was a penny stock that, according to regulators, hasn’t made a public disclosure since April 2015 and was last known to be operating in Beijing. Zoom Video Communications is the actual company these investors thought they were buying into. But, alas, the “fake” Zoom had the good luck to own the ticker symbol “ZOOM” and that was apparently enough due diligence for many people. Frenzied investors loaded up on ZOOM, sending the stock price soaring more than 2100% in just two weeks. Meanwhile, the stock of the “real” Zoom (whose ticker is the pedestrian “ZM”) gained a mere 50% during the same period of time.
So widespread was the confusion that the Securities & Exchange Commission finally felt compelled to intervene to save these poor investors from themselves, pausing trading in ZOOM on March 27. The regulator cited “the public interest and the protection of investors” as the reason for its order. But investors continued to pile into the stock when trading resumed, pushing it up a whopping 51,000% before the inevitable plunge to earth occurred in late April. Since that time, ZOOM stock has lost about 85% of its value – whatever that value may have actually been.
We are happy to report that real Zoom is alive and well.
As always we are here to help.
CAM Investor Solutions
As cities around the world continue to move forward at their own pace, the demand for goods and services continues to look different. While many are pricing in deflation in the near-term, we think ALL investors should consider the implications of an inflationary environment going forward. But, let's dive in and understand perhaps why and how this may impact you.
It’s tempting for future inflation expectations to be prominently influenced by the experiences of recent years. The University of Michigan’s Institute for Social Research publishes one of the most popular surveys of inflation expectations. Conducted monthly, the survey asks households to estimate expected price changes over the next 12 months. Figure 1 showcases inflation expectations on a monthly basis from 1978 onward. A steady level of inflation expectations since the mid-1980s has hovered around 3% with few spikes downward (2002) and upward (2008, 2011). There was a small downtick in the first three months of 2020 but nothing dramatic given the Fed’s large-scale asset purchase program intended to keep interest rates low and financial markets well-functioning to fight the COVID-19 recession.
Viewing this data suggests these inflationary expectations track actual inflation quite well. A 2007 Journal of Monetary Economics study involving a forecasting experiment shows that survey forecasts outperformed several alternatives, including simple predictive time-series models and others using real activity measures like economic growth and unemployment. Determining that these survey forecasts do well on their own is probably the study’s most provocative finding. Making adjustments to account for biases from reporting lags or combining forecasts with other approaches yield worse or no better out-of-sample forecasting performance.
While inflation is a measure of the average change over time in the prices for a market basket of goods and services of a typical American, fluctuations in food and energy prices, which tend to be volatile, can heavily influence short-term changes. Core inflation typically excludes these two categories and is often the focus of policymakers when they gauge inflationary pressures. Core inflation includes consumer durables that are long-lasting items, such as cars and refrigerators, non-durable goods that households use more quickly, and services like health care, transportation, financial and recreation.
Figure 2 illustrates differences between inflationary pressures over the past eight years. Using December 2012 as the starting point, we compound the index of personal consumption expenditures (PCE) through March 2020 to represent 10.5% (teal line, final index level of 110.5). The more volatile, down-trending (green) line is the sub-index of PCE for energy only. It indicates negative inflationary, or deflationary, pressures of -19% over that same period, especially in the first three months of 2020 during the COVID-19 crisis. We can also see a steady deflationary trend in PCE durable goods only (orange line). It wouldn’t be surprising to think assumptions about future expected inflation incorporated into a customized financial planning exercise might be influenced by the more salient components of a consumer’s (aka investor’s) basket of purchases.
Does the Fed Offer Useful Guidance?
Maybe experts at the Fed have a crystal ball that we could peak into? Indeed, the Fed explicitly states that an inflation rate of 2% per year is most consistent with its mandate for price stability and maximum employment over the long run. What we don’t know is which of the multiple measures of components of PCE that Fed officials study or what macroeconomic data they review to evaluate inflation trends. What we do know is that the Federal Open Market Committee (FOMC) releases transcripts and a statement to accompany its “projection materials” when meetings conclude. The Fed chair typically leads a press conference as well.
The statement for the December 10-11, 2019, meeting (issued December 11 at 2 p.m. EST) affirms that “on a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent.” The projection materials, which survey Federal Reserve Board members and Federal Reserve Bank presidents, report a median core PCE inflation rate for 2020 of 1.9% with a (central tendency) range of 1.9% to 2.0%.
Before putting too much weight on this form of central bank forward guidance, know that scholars have also drilled down into such statements with the goal of extracting information to guide forecasts of future expected inflation and market returns.
A 2018 Quarterly Journal of Economics study, for example, looks at a high-frequency 30-minute window surrounding scheduled Fed announcements to gauge whether expectations about inflation move as a result of news about monetary policy.
It turns out a tightening of monetary policy does reduce inflation, as theory and our intuition would predict, but the responses are remarkably small. This could imply that forward guidance is already known to market participants, making it a no “new” news event.
Should the Market’s Breakeven Expected Inflation Rates Be a Guide?
Could the markets themselves help manage our inflation expectations better? The U.S. Treasury bond and Treasury Inflation-Protected Securities (TIPS) markets are two of the largest and most actively traded fixed-income markets in the world. TIPS are like Treasury bonds except the principal amount is adjusted over time to reflect changes in consumer prices to protect the investor. A fixed coupon rate is applied to a principal amount that changes in response to realized inflation (or deflation), so the actual semi-annual coupon the investor receives in dollars changes similarly. The difference between the nominal 10-year Treasury bond yield and the 10-year, inflation-adjusted TIPS yield implies the average rate bond market investors expect over the next 10 years. A 1% yield on a 10-year Treasury note associated with a 0.25% 10-year TIPS rate means an investor gets a so-called “breakeven inflation rate” of 0.75% per year over the next 10 years.
If that sounds low, examine Figure 3 which presents the daily 10-year breakeven inflation rate since 2015. It has hovered in the range of 1.40%- 2.00% for much of that time. While there has been a spike downward during the COVID-19 crisis to a historically low 0.50% in early March 2020, it has trended upward since—approaching 1.40% at the end of June. Some caution may be in order with these market-determined breakeven inflation rates. A 2014 Journal of Finance study shows that Treasury bonds are almost always assigned lower discount rates relative to TIPS— especially in times of increased market volatility.
Such market dislocation means these two types of securities aren’t otherwise equivalent but for the inflation protection mechanism in TIPS, as assumed above. Most importantly, the Treasury-TIPS price differentials can’t be used to reliably back out the market’s inflation expectations with a high level of accuracy, as the breakeven rates are biased downward. Despite this known bias, this method could still be used to inform inflation expectations for financial planning purposes so long as we are cognizant of the inherent limitations, much like many other inputs in a long-term financial plan forecast.
Inflation Isn’t So Easy to Forecast
While the market’s implied forecasts for inflation aren’t reliable, there are few alternatives available to forecast it. Forward guidance from the Fed and other monetary policy authorities seems fraught. And extrapolating based on recent historical experience is likely more dangerous than ever in light of the COVID-19 recession and unprecedented Fed actions to counter its impact. Maybe the best strategy for financial planning is to anchor the Fed’s inflation target and guidance with the 10-year breakeven rate from the market. The most important takeaway is that each investor should work to build a diversified portfolio with an understanding that the actual path of inflation may be quite different than what was originally forecast. Monitoring and reassessing can help ensure nimble pivots in the allocation mix if the need arises.
As always we are here to help.
CAM Investor Solutions
On February 12, the Dow Jones Industrial Average closed at an all-time high of 29,551. At that time, the economy was humming, corporate earnings were rising and unemployment was at lows last seen during the mid-1950s. While global health experts were increasingly worried about a potential pandemic caused by a new Coronavirus, it seemed to be something that was off in the distance. SARS, MERS and the 2009 Swine Flu pandemic had all run their respective course without derailing the global economy. The hope was that COVID-19 would as well.
Needless to say, things didn’t exactly pan out that way. In mid-February, health officials sounded the alarm that COVID-19 was coming to virtually every corner of the globe and would be difficult, if not impossible, to contain. Models from medical institutes were generated showing grim infection and mortality rates. Governments around the world responded by implementing extreme measures to combat the pandemic, shuttering all but essential businesses, canceling public gatherings of most any size, and ordering people to shelter in place for an extended, and undetermined, amount of time.
The combination of events effectively turned both corporate and consumer spending – the twin engines of global economic growth – to a trickle. This unavoidable and unexpected reality sent stocks into a tailspin so rapid that there was no historical precedent, even during the Great Depression. When the Dow reached its (thus-far) low of 18,591 on March 23, it represented the shortest period of time ever in which that index declined 30% or more from its peak.
Economists refer to developments such as the COVID-19 pandemic as “exogenous events” – unexpected and highly impactful events that are so far outside the bounds of normal expectations that they can’t be modeled. After a twenty-year time period in which we’ve seen 9/11, the Great Recession and the current pandemic, we feel we speak for most people when we say we’re getting a little tired of exogenous events.
As individuals, we are all grappling with the anxieties and uncertainties that the COVID-19 pandemic has ushered into our lives. On a purely investment level, however, we would like to share some of our thoughts that we hope will provide some perspective during this time of uncertainty.
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When the Dow fell to about the 20,000 level on March 17, the stock market at that point was pricing in an expectation of a 50% to 80% decline in corporate profits from the economic fallout associated with the pandemic (source: Brian Wesbury, Chief Economist, First Trust). By comparison, corporate profits fell 46% in 2008, a time when the global financial system was on the brink of collapse. Being forward-looking, the stock market has already priced in a drop in corporate profits as bad or worse than anything we saw in 2008. So, while the market may well decline below its recent lows, it is hard to argue that it hasn’t already factored in a major economic downturn.
Should that dire scenario fail to materialize, we would expect a rapid rebound in stocks as the market quickly reprices itself for expectations of higher corporate profits. That repricing may (or may not) already be underway in light of the significant gains stocks have posted since the Dow reached its recent low on March 23. Since that point, the Dow has seen two historically large moves upward, and a lot of volatility in between. The first big move was on March 24, when the Dow gained more than 11%, the largest one-day percentage gain for that index since 1933. The Dow continued upward for the next two trading sessions, at the end of which it had soared more than 21% in just three days. If you’re keeping score at home, that effectively ended the official bear market that had begun on March 11, when the Dow closed 20% below its February 12 record high. It may be semantics when we look back on this down the road, but it was the shortest bear market in history. Stocks then bounced around in late March and early April before another big move upward April 6-8, when the Dow gained 11.23%.
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The pundits love to dismiss these sudden upward moves in the stock market as “fake bounces.” They say they are but mirages, temporary upward climbs on a long, painful slog downward. They may well be right; only time will tell. But one thing we know for certain is that they don’t know anything more than you or us about whether the market truly hit bottom on March 23 or whether there is more in the downturn yet to come.
“Fake” bounces are indeed common occurrences during times of extreme market volatility. We saw many of them during the Great Recession in 2008-09. But the thing is, sooner or later that bounce will turn out to have been real, and we will only know it with the benefit of hindsight. A great example of this was when the Dow bottomed out at 6,469 on Friday, March 6, 2009. You may recall that, at that time, there was no good news to be had. The foundation of the global financial system was still quaking, unemployment was soaring, and stock investing was derided as a fool’s errand.
The conventional wisdom of the day was that we should not expect a v-shaped recovery in stocks, but more of a u-shaped one in which we slogged along at the bottom for months or years. An unnerving headline in The Wall Street Journal the next Monday read: “Dow 5000? There’s a Case for It.” Let the record show that this was the exact date the bear market ended and stocks took off; a decade later the Dow was at 25,650.
When the market does reach its bottom and the current downturn ends, investors on the sidelines who have been awaiting the all-clear signal will be in for a rude awakening. Stocks do not send out announcements when they change course, and the news environment is often deeply negative when they do. For example, when stocks began their turnaround in March 2009, they did so with breathtaking speed. Here is a graph showing the cumulative gains logged by a variety of market benchmarks from March 10, 2009 to December 31, 2009 (remember that these are indexes, not actual investment products; past performance is not an indication of future results):
In a span of less than nine months, stocks across all sectors posted gains that often take a decade or more to achieve. The pundits were there every step of the way to warn us that this was yet another fake bounce. But it wasn’t, and investors who heeded the bad advice missed out on crucial gains that those who stayed invested enjoyed.
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We are all feeling a lot of empathy these days for the economic pain that the shutdown is inflicting on millions of people. When we dare to venture out of our homes to make a dash into a grocery store or pharmacy, we all see the same thing: mile after mile of businesses shuttered and parking lots emptied. We ache for the owners of the businesses in our own neighborhoods, many of whom we know and care about, and wonder if they will be able to survive. It’s tempting to extrapolate what we see with our own eyes to the larger investment picture. With so many businesses – even publicly-traded ones – likely to fail, how can we have confidence in investing in stocks?
This is where it’s important to remember that our investment philosophy at CAM Investor Solutions is grounded in the belief that we should invest in markets, not individual companies. We construct our portfolios so that every client has broad exposure to thousands of companies. Inevitably there will be winners and losers in the months and years ahead. As we saw in 2000-02 and again in 2008-09, there will be high profile, household-name companies that fail. But there will also be winners that come out of the aftermath, companies that are well positioned and able to pivot to take advantage of the new economic environment. New companies will come out of nowhere and bring vital new products and services to the world and thrive because of it.
In the long run, stock returns are a reflection of the future expected earnings and the cost of capital for public companies. When we employ a broadly diversified portfolio strategy, we are effectively letting the free market sort out the winners and losers while we capture the long-term benefits of stock investing.
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We are not typically fans of Jim Cramer’s shock-jock approach to stock investing on his CNBC show, but he did raise a point recently that resonated with us.
“If you’re short (i.e., betting against the market), you’re betting against science,” he said on March 27. His point was that scientific innovation is an incredible tool for solving seemingly insurmountable problems, and assuming the current Coronavirus pandemic will go on without any solution to it is, well, a rather dim view of human ingenuity.
With that, we wholeheartedly agree. And the point is valid well beyond the realm of science. Consider that, for the first time in human history, the world is collectively focused on solving a single problem. Right now, there are 7.5 billion people on this planet who are all anxious to see an end to this pandemic as soon as possible. Scientists, engineers, executives, entrepreneurs, politicians – everyone wants an answer to the Coronavirus crisis.
This unified desire has provoked an unimaginable deployment of the world’s resources to the crisis. In just the span of a few weeks, we have seen the following response to a virus that has only been known since late December:
Over 52 potential vaccines submitted for review to the FDA and other global health organizations.
Testing kits that are being produced in the millions to detect both current infections and prior exposure to the Coronavirus. This will provide vital knowledge to understanding how widespread the virus is and when the world can get back to work.
Assembly lines at Ford and General Motors converted to manufacturing ventilators.
Cruise ships converted to hospital ships.
Breweries converting their fermentation tanks to make hand sanitizer.
Apparel companies converting their production lines to manufacture masks, face shields and gloves for healthcare workers on the front lines.
Corporate jets being used to transport critical supplies to the most affected areas at no charge.
We could go on and on, but the point is clear. Human ingenuity is a vast and incalculable resource and it is being put to use on a single problem like never before. In times of crisis, it can be difficult for investors to put their faith into solutions that haven’t emerged yet. But we can look back over the course of history and see that human ingenuity has seen us through every crisis we have ever faced. We are confident it will see us through this crisis as well.
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As wealth advisors, we are – first and foremost – in the relationship business. Building trust and rapport with our clients is vital to helping us understand their needs and achieve their goals. It’s something that happens organically over time; along the way, we get to know our clients and our clients get to know us.
All of which is to say, our relationship with each of you means a lot to all of us at CAM Investor Solutions. Financial events – market declines, recessions, etc. – can be difficult times for investors. But a pandemic brings a different type of anxiety altogether. All of us worry about how the people we know and care for will be affected by this, both from a health perspective and an economic perspective.
If there is any silver lining in all of this, it’s that this crisis has honed all of our priorities and deepened our appreciation for the people we care about. Please know that we are here for you in this trying time, both as advisors and as friends. If you want to discuss your financial situation, of course, we are always available for that. But if you just want to vent, be reassured, or just generally have some human connection while we are all feeling housebound and isolated, please pick up the phone (or send us a Zoom meeting invitation!) and we will be there for you. And if there is anything we can do to assist you or a loved one who is in need, please know that we will be happy to help in any way we can.
CAM Investor Solutions
Last week, we saw market movements that signaled a low-yield environment. Since then, rates have continued to fall. Currently the 10-year treasury is trading close to 50bps and the entire yield curve is pricing at below 1% for the first time in history.
Although these unprecedented movements may reflect more short-term fears, we believe they should motivate a revaluation of traditional notions of risk and reward. As we look to ensure one's financial planning strategies remain sound, below we highlight some key considerations that may impact all of us:
Over the past couple of weeks, coronavirus fears and the rapid drop in oil prices have gripped global markets.
In the US, the S&P 500 recently experienced its worst week since the global financial crisis as investors piled out of risk assets, and yields on safe haven assets have collapsed.
In particular, the yield on the 10 year Treasury breached the 1% mark - and is currently the lowest it has been in modern record (back to 1962).
Although the bond market rally may have benefited many traditional fixed income investors in recent weeks, we view the level of current yields as the most relevant measure of investors' experience to come. And we believe these yields may predict a prolonged period of challenging performance by traditional fixed income portfolios.
While this may concern some, it really means that everyone should review all of their current bond and fixed income strategies to ensure they still meet one's financial planning and retirement income needs.
In contrast, there are some strategies that still invest and currently offer higher yields above current fixed income solutions – far more than the 1-2% yields currently offered by traditional fixed income.
In addition, some of these strategies have established a track record of delivering consistent returns which have been relatively robust to market instability, due to their structure and near-zero correlation to equities and bonds. While we invest in these strategies for some clients, they are not a one size fits all and require additional consideration and due diligence.
Whatever developments may unfold over the next few weeks and months in financial markets or global economies, we believe smart financial planning will continue to serve as a ballast in investors’ portfolios.
Over the past few years, we've discussed the impact of a low interest rate environment on investors' financial planning goals and investment returns. While some argue rates may one day rise again closer to long-term averages, this is very hard to predict.
Of course, low rates can be great for so many things such as:
Lower mortgage payments
Smaller borrowing costs
Increased stimulus and economic growth
Greater business valuation
Global trade benefits
However, as we've discussed prior, low rates and in particular a low risk-free rate can have consequences on our investment returns, our financial planning assumptions, and the ability to generate sustainable lifetime income. Therefore, it is important to be proactive and understand these implications in order to create a smoother path both during the working years and well into retirement.
For reference, academia has documented the fact that higher portfolio volatility can subject investors and retirees to significant sequencing risk. It can also result in a lower level of gross accumulation of wealth. In contrast, there may be better planning and investment strategies that can be measured with greater precision, with less volatility, and where the sequencing risk works in investors favor.
With all this in mind, we want to remind investors that during a time of economic changes like the ones we are experiencing now, it is important to evaluate and trust the financial plans you have put in place and avoid the temptation to let emotions make your financial decisions. Your financial plan is there to guide you through times like this.
As always we are here to help.
CAM Investor Solutions
It seems investor sentiment has quickly changed since the beginning of the year, not to mention from just about 10 days ago as witnessed by the recent stock market decline. Many argue "why" this has happened and here's a quick look at the potential reasons:
Coronavirus: Most argue this is the primary reason for the recent market sell off. Its certainly terrible what is happening across the globe to humans who are suffering or have passed away. Our hope is that we have containment and a cure soon.
Presidential Election Uncertainty: Others will point to the future expectation being priced in on who will win the next election based on recent debates. We won't go here, especially because the market will figure it out faster and price it in before any of us can profit from the future results.
"We were due for a correction": Always a classic reason for market sell offs, especially coming off all-time market highs just a couple of weeks ago.
Insert your own "crisis of the day": We are adding this one in advance of what will happen in 2020 and beyond. We don't know what the next crisis will be or when, but its highly probable that it will be something we can't control or predict.
Who should be concerned? Its simple: those who have not put a good financial plan in place. For those of you who have taken the time to establish a well thought out financial plan, you've been planning for short-term market fluctuations like this which will have no impact on your current or future lifestyle. For the latter audience, it is also probable that you and/or your advisor are rebalancing your portfolio given the opportunity. This is how risk is properly managed and how investors build a larger nest egg over time. It is also what we call investor discipline, but we know its not always easy to watch depending on your stage of life.
In light of recent investor questions, market volatility, lower interest rates, and lower inflation expectations, we thought we would leave you with some additional food for thought as you might be considering rebalancing and/or different investment strategies going forward. And of course beware of those trying to sell you the "guaranteed" products that are not a fit. These folks seem to be everywhere at a time like this.
Investment Strategy Considerations/Risks:
PASSIVE FIXED INCOME
Many investors use the Barclays Agg as a proxy for the fixed income universe. The Barclays Agg has no TIPs, 28% of the index is short volatility and 32% has credit spread risk. Some larger, well-known mutual funds hold this type of risk.
While rates are extremely low, any jump in higher rates increases the all-in cost of buying a home or other property, which can depress demand. Increased rate volatility can reduce mortgage lenders' appetite for new loans.
MINIMUM VOLATILITY / LOW VOLATILITY STOCKS
Min vol / low vol stocks can be seen as "defensive" and used with the goal to generate yield with less equity risk than the broader market. However, investors might be overpaying for "safe" stocks. These stocks have nothing to do with owning "volatility".
SHORT DURATION BONDS / TIPS
TIPS are set using the Consumer Price Index (CPI), which only represents today's inflation level.
FLOATING RATE NOTES (FRN)
Frequently used to profit from higher yields, FRNs may have credit risk and almost no sensitivity to interest rates. Currently 91% of the bonds trading in the Bloomberg Barclays Floating Rate <5 Year Index are trading above par.
PRIVATE ALTERNATIVE INVESTMENTS
While some private alts may serve as a good diversifier, caution is recommended as most strategies in this arena perform just like the stock market with a lag in reporting. Not to mention, most are super expensive, over-leveraged, and illiquid.
EQUITIES / GLOBAL STOCKS
Global Equities are a very efficient and low cost way to gain exposure to the capital markets. They can also serve as a way to keep pace with inflation over time. Given their risk/return characteristics, global equities are subject to market sell-offs due to deteriorating economic conditions.
Of course, there is a lot more to consider given investor needs, circumstances, and risk tolerance. Having a well-designed plan can address most all of these concerns and uncertainties.
As always, we are here to help.
CAM Investor Solutions
Everyone has a different value of a dollar. Regardless of how we view our investments, manage our liabilities, claim our social security benefit, and many other financial decisions, the illusion of wealth is real.
If given the choice of receiving $100,000 at the start of your retirement or $500 per month for the duration of your retirement, which would you choose? What about $200,000 versus $1,000 per month? Which option seems more adequate—the lump sum or monthly amount?
In reality, purchasing an annuity for $100,000 would result in a guaranteed lifetime income of approximately $500 per month, while buying one for $200,000 would yield roughly $1,000 per month. So, these lump sums and annuitized streams are economically equivalent. But are they psychologically equivalent? (Note: As a fee-only fiduciary, CAM earns no fees from any annuity or insurance recommendations).
Perceptions of Wealth: Lump Sum Versus Monthly Income
Behavioral science researchers Hal Hershfield, Dan Goldstein, and Shlomo Benartzi have investigated this question in several studies involving thousands of middle-aged adults (approximate ages 40-60) with varying incomes, educational levels, and ethnicities. In one study, for example, they asked a group of people if they thought $100,000, $200,000, $1 million or $2 million would be adequate to fund their retirement years. To keep things well controlled, they told them to imagine that each sum represented the total amount of money they would have to spend in retirement. The researchers then asked a separate research group how adequate these same amounts would be as monthly income of $500, $1,000, $2,000 and $4,000.
Not surprisingly, as the following figure shows, a lump sum of $100,000 didn’t rate very high on perceived adequacy. Their research participants gave it roughly a 2.25 on a 1-7 scale (where 7 represented “totally adequate”). But participants didn’t think about $500 per month in the same way. That amount garnered roughly a 1.75 on our seven-point scale. And the same was true for the $200,000 lump sum (which averaged a 2.5 rating) and the annuity of $1,000 per month (which rated a 2).
Annuity Income May Boost Saving Intentions
Although lump sums and their equivalent monthly amounts are financially the same, they are not psychologically equivalent. At times, lump sums may seem like they are worth more than their resulting annuitized streams. This matters for more than just simple perceptions of adequacy. When offered a $200,000 lump sum versus an equivalent $1,000 monthly annuity, research participants in another study were more motivated to increase their retirement savings (in a hypothetical context) when seeing the annuity compared to the lump sum. In other words, the $1,000 monthly annuity seemed less adequate and therefore boosted savings intentions.
But the story isn’t quite so simple. Yes, lump sums may sometimes seem more adequate than their annuitized streams. But look what happens when we asked people about the adequacy of a $2 million lump sum versus an annuity of $4,000 per month—the annuity seemed more adequate than the lump sum.
Annuities Become More Attractive When Amounts Are Larger
What’s going on here? When people think about how much money they’ll have for the future, more money will always seem better. But the mode of distribution—a lump sum or a monthly amount—will change perceptions of that wealth. From mortgages to car payments to credit card statements, we typically have more experience dealing with monthly amounts of money and whether a given amount will cover our expenses on a monthly basis.
As a result, it appears that people are more sensitive to changes in wealth expressed in monthly terms. This sensitivity can set up an interesting situation in which people perceive monthly amounts as less attractive than lump sums at lower levels of wealth (e.g., $100,000 lump sum versus $500 monthly). At lower levels of wealth, people can more accurately judge just how little a given amount would get them. We call this situation the “illusion of wealth.” Yet, people see monthly sums as more attractive at higher levels of wealth (e.g., $2 million lump sum versus $4,000 monthly income) where people can more accurately judge just how much a higher amount would buy them, or the reversal of the illusion of wealth.
These illusions can affect other financial decisions as well. Claiming Social Security benefits early, for example, results in slightly lower monthly payments over the course of retirement. When the earliest claiming age was 62, workers would forego $119 per month if they claimed benefits at 62 compared to 63. Over time, however, that same amount in lump-sum form would be equal to about $21,492. The illusion of wealth would suggest that the $21,492 lump sum seems larger and therefore a more painful amount to give up compared to the $119 monthly payment.
But it’s not just large decisions like retirement claiming age that are relevant. Consider the case of liabilities. Focusing on small monthly payments spread out over time can have detrimental effects on overall financial well-being if we simultaneously ignore the effects of compounding interest.
Numbers in Isolation Probably Don’t Provide Enough Information
Taken together, we might be better served to question the format that we use when we consider a variety of important financial decisions. Each number—whether it is a monthly amount or a lump sum—is probably not sufficient to use as the basis for a well-informed decision. Rather, when making saving, spending, and investment decisions, we are likely better served by having an understanding of both the sum and its broken-out parts.
Because these decisions can have such a significant impact on one's current financial planning or longevity planning assumptions, we believe a greater understanding for investors is deserved in order to maximize their well-being for the future.
As always we are here to help.