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Bonds: The Long and Short of It

By Posted on In Asset Allocation, Economy, Investment Strategies

Bond funds are often lumped together as one.  However, they are actually a range of very different investments.  This post will address only investment-grade bond funds which have a low probability of default as these are bonds that are issued by large and established corporations and the U.S. government.

It is important to know how changing interest rates affect short-term and long-term bond funds differently.  Short-term bond funds hold individual bonds that mature and ‘roll’ quickly into new bonds with current interest rates. This means short-term bond funds adjust relatively quickly to changing interest rates, so the principal risk is relatively low.   Short-term interest rates are set by our Central Bank as policy.  Long-term rates, however, are set by market forces and investor expectations.  Our Central bank influences, but does not control long-term interest rates. The interest rates on long-term bonds do not change for the length of their maturity.  What must adjust to changes in interest rates is the current price of the bond.  Higher interest rates mean lower current bond prices and vice versa (refer to my posts on duration).

What is important to know for today’s investors is that the Federal Reserve has raised short-term interest rates meaningfully off of zero over the last year or so and plans on continuing this trend.  As a result, some short-term investment grade bond funds are now offering SEC yields of around 2.5%.  However, long-term interest rates have only risen somewhat and, as a result, long-term investment grade bonds are offering an SEC yield of only 3 to 4%.  It was expected that long-term interest rates would rise accordingly with short-term rates, but thus far they have not.  Should this change, there is a real potential that longer-term interest rates will rise and the price of long-term investment grade bonds funds would be negatively impacted.

Investing in short-term investment grade bonds may currently have a lower dividend, but offer less principal risk.

Stock Market Update

By Posted on In Economy, Finding Confidence, Investment Strategies
For the first time in close to two years, the stock market is spooking investors. The decline was swift, sudden and unexpected.  It caught many people completely off guard.  A lot of the headlines I read over the weekend, yesterday and this morning were written to evoke more fear.  I’ve pulled together a few good quotes and excerpts to help put recent market events in perspective:
  1. “Don’t be scared, and don’t be impulsive. Be disciplined no matter what the market environment, and keep saving and investing according to your long-term plan,”  Kristin Hooper, chief global strategist at Invesco. Source
  2. “We are reminding clients to keep this in perspective and look to be proactive not reactive to the markets at this time. It is a big emotional test of…risk tolerance; we all want the upside but remember there is downside risk and goals, risk tolerance and time frames must always lead one’s investment decisions.”  Jeff Carbone, Managing Partner of Cornerstone Wealth. Source
  3. On average, there’s been a market correction every year since 1900… Instead of living in fear of corrections, accept them as regular occurrences. Source
  4. What’s more, the abnormal smoothness of the stock market over the past couple of years set investors up for a shock whenever stocks did fall at least 5%, as they did on Monday. As I pointed out last month, in the low-volatility market we’ve seen until recently, “even slight declines are apt to set off talk of Armageddon, and you will need to focus harder than ever on long-term returns to keep short-term losses from rattling you.” Source
  5. The Dow is down -0.4% year to date.  Source
  6. And then some people are selling because they aren’t people at all, but software programs that have been programmed to sell when others are selling. Source
  7. Losses — as in the Dow falling a little more than 7% over the past two trading sessions (including its biggest point drop ever on Monday) — loom larger than corresponding gains, according to those who study behavioral economics. In other words, losing 7% of your money hurts twice as much [as the pleasure of] making 7%. So, it’s normal, it’s human nature, that you’re in panic mode. But don’t act on your panic. Or at least don’t panic sell. Source
  8. “If investors were happy with their asset allocation on Thursday, they should find stocks more attractive today. Of course, investors sometimes are asleep at the wheel and a periodic wake-up call can be useful, but prices are just back to where they were a couple weeks ago, so why panic?,” Source
  9. We’ve had 15 straight months without a monthly loss in U.S. equity markets. Source
  10. The 665-point decline in the Dow Jones Industrial Average on Friday was the largest since June 2016. However, back in 2016, the Dow declined about 5%, and Friday’s drop was 2.5%. Source
  11. And while Monday’s drop was the biggest point drop ever, it still pales in comparison to the largest daily percentage losses: On Oct. 19, 1987, the Dow fell 22.61% and on Oct. 28, 1929 the Dow fell 12.82%. By contrast, Monday’s drop was 4.6%. Source
Still looking for some more perspective?  Consider reading this article written by CNBC a few years ago.
We are closely watching the situation and will act accordingly as the events continue to unfold.

Patience is an investment strategy

By Posted on In Finding Confidence, Investment Strategies

“The secret to investing, is to sit and watch pitch after pitch go by and wait for the one in your sweet spot. If people are yelling, ‘swing, you bum!,’ ignore them.”

Warren Buffet (Source)

 

I remember, years ago, a client called and exclaimed: “This market is on a rocket ride, you better get on board.” At the time, the stock market was trending higher and higher with disregard for how much the price (of stocks) were in excess of their actual value. The market continued to go up until it didn’t. And, as history shows, it didn’t end well. The trend exhausted itself and, in the spring of 2000, it turned, suddenly and dramatically. In 2007, the same scenario happened again.

Recently in an article by article by Rob Arnott Vitali Kalesnik and Jim Masturzo they pointed out that when the price of stocks is extended over their traditional value measurements it “is not a useful timing signal for market turning points, but is a powerful predictor of long-term market returns” and that currently “no matter what adjustments we make, the U.S. market is expensive.”

But wait, rapidly rising markets can be a great way to make money? As we are seeing, overvaluation can continue for some time.

Per wisdom of Jeremy Grantham, a legendary value investor: “I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.”
“Bracing Yourself for a Possible Near-Term Melt-Up.”

So what to do?

The pull of this rapidly rising market is too strong to ignore. The fear of missing out (FOMO) is irresistible. You’ve got to be in. You’ve got to do it. Prices may well move much higher and stay there! But know the stock market is currently no bargain. Maybe being patient and waiting to buy when prices are below values is an investment strategy.

I believe now more than ever it is important to know what you own so you can stay focused on the long-term. Stay diversified, do not over-invest, stick with quality, and wait for the ‘fat pitch’. Do not let the fear of missing out cloud your long-term investment decisions. If you are not going to try to time the market with short-term trades, do not be afraid to wait for a fair price.

Diversification Lessons Learned From Venezuela and Saudi Arabia

By Posted on In Investment Strategies

This winter we are excited to introduce you to our winter intern, Armani J. Nieves. Armani is a freshman at Bryant University and is majoring in finance. He first became interested in the world of finance in middle school when he started purchasing stocks. Armani envisions himself working with people to support them in achieving their financial goals when he receives his undergraduate degree.

The following post is written by Armani Nieves:

Inflation, poverty, starvation are words that are synonymous with the economic situation in Venezuela. In addition, investment, growth, diversification are words that are almost synonymous with the economic situation in Saudi Arabia. How can two countries, in a world of overall growth and prosperity, vary so much? It all stems from asset diversification.

In 1970, the price of oil skyrocketed and increased to $120 a barrel. As a result, this caused Venezuela to become the richest country in Latin America. Venezuelans lived lavish lifestyles and enjoyed earning high wages. However, when oil decreased in in the 1980s, inflation rose 80% in this country.  The temporary adjustment to this problem was to cut government spending as well as open financial markets. Although this supported an increase of GDP from -8.2% to 4.4%, employee wages continued to remain low while unemployment remained high. This was only a warning of the dangers when countries predominantly invested in oil.

In the summer of 2014, a strong US dollar and higher output of oil resulted in the price of oil decreasing. Now, Venezuela experiences inflation like never before. In 2016, Venezuela experienced a 2,000% inflation. Although the price of oil is steadily rising, it will take a long time for Venezuela to recover as a result.

On the other hand, Saudi Arabia has undergone a massive initiative to get its country’s economy not to rely on oil. Saudi Arabia started this initiative after observing how dependency on oil may negatively impact a country’s economy. Saudi Arabia is diversifying its investments from oil to real estate, technology, and startup companies. Furthermore, they have been developing new solar farms. Research labs have been created in the King Abdulaziz city of Sciences and Technology to study and improve solar technology. They have invested over $50 billion into producing wind and solar projects by the year 2023. Saudi Arabia is pushing to become a global player in the renewable energy market.

From examples provided with both Venezuela and Saudi Arabia, we learn the lesson of not “putting all our eggs in one basket”. Venezuela put predominantly their “eggs in one basket” cited for oil. However, when oil lost its value, this country lost a lot of its financial resources. On the other hand, Saudi Arabia placed their “eggs in various baskets.”  So, when oil prices lower again in the future, Saudi Arabia will be ready and may continue to profit in other manners. As a result, it is important that we do not put all of our financial resources into one stock. For example, if we place all our financial resources into the technology or healthcare sector we could be taking on a significant risk. If healthcare were to have a bad year, your portfolio could be negatively impacted. It is always important to invest in different sectors. The example of Venezuela and Saudi Arabia can serve as a good reminder of the importance of diversification – not just at the individual level, but at all levels of investment (including government investments).

The Art & Science of Investing: Bonds

By Posted on In Investment Strategies

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community and how it impacts equity valuations.  This post delves into some of the issues as they relate to bonds and fixed income.

Although the bond markets are multiple times larger than the stock markets, they receive far less attention. These markets are usually set by free market forces. However, today it is no secret that Central Banks are manipulating interest rates in an effort to artificially stimulate demand for loans in an effort to provoke greater economic activity. Consequently, interest rates are at 100-year lows. These Central Banks need to hold interest rates down to avoid paying higher rate payments on the ever-increasing mountain of government debt. Currently, this debt is currently over 100% of the entire nation’s GDP (If interest rates were to rise, interest payments on the debt alone could consume the entire amount of taxes that are paid).

The plan of the Central Banks around the world is to create new money, buy bonds, and keep interest rates low until the economy revives (Quantitative Easing). Inflation will then pick up along with higher wages. Deficits will subside due to higher taxes from a growing economy. Total debt will shrink relative to a larger economy and interest rates could slowly rise to free-market levels. Again, politics influences economics and politics cannot be reduced to computer models.

For the average investor, duration and must be considered. Duration is a very important concept for bondholders. It measures the degree of risk of principal loss should interest rates rise from our current historic very low levels. For example, if interest rates rose by 1%, an investment-grade bond with an SEC yield of about 2.4% and duration of about 6 years could lose about 6% of its market value.  Given the meager 2.4% SEC yield that is not much reward for that much risk. Currently, government policies are holding interest rates at depressed levels. Should interest rates rise, many investors would be left with unexpected losses.

Given the potential explosion of future events, a human element is needed. It has become increasingly obvious that some things are not reducible to mathematical equations. Investment planning is an art that requires a human touch not just mathematical science.

The Art of Investing: Stocks

By Posted on In Investment Strategies

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community.  This post delves into some of the issues as they relate to equities.

The Science Argument: Valuation. There is a camp of investment managers who believe that the value of a stock is simply the present value of future earnings. After all, it is no more than partial ownership of a business. Viewed as an investment, the long-term stream of future cash flow must justify the initial cost of the investment. Therefore, stocks have a fair value based on past, current, and estimated future earnings. Historically, there has been a fair value for the major stock indexes which is in the area of 15x’s earnings. Higher than 15x’s earning, the stock market is expensive; lower than that, the market is cheap. Currently, the major indexes are over 20x’s earnings.

The law of fair valuation states that, while actual prices will fluctuate, fair value will inevitably win over the long-term. But in the short term which can last many years, perhaps even a decade, this law is at best obscure. This brings into play the second, and often the more important rule.

The Art Argument: The Trend is your friend.  As mentioned, in the short term, value may not be the best indicator. Instead, we in believe momentum and mass psychology rules. It is currently ruling up. Once a direction is established, either up or down, it takes on a life of its own. Numerous factors have combined to yield 10 years of low volatility. Stock market sell-offs have been minor despite subpar economic growth and high valuations. Many argue that an important factor is that central banks around the world have been openly buying assets (bonds & stocks) to boost prices and to induce economic growth. This intervention induces another factor of stock buy-backs on the part of our major corporations to boost earnings per share; this has created enormous upside momentum. Furthermore, it is common knowledge that the Federal Reserve will support asset prices when necessary (the Bernanke Put).

As a result of these influencing factors risk awareness has been dulled and, in the short term may be rightfully so. The stocks markets continue to smoothly chart higher and higher. But is the concept of fair value still lurking out there?   When, if ever, will it return?  But in the meantime, there may be a great deal of money to be made. And, after all, many, many good things are happening that could rightfully drive the markets by increasing earnings and thus fair value.

Further complicating proper investment decisions is ever-changing government policy. For example, our government is now in a heated debate over tax policy. If they lower corporate tax rates, what will that do to boost earnings? If the abundance of cash reserves held overseas by corporations are induced to come home, what will that do to stock buy-back programs and economic expansion? Politics influences economics and politics cannot be reduced to computer models.

So can investment planning be reduced to math inside of a computer model? We would argue that a human element is needed. It has become increasingly obvious to us that some things are simply incomprehensible and that investment planning is just as much art, as it is science. This is especially true in today’s world where headlines are manipulated and central banks of governments are overriding free market forces.