WHAT IS NORMAL?
How much volatility is normal?
Hitch your wagon to long-term innovation
WHERE ARE INTEREST RATES HEADED?
If only knew...
Quantitative Easing's Effect on the Dollar
Different than many had thought
SUMMARY OF INVESTMENT THEMES
WHAT ARE NORMAL STOCK MARKET RETURNS?
This is a question I get from almost every new client I interact with...and almost everyone has a different opinion. Lots of the time it has to do with either the recent past experience or something they read a long time ago. Should we use long-term average returns? Should we use the returns over the last five years and extrapolate those?
The past 118 years include several golden ages, as well as many bear markets; periods of great prosperity as well as recessions, financial crises, and the Great Depression; periods of peace, and episodes of war. In order to obtain a realistic understanding of what long-run returns can tell us about the future, it is important to have a large data set.
According to the Credit Suisse Global Investment Yearbook, stock markets in the developed world delivered an annualized 9.6% return over the 118 years leading up to 2018.
In the book Debunkery, Ken Fisher found that from 1926-2009 the annualized return was 9.7% and the simple average was 11.7%. However, actual 12 month periods rarely looked like that. Returns were between 10-12% only 5 times in 84 years!
66% of calendar years produced returns either north of 20% or worse than -10%!
Normal returns are hardly normal. Maybe that is why so many investors struggle with the markets. Maybe the investment community is getting its messaging all wrong. I started my career on Wall Street. I learned a tremendous amount from my time there. One of the key lessons I learned is that Wall Street is a marketing machine. Do investors really understand that 2/3 of the time their hard-earned savings invested in the stock market would earn more than 20% or lose more than 10%? That is a lot of volatility for the average investor to handle. Maybe that is why emotions sometimes get the best of us.
If you are waiting on stocks to earn you their normal 9.6% or 9.7% return you may be waiting awhile. Sharp declines followed by soaring recoveries are the norm...both for individual stocks, industries, and markets.
If those single-digit returns are so hard to achieve in a calendar year, why do so many Wall Street "strategists" year after year prognosticate that stocks will earn somewhere between 6% and 11%?
The daily noise, the talking heads on television and the Wall Street strategists are consistently telling the public to expect something that happens less than 1/3 of the time. Why do they constantly prognosticate something that statistically is unlikely to occur? I have my opinions, but I will keep them to myself.
THINK LONG-TERM, THINK THEMATICALLY
My first piece of advice is to think long-term. I know its hard to tune out the daily market noise, but that is all it is...noise. Every day is a scramble by the financial media to come up with a reason for the markets every wiggle. Sometimes the market is up because oil is down and sometimes it is up because oil is up. How can the same reason be given for the market moving in opposite directions? Just Google, "market up, oil up" and "market up, oil down". You will surely be amazed that the same reasoning can be behind opposite market movements. In my opinion, short-term news stories have little effect on market returns...yet the media trains us to think they do.
The best antidote for the ever-changing minds of "Wall Street Strategists" may be to understand where the economic tailwinds are and hitch a ride on the train. Basically, hitch your future to what could be the future.
There are a number of potential investment themes I have mentioned in this letter over the past couple of years. A few are listed at the end of this letter. In addition, I think a focus on businesses that are subject to mass adoption, are at least somewhat proprietary, are innovative and are either critical for life or business sustainability is a good place to start. Remember, smartphones didn't even exist 10 years ago. 3-D printing of organs and various "replacement" parts was a pipe dream. Now one is ubiquitous with current civilization and the other is actually happening.
WHERE ARE INTEREST RATES HEADED?
Of course that is a trick question! I have no idea, and neither does anyone else. As you can see in the chart below, it does appear that the long-term lows in interest rates have been seen. After a "double bottom" in 2012 and 2016 at the lowest rates recorded, the U.S. 10 Year Treasury yield has moved higher. It broke through the resistance levels market by the horizontal blue line. The first resistance at roughly 2.60% was the 2017 high yield. Yields crashed through that level easily. Currently, at 3.10%, rates have crossed through the 3% barrier and are right at the 2013/2014 high yields.
What does this mean for bond and bond fund holders? When rates rise, the prices of existing bonds come down. For holders of individual bonds held to maturity that is of little consequence. However, holders of bond mutual funds and ETFs will have to contend with falling prices. Will increased yields be enough to offset the price declines? in 2018, bond investors may be seeing the first losses in the portfolios since 2013.
Now comes the real test. The Federal Reserve has raised short-term interest rates to the point that longer-term interest rates are finally rising. The yield curve is steepening. What does that mean for risk assets? What does that mean for businesses? The economy will need to recalibrate around these higher interest rates in order to move forward.
QUANTITATIVE EASING'S EFFECT ON THE DOLLAR
When the Federal Reserve initiated their program of QE (quantitative easing) during the financial crisis, no one knew exactly what to expect. By design, it was to increase the flow of currency into the market by purchasing bonds from bondholders and thus reducing the supply available. These new currency units could then be used to spend and invest in the economy.
At the time, many in the financial press and me included assumed that the dollar would be debased and decline in value. The new "money printing" would surely put the strength of the U.S. dollar into question. Well, might I say many were wrong? By looking at the chart above you can see that the U.S. Dollar's value bottomed back in 2008 and went on a multi-year strengthening cycle that peaked in 2016.
The interest rate increase in March was the sixth 0.25% hike since the end of 2015. What is interesting to me is that just about the time the Fed began raising interest rates and winding down it's QE program, the dollar stopped rising. In the fall last year, the Fed began its path to "normalization" by reversing the process. Last fall it was reducing its QE by $10 billion per month. That number grew to $20 billion per month in Q1 2018 and now is roughly $30 billion per month. Before the recent bounce, the dollar had steadily weakened in the face of a program reversal that many thought should have strengthened the dollar. The bottom line is to be careful of the herd. Often, the prevailing "wisdom" is not true.
Shorter-term, the dollar has bounced significantly. According to Elliott Wave, in April, futures speculators had the largest short position in 7 years. These speculators are almost always wrong at extremes. I think this recent bounce in the dollar was needed to reduce that speculative fervor. The dollar has rallied up to a critical resistance level. It will be interesting to see if it can break through. This is the most significant bounce in the dollar since 2016. Continued strength should be watched. Here is a chart of the more recent action.
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
- A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.
- Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
- The information herein was obtained from various sources and we do not guarantee their accuracy.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
- The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
- No security, financial instrument or derivative is suitable for all investors.
- In some cases, securities and other financial instruments may be difficult to value or sell and reliable information about the value or risks related to the security or financial instrument may be difficult to obtain.
- Investors should note that income from such securities and other financial instruments, if any, may fluctuate and that price or value of such securities and instruments may rise or fall and, in some cases, investors may lose their entire principal investment.
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- The fast pricing swings in commodities and currencies may result in significant volatility in an investor's holdings.
- There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
- Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
- The prices of small and mid-cap stocks are generally more volatile than large-cap stocks.
- An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
- High yield/junk bonds (grade BB or below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
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