Based on many different valuation measures, the U.S. stock market has been overpriced for quite some time, which we have explained in detail in the last three LTWM quarterly commentaries. We highlighted that high valuations do not create a correction by themselves, but need a catalyst. The slowdown in China, the People’s Bank of China’s decision to allow the Chinese Renminbi (Yuan) to depreciate versus the U.S. Dollar, and lack of effective policy support for China’s local stock markets sparked the current correction; all with the backdrop that the Federal Reserve was preparing to raise their target rate.
Markets are finally recognizing that prices of stocks likely outpaced earnings growth with this backdrop. The reactive selling of this morning was likely exacerbated by a number of factors, including computer based trading (both algorithmic and high frequency electronic trading), foreign investors raising cash, and low mutual fund cash levels. As an example, if large foreign investors needed to sell this morning at the U.S. market open, the local high frequency computers would pick up on the large orders and also sell, causing the market to go down more than it should; and then the computers would purchase as soon as pre-programmed price levels are reached. Also, mutual fund cash levels were at historic lows; which means if fund redemptions were larger than expected as investors sold last week, the mutual funds must sell stocks to have cash. Trading volume was twice the daily level in the first half hour of trading today, which is well above normal.
So how does the recent market volatility affect you?
Let’s review an illustration of how diversified portfolios behave over time throughout multiple time periods along with the S&P 500 Index. The following chart represents the blended benchmarks that we use to compare our model portfolios against over time. These are benchmarks constructed of stock and bond indices. They are not actual portfolios and do not have any fees associated with them. An investor cannot directly purchase an index. However, they are useful because asset class benchmarks serve as a target for our asset class managers/funds. “LTWM 80-20 Benchmark”, which is 80% stocks, 20% bonds, is represented by the yellow line. “LTWM 70-30 Benchmark”, which is 70% stocks 30% bonds, is represented by the red line. “LTWM 60-40 Benchmark”, which is 60% stocks, 40% bonds is represented by the green line. The S&P 500 Index, which is 100% U.S. Large Cap stocks, is represented by the blue line. Each blended benchmark’s construction and indices used can be reviewed at the footnote below.1 Please review the disclaimers in the footnote as well.
The above chart spans from August of 2000 through July of 2015. It assumes that $1 was invested in the beginning of the period. This time period was the beginning of a famous market crash known as the “Dot-Com Bubble Burst”. We chose this time period because it occurred right before a recession and market correction. At the start of the period, right in the beginning of investing, the investor had flat returns at best and negative returns for the most part. You can see both the S&P 500 and the diversified portfolios recovered thereafter, although it took the S&P 500 longer. We then had the financial crisis and Great Recession which roiled markets from early 2007 to early 2009, followed by yet another recovery. One can see the diversified portfolio clearly would have benefited the investor over this time period, but it does not eliminate short term pullbacks completely. There are still time periods of negative returns. A hypothetical investment in the S&P 500 in 08/2000 would have almost doubled in the 15 year period. A hypothetical investment in the blended benchmarks would have more than tripled, approximately. Even if a person would have just stayed consistent with their S&P 500 index, they would be O.K., even with all of the turmoil of the past decade and a half. Had a person stayed consistent with their diversified portfolio, they would have fared even better. We think it is important to take a step back every once in a while and change one’s context from “the trees” to “the forest”, or from “today” to “over time”. This chart illustrates why. While these indices cannot be bought directly, it is a good illustration of how markets behave over time; and how diversification can smooth out volatility over time. One can see the effects of volatility on their personal finances by asking their LTWM advisor to walk them through financial plan sensitivity analysis. "What happens if I retire and the Great Recession hits immediately thereafter?" - we can answer that.
The above picture was investing right before a bear market. Now let's review five years prior, in the middle of a solid bull market:
Notice that during the bull market of the late nineties, the S&P 500 tore out ahead of the blended (more diversified) index. For years the investor may have thought that it was a mistake to diversify. After a couple of business cycles, however, things turn around and the blended indices end up close to or above the S&P 500 in this illustration. One takeaway here is that the blended indices had lower volatility compared to the S&P 500, which is relevant when cash flows in and out of a portfolio are involved. The other key point is that it takes time (not a day, week, month, year, or even five years) to see a long term portfolio strategy fully play out.
There are many “markets” beyond U.S. large stocks. There are “factors” that drive returns in all of these markets. The key is using these factors in a way that can be tied to long term goals with portfolio construction, and maintaining the portfolio while harnessing momentum with opportunistic rebalancing.
Market corrections happen sharply, just as market rallies happen rapidly, and cannot be timed. This is why the prudent investor uses diversified portfolios. Instead of trying to time markets and “beat” them, which empirical evidence has shown does not add value over the long run, we “use” markets. We use markets by understanding the factors that drive returns and risk, using those factors like “dials” to fine tune a portfolio’s risk/return directly to a person’s life goals. In a sense, the above charts, while interesting, are completely meaningless to an actual human being. You saved your money for a reason. There is purpose behind it. Whether it is for education, retirement, to create a legacy, or any other dream you have, there is a purpose for the money…..not just to gamble with and “beat” any irrelevant benchmark. You saved your money to make something happen in the future, to increase the probability that it actually comes to fruition. This is why we directly tie what we are doing in your portfolio to your life goals over the long run, and perform statistical analysis to determine probability of success. We then implement what we know leads to long-term investment success:
- Successful investors are diligent and prudent. We have taken care of that for you with our portfolio construction, Investment Policy Statement, investment manager selection and monitoring, and rebalancing methodology.
- Successful investors exercise patience. Our process allows for patience and for markets to work for us over time.
- Successful investors ignore noise and stay goal-focused. Our planning process helps you tie your goals directly to action (and inaction) that should be taken today to meet those goals. As human beings, rapid change and perceived risk can cause us to want to take an immediate action. This was helpful to us in 10,000 BC as hunters and gatherers, but not helpful to us as investors. The fight or flight response is never the right response in investing. Having a strategy in place for when the inevitable pullbacks occur ahead of time is helpful to investors.
- Successful investors exhibit discipline. Our process helps you maintain consistency with your investing. Consistency is key when a strategy is long term in nature.
- Successful investors understand how their portfolio ties to their goals. They understand that markets pull back at times, and that those times provide opportunity.
- Successful investors avoid gimmicks (such as “trades” or positioning that only works in certain environments), ridiculous fees and commissions, and products that are sold to them using fear and/or greed.
Notice that what makes a successful investor has nothing to do with reacting to markets. All of the “reacting” for any market environment should have already been taken in the portfolio construction phase. The business and market cycle will continue as long as we have a market-based economy. Understanding how the business and market cycles work over time and how asset classes behave when paired together over time helps one “see through” the short term static, and harness the markets and use them instead of fighting them. The more people around you get irrational and succumb to their inner cave-man, the more opportunity you have in the markets.
Our hope is that our clients can sit back and watch the hysterical news anchors and pundits and laugh, knowing all of this is short term in nature and knowing they planned for the inevitability of negative volatility in markets by having a financial plan and appropriate portfolio construction to begin with. Our hope is that our clients will further relax knowing that we employ a portfolio strategy that is empirically based, academically reviewed, and that does not involve reactivity; instead rebalancing the portfolio based on emotionless triggers.
So why are markets selling off?
Nothing has changed since our last communication, economically. While this business cycle has been elongated, and there is little doubt that we are late in the business cycle, we do not believe we have reached the end of the business cycle yet. For a recession to start at this point in time, central banks would have to lose control of the battle between inflation and deflation, and they still have many powerful tools to implement monetary policy. The Fed will likely decide to keep the zero interest rate policy (ZIRP) in place for another month, and possibly longer; as global deflationary pressure will likely handcuff the Fed to ZIRP until deflationary forces subside. The market likely agrees with this view, given the depreciation we have seen in the U.S. Dollar on the currency market over the past week. A weakening dollar is welcome news for U.S. exporters who have been pinched by a rising Dollar recently. Over the last six years, the Fed has used significant quantitative easing and ZIRP with a twofold goal of hitting 2% target inflation and full employment. The Fed is achieving the employment goal. The Bureau of Labor Statistics reported total U6 unemployment (all marginal workers) down to 10.4%, from 12.2% one year ago and U3 headline unemployment (only workers looking for a job) down to 5.3%, from 6.2%, one year ago. The Fed has not achieved its target inflation rate of 2%, even with the most inflationary monetary policy in its history. The consumer price index (CPI) for all items is only 0.2% annually, and if excluding food and energy, it is 1.8%.
One of the best charts for determining the start of a U.S. recession is the 4 week moving average of initial unemployment claims.
This chart has a strong trend line down and has not leveled off or reversed course, which highlights that we are not at the end of the business cycle yet. Notice that we are now at a level of jobless claims below the lowest levels of 2006.
If the job market is strong, consumer spending improves. The trend line of retail sales over the past 5 years also looks positive (Source: Ycharts) and is important since over two thirds of U.S. GDP is consumer spending (71% in 2013). It is difficult to have a recession when the U.S. economy is this stable. U.S. consumers are still buying goods from all over the world.
The China slowdown is real but contained so far. It is material because while China only represents 15% of global trade, China has represented about half of the global growth over the past five years. The slowdown in China and the emerging world is evident in rapidly declining commodity prices. Chinese consumers are buying fewer cars but more iPhones. Chinese stocks have exhibited extreme volatility as investors experimented with margin; and some of that volatility moved to Europe and to the U.S. equity markets. However, the U.S. bond market is stable and the yield curve is steep (long term bond yields are higher than short term bond yields). If there was panic, you would expect to see Treasury bond yields drop and high yield spreads widen noticeably and both are consistent with levels from previous weeks. Yield Curve source: US Department of the Treasury.
While we do not expect a deeper slowdown in China will create a global recession, we will be diligently watching for any signs of contagion or illiquidity. We will continue to monitor valuation levels, which become more reasonable as prices decline. No one can time the markets and we can’t remove investment risk, it is the reason we have returns greater than the risk-free rate, risk and return are related. One can diversity certain risks with diversification, known as unsystematic risk, but not systemic, or market risk. While we can’t fully eliminate negative returns, we can use a portfolio methodology that is built around resiliency, reduced volatility, and exposure to factors that drive return. The best path forward is to maintain an optimized portfolio of globally diversified investments, which represent the productive assets of the global economy; and diligently rebalance according to our methodology.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.
The portfolio returns presented are models comprised of indices, not actual portfolios, and represent past performance of the included indices. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. The first LTWM 80-20 Benchmark is 80% equities and 20% fixed income, the LTWM 70-30 Benchmark is 70% equities and 30% fixed income and the LTWM 60-40 Benchmark is 60% equities and 40% fixed income. The blended benchmarks are rebalanced back to target quarterly, which represents a rebalancing strategy different from the strategy used for client portfolios, which is based on asset class weight tolerance bands. The software used for the presentation does not allow for illustration of this rebalancing strategy, which research has shown to be more effective than quarterly or another time based rebalancing strategy. An investor cannot buy an Index, and the Index does not include any management fees.
100% S&P 500:
Period 1: From 07/2000 to 06/2015. Rebalance: Never Rebalance. S&P 500 Index: 100% Currency: USD
Period 2: From 07/1995 to 06/2015. Rebalance: Never Rebalance. S&P 500 Index: 100% Currency: USD
LTWM 60-40 Benchmark:
Period 1: From 07/2000 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 10.05%, BofA Merrill Lynch 1-Year US Treasury Note Index: 14%, Dimensional EAFE Small Value Index: 7.35%, MSCI World ex USA Growth Index (net div.): 4.05%, Citigroup World Government Bond Index (hedged to USD): 26%, MSCI World ex USA Small Cap Growth Index (net div.): 3.15%, Dimensional Emerging Markets Large Value Index: 3.6%, Dow Jones US Select REIT Index: 3.6%, Dimensional EAFE Large Value Index: 10.05%, Dimensional US Small Cap Growth Index: 4.05%, Dimensional US Large Cap Growth Index: 4.05%, Dimensional US Large Cap Value Index: 10.05%. Currency: USD
Period 2: From 07/1995 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 10.05%, BofA Merrill Lynch 1-Year US Treasury Note Index: 14%, Dimensional EAFE Small Value Index: 7.35%, MSCI World ex USA Growth Index (net div.): 4.05%, Citigroup World Government Bond Index (hedged to USD): 26%, MSCI World ex USA Small Cap Growth Index (net div.): 3.15%, Dimensional Emerging Markets Large Value Index: 3.6%, Dow Jones US Select REIT Index: 3.6%, Dimensional EAFE Large Value Index: 10.05%, Dimensional US Small Cap Growth Index: 4.05%, Dimensional US Large Cap Growth Index: 4.05%, Dimensional US Large Cap Value Index: 10.05%. Currency: USD
LTWM 70-30 Benchmark:
Period 1: From 07/2000 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 11.72%, BofA Merrill Lynch 1-Year US Treasury Note Index: 10.5%, Dimensional EAFE Small Value Index: 8.58%, MSCI World ex USA Growth Index (net div.): 4.72%, Citigroup World Government Bond Index (hedged to USD): 19.5%, MSCI World ex USA Small Cap Growth Index (net div.): 3.68%, Dimensional Emerging Markets Large Value Index: 4.2%, Dow Jones US Select REIT Index: 4.2%Dimensional EAFE Large Value Index: 11.73%, Dimensional US Small Cap Growth Index: 4.72%, Dimensional US Large Cap Growth Index: 4.72%, Dimensional US Large Cap Value Index: 11.73%. Currency: USD
Period 2: From 07/1995 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 11.72%, BofA Merrill Lynch 1-Year US Treasury Note Index: 10.5%, Dimensional EAFE Small Value Index: 8.58%, MSCI World ex USA Growth Index (net div.): 4.72%, Citigroup World Government Bond Index (hedged to USD): 19.5%, MSCI World ex USA Small Cap Growth Index (net div.): 3.68%, Dimensional Emerging Markets Large Value Index: 4.2%, Dow Jones US Select REIT Index: 4.2%Dimensional EAFE Large Value Index: 11.73%, Dimensional US Small Cap Growth Index: 4.72%, Dimensional US Large Cap Growth Index: 4.72%, Dimensional US Large Cap Value Index: 11.73%. Currency: USD
LTWM 80-20 Benchmark:
Period 1: From 07/2000 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 13.4%, BofA Merrill Lynch 1-Year US Treasury Note Index: 7%, Dimensional EAFE Small Value Index: 9.8%, MSCI World ex USA Growth Index (net div.): 5.4%, Citigroup World Government Bond Index (hedged to USD): 13%, MSCI World ex USA Small Cap Growth Index (net div.): 4.2%, Dimensional Emerging Markets Large Value Index: 4.8%, Dow Jones US Select REIT Index: 4.8%, Dimensional EAFE Large Value Index: 13.4%, Dimensional US Small Cap Growth Index: 5.4%, Dimensional US Large Cap Growth Index: 5.4%, Dimensional US Large Cap Value Index: 13.4%. Currency: USD
Period 2: From 07/1995 to 06/2015. Rebalanced every 3 months. Dimensional US Small Cap Value Index: 13.4%, BofA Merrill Lynch 1-Year US Treasury Note Index: 7%, Dimensional EAFE Small Value Index: 9.8%, MSCI World ex USA Growth Index (net div.): 5.4%, Citigroup World Government Bond Index (hedged to USD): 13%, MSCI World ex USA Small Cap Growth Index (net div.): 4.2%, Dimensional Emerging Markets Large Value Index: 4.8%, Dow Jones US Select REIT Index: 4.8%, Dimensional EAFE Large Value Index: 13.4%, Dimensional US Small Cap Growth Index: 5.4%, Dimensional US Large Cap Growth Index: 5.4%, Dimensional US Large Cap Value Index: 13.4%. Currency: USD
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, LLC (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.