risk

  • The Biggest Risk To Financial Markets – (It is not what most investors think)

    When investors consider risk today they think of North Korea, elevated stock prices, Trump, or maybe even Bitcoin!  However, the real risk to today’s financial markets is something bigger and that is rarely mentioned. It is also something that has caused most of the big stock market declines over the past five decades.  What might that be?

    Historically, most significant and longer term stock market declines (beyond 20%) have been a result of Federal Reserve policy and its corresponding negative effect on economic growth – namely a policy of raising interest rates too much in an effort to ward off inflation, particularly during a period of strong economic growth.

    As you may know, when the Federal Reserve (“the Fed”) lowers interest rates, it has a tendency to spur economic growth as businesses and individuals become enticed to borrow and invest for future projects creating greater good for the economy as a whole.  The most recent and historic case was in 2008-09 when the Fed reduced rates to near zero in an effort to bring the global economy back to life – which eventually, and thankfully, worked!  On the other hand, during periods of strong economic growth Federal Reserve policy becomes more “tight” as they begin to raise interest rates back to more normal levels.  Over the past 12 months we have seen the Fed raise rates three times and the general consensus is that they will raise rates one more time by year’s end.

    The Fed’s main objective in raising rates is to mitigate the economy from growing too strong. What’s wrong with an economy that is growing too strong?  It creates inflation which causes the prices of goods and services to skyrocket, eventually choking off growth and causing economic havoc.  Once inflationary spirals begin they can go on for years, as any of us who recall the mid-70s-mid-80s can attest. So when economies are growing the Fed is caught in a very fine balancing act: raising rates gently enough to allow growth to continue while keeping inflation at bay; and simultaneously being sure not to raise rates too much or too fast to avoid halting economic growth and tipping the economy into recession.

    If this balancing act sounds challenging, believe me, it is!  When you keep in mind that the Federal Reserve Board is comprised of smart, experienced, individuals, it is important to remember that they, too, are prone to error – hence their track record of causing many of the past recessions and market plunges over the past few decades.  Often when economies have been perceived to be growing too strong, their policy of raising rates has not just slowed, but stopped, the economy in its tracks and caused recession.  Is Fed Policy a risk right now? NO.  Is it a risk coming in the next few years? YES.

    My company’s research suggests that the risk of Fed Policy error will become higher over the next 2-4 years.  Though we have confidence in Janet Yellen and her most likely replacement, Jerome Powell, both are prone to error given that they, like us, are human.  This economy is just shaking off a mild recession in 2015-16, so we believe it is still in its early stages (hence the rapid rise in stock prices this year).  However, as economic growth over the next few years continues, finding that right balance – the Goldilocks’ formula of “not too hot” and “not too cold” – may become a challenge and will be a risk today’s investors should prepare for in their investment portfolio.

    The Big Risk for Most Investors…But Not You!
    Strangely, the biggest risk of an error in Fed policy will be in the bond market – more so than the stock market – particularly for holders of bond funds as opposed to those that own individual bonds.  I do not suggest investing in bond funds or bond products – only individual bonds.  Bond funds have no maturity date, they will decline in value every time rates rise, and will not return to their original value until rates eventually come back to earlier levels.  This recovery time could take many years, if not a lifetime, given that we are at a historically low level of interest rates.  This risk is compounded given the nature of today’s demographics and the advent of bond “products.”

    A quick peek at where most bond assets are held today, and one quickly realizes that there are trillions of dollars in bond mutual funds, bond exchange traded funds (ETFs), and other Wall Street products.  None of these have maturity dates and once rates rise in earnest, investors will begin to experience declines – those with longer maturity funds will be the worst.  The sheer amount of assets held in these products begets a bigger problem.  Should investors try to sell their bond funds and other bond “products” (which investors always do when prices fall more than normal!) there will not be enough liquidity (buyers) to support the underlying bond prices and interest rates could likely skyrocket, causing bond funds to fall even more significantly!  We have seen smaller versions of this throughout history, but never has there been so much money tied to bond products in the past, which threatens to make this time a real doozy!

    Though I think that the next few quarters should be good for corporate profits, the economy and stocks, a significant rise in interest rates could have a negative impact on the stock market or parts of it.  

    Again, I believe that the current level of stock prices is justified based on economic and corporate profit growth.  There will be some corrections along the way, but until the Fed gets heavy handed, we should see financial markets embrace this better growth environment.

    Happy Holidays!

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  • Markets Don’t Go Up Forever

    I hope you are enjoying the profitability that stock ownership can provide as global stock indexes continue to reach new highs. Year-to-date most indexes have reached double digit returns, with global indexes providing the most upside.

    I believe that the last bear market occurred in 2015-16 when global indexes fell 20% and corporate profits experienced a very mild recession. Over the past year we have been witness to a significant global corporate profit and business cycle recovery. Though many have called this a “Trump Bump,” it should be obvious at this point that the improving global economy and corporate profits cycle has little to do with the US President and more to do with how the business cycle works. The best part of our message today is that we believe that this new bull market has a brighter and longer future than most investors believe.

    Corporate profit cycles last years – not months – and this one is in its infancy. Though many investors are in awe that the Dow Jones Industrial Average is over 22,000, they should try to remember that it is simply a number – it was 800 when I started my career! What is more important is the price of the market related to its underlying profitability or “price-to-earnings ratio.” In statistical terms the market is nowhere near overvalued. In fact, there are sectors of the market that still trade at ridiculously inexpensive multiples to earnings – not at all a symptom of a market that is overvalued.

    There are many investors who question the future longevity of this market strength – which is another indication that we are far from a market top. However, there is a much larger crowd who seem immune to the old adage, “what goes up must (at some point) come down.” Though we believe that the recent market strength is well justified and has “legs,” we would not advise investing without some tools to manage the risk of this thesis being wrong and to protect your portfolio from catastrophic loss. As you know, we employ our Active Risk Management process specifically for this reason – this includes actively managing your asset allocation, your sector exposure and the careful placement of stop loss orders – the combination of which we call our “plan B.”

    I find it hard to believe that today’s investors would invest aggressively without some sort of “plan B” should it all come to a crashing halt. Surely investors must recall the recessions and corresponding stock market declines of 35-55% that have occurred several times in the past two decades?  Or the time it took for stocks to recoup those losses – on average six to seven years?  I find the short term memory of the average investor just plain astonishing. However, with the media’s attention on passive/robo/index investing, perhaps we can’t blame these naïve investors for getting sucked in! Let’s face it – while markets are going up the tide lifts all ships and your average index fund will participate in market returns. However this view is extremely shortsighted, particularly when it comes to the bulk of an investor’s wealth as they approach important timelines, such as retirement. They say that stock market history is riddled with investors repeating the same mistakes. The lack of some sort of “plan B” risk management appears to be the most obvious.

    The increasing popularity of passive/robo/index investing should be a warning to all investors to employ risk management tools and a plan for avoiding catastrophic loss, for the next inevitable and eventual market decline may just be much bigger than expected. In the meantime, continue to invest with an eye towards growth and be well prepared should things go awry. My book can help.

    No matter your level of experience, The Journey to Wealth teaches you to invest using a clear, easy-to-follow sequence of concepts. In a four-step process, you will learn how to identify your lifestyle goals for building immediate and long-term wealth, as well as how to invest according to your risk tolerance and needs. Straight-forward detailed explanations, charts and graphs, inspiring citations about wealth creation, and artwork will keep you reading, learning, and creating a SMART investment plan for your future

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