2.5% is really “that bad” ?

So the “concern du jour” is lower than expected 1Q GDP growth: 2.5% instead of the expected 3%.  As usual, we see a lot of quotes this morning from so-called “experts” conjuring up new concerns about slowing growth to wit: "There are some concerns as we head into the summer," said JJ Kinahan, chief derivatives strategist for TD Ameritrade. "In the last three weeks, we've have seen numbers that weren't exactly what you'd love to see."  C’mon. The economy showed decent improvement in Q1 over Q4 (+0.4%) despite a drag from a decline in government spending, which is estimated to have cut Q1 GDP growth by 0.8%. It was also encouraging to note that consumer spending was the strongest in over two years. That’s important because consumer spending is over two-thirds of the economy. And while hiring remains slow, business spending remains relatively healthy. Point is, the improvement in Q1 GDP is a positive but the tone of this recovery has not changed: it will continue to be a slow, grinding recovery. In the meantime, the private sector continues to do OK. Corporate earnings and cash flow continue to improve, providing a positive backdrop for stocks. In fact, analysts actually raised their forecasts for 2Q earnings growth from 1.5% to 3.6%. From a financial planning perspective, we believe a normal allocation to equities is warranted with some of our favored sectors being real estate, health care, and large-caps.

Summary of Our Recent Investment Strategy Meeting

We held our second quarter investment strategy meeting on March 28, 2013. Despite the market achieving record levels recently, we remain constructive on the outlook for equities for a number of reasons. We expect the economy to continue to grow with the potential for some acceleration later this year and in 2014. Continued economic growth should support further growth in corporate profits and cash flows, which are key drivers for stocks. We expect inflation to remain relatively low, particularly near term, and with a continued accommodative Federal Reserve policy, we also expect interest rates to remain relatively low. Valuations, while increased, are not yet at levels that would cause us to be overly concerned. We also believe investor sentiment, reflected in continued apathy and disbelief, remains constructive.

We now view the stock market as reasonably valued but not overvalued. We believe the enormous amounts of cash sitting in corporate coffers provides considerable “fuel” to ramp up M&A activity, which would be positive for stock valuations. We see similarities in the current market with that of the late 1970s and early 1980s period. During that period towards the end of that secular bear market, corporate cash flows became grossly undervalued. This eventually resulted in a wave of mergers and LBOs that preceded the secular bull market of 1982-2000. We think many of the same conditions exist now: lot’s of corporate cash, many businesses still undervalued relative to sustainable cash flow.

With regard to fixed income, we are keeping an eye on the possibility that interest rates could begin to rise more sharply. Interest rates, as reflected in the 10-year Treasury, actually bottomed in late July and have risen modestly since then, perhaps presaging an improving economy or an end to Fed easing. Given the rather modest growth of the economy, as of now, we suspect any increase in rates will continue to be moderate and not of a jarring or rapid increase that could upset the stock market. We are watching the trends in interest rates carefully as a rapid rise in rates would have potentially negative ramifications for both stocks and bonds.

In terms of changes to our allocation model following the meeting, we increased our allocation to equities slightly, while reducing exposure to fixed income. The increases in our equity allocations were primarily in large cap equities, mid-cap growth stocks, and natural resources. Within large cap equities, we added a new investment in the health care sector. We believe this sector offers strong secular growth prospects and believe it deserves some added emphasis in client portfolios. Our reduction in fixed income exposure was primarily centered in intermediate-term holdings, primarily intermediate-term TIPS.

What? No Phone Calls ?!

The stock market’s recent rise to new record levels is impressive, particularly in light of economic conditions. Why is the market achieving new highs? We suspect, as a discounting mechanism, the market continues to foresee healthy corporate earnings and cash flow and continued subdued inflation, and is therefore feeling a little more “confident” about the future. Also, because of the slow growth economy, the market remains optimistic that excess monetary reserves being pumped by the Fed will continue to find their way into the stock market.

 What is interesting about the new highs we’ve been reaching of late is how quiet our phones have been. It’s a very different mood now than was experienced in 2008 and 2009, when the markets were plunging. Back then, most every advisor was getting calls daily from distressed clients worried sick about their money. In fact, it got so bad in early 2009 that many investors who lacked discipline or good guidance, panicked and liquidated their holdings at or near the bottom of the bear market. Right now, the phones are quiet.

What drives this behavior? Predictable human psychology: greed and fear. People make irrational decisions when these emotions take over, like selling out at the bottom in a panic, or getting in at the top. People also tend to extrapolate the recent past into the future: if it’s really bad now it can only get worse tomorrow, and vice versa. It is also normal human psychology to fear loss more than cheering gain. But the long-term history of the markets show us that 75% of the time the market is rising and, over the long term, has always gone up.

So what is the point of this for financial planning?  One, avoid emotionally-based decisions, which can wreck a financial plan; and two, avoid trying to time the market. In his most recent letter to shareholders, Warren Buffett put it in his inimitable way with regard to investing. He stated that “the basic [long-term investment] game is so favorable……. it’s a terrible mistake to try to dance in and out of [the market] based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it”. While there may be times where it is prudent to reduce exposure to the stock market, over the long term, as Buffett points out, the odds are stacked in the favor of long-term investing. Developing and sticking with a sound financial plan is a great way to help investors stay on course and avoid the disasters that can be caused by emotionally-based investment decisions.

Triggers and Emotional Investing: Part 2

We’ve been commenting recently about our use of triggers as part of our process in managing risk in client portfolios. The use of triggers compels us to rationally assess potential risks in the macro environment and take steps to protect client capital by establishing a rule to take specific action if the potential risk actually materializes. One could argue that you can’t anticipate every risk, or you can’t do it “after the fact”, so why set triggers? It is true that no one can anticipate every risk; however, as fiduciaries of client capital, it is incumbent upon us to analyze macro risks to the best of our ability and take prudent and compensatory measures to protect client capital from these risks. In this way, we try to reduce the “risk” of making emotionally-based investment decisions.

As humans, we are all prone to make emotionally-based investment decisions. However, these types of decisions can be some of the worst and most harmful decisions we can make as investors. They usually occur at or near market extremes when we are painfully aware of a trend and finally reach the point where greed and fear override rational logic. They occur when one has not taken the time to understand the fundamentals of an investment and buys too high (GREED). They can occur when we act on casual advice or a rumor without doing adequate homework (GREED).  A market bottom usually is accompanied by extreme fear and pain, and many people decide they “can’t stand it anymore” and bail right at the bottom. Again, a bad decision based on FEAR.

Great investors like Warren Buffett have done so well by investing in a very rational and non-emotional way. What are some of the keys to Buffett’s success? Rational and thorough analysis of business fundamentals and valuation for any investment; not “chasing” stocks that have gone way up; avoiding the temptation to time the market (in fact, generally, Buffett couldn’t care less what the market is doing).

All of us can learn a great deal from the approach of great investors like Buffett; their process is rational and disciplined. The carryover lessons for financial planning are several: 1) develop sound long-term financial and investment plans and stick to them; 2) do not be tempted to time the market; 3) maintain a diversified portfolio to reduce risk and portfolio volatility; 4) have a disciplined investment process that minimizes the risk of making emotionally-based decisions; 5) stay humble and admit if you don’t understand aspects of financial planning and investments and, if it seems “out of control” or too complex, seek the help of an experienced advisor that you trust.

 

 

Our Triggers and Emotional Investing

We talked last week about our firm’s use of triggers in our investment process. We use triggers not only as a way of managing risk but also as a way of avoiding emotionally-based decisions. The trigger is part of what we believe is a rational decision-making process. The trigger essentially sets a rule or requirement for us to take action in client portfolios based on the outcome of a perceived risk event that could or will happen usually in the near future.

 Avoiding emotionally-based decisions is a critical element in successful investing. A lot of people get caught up in “fighting” the market: buying or chasing stocks after they have run up; or conversely, selling at the bottom after stocks have plunged. Why do people do this? Emotions: fear and greed -- greed on the way up, fear on the way down. This reaction is natural: we humans are prone to emotional investing because we are emotional beings, not robots. And issues surrounding money can get highly emotional.

When done properly, a rational investment process that can be repeated greatly reduces the chances or temptation to make emotionally-based investing. Some of the key elements to a rational process include: a solid understanding of investment fundamentals and macro risks; having a sound vision and investment thesis regarding the global investment environment; and having a sound process for managing risk. When you really boil it down, investing is all about assessing probabilities and managing risk.

Why is our use of triggers important in managing risk? Because we attempt to identify risk in a rational way, anticipate this risk, and have a plan of action to deal with that risk. We consider triggers at every investment strategy meeting for various macro risks that could be a problem. Some of the risks that could cause us to set a trigger include economic and political risks, risk from geopolitical events, risk of central bank policy changes, corporate earnings and/or industry sector risks, inflation and interest rates…. The list goes on and on. The trigger literally forces us to make a non-emotional decision because it is based on an indentifiable risk with a pre-defined action. While we may not be correct 100% of the time on our forecasts (and no one is), taking a pro-active policy towards risk enables us to address a very important part of investment management in a reasonable and rational way and avoid making emotional decisions in the wake of news events that may have already moved the markets significantly.

 Next week we will discuss a little more about emotion-based investing and why it occurs.

Pulling The Trigger

As part of our ongoing process to manage risk in client portfolios, we occasionally use investment “triggers”. The investment “trigger” is a rule or a requirement to take a specific action at a future time based on the outcome or resolution of a potential, identifiable risk. The trigger is usually set in conjunction with reducing clients’ market exposure due to this perceived risk. It allows us a way to rationally consider the probability and impact of a potential event that presents risk and take a deliberate and reasoned approach to dealing with this risk, rather than waiting and reacting emotionally after the fact. We believe actively managing risk in this way is the prudent thing for us as fiduciaries of client wealth.
 
For example, in preparing for our first quarter portfolio re-allocations in December, we considered probabilities of outcomes of the fiscal cliff deliberations then underway, and ways in which those outcomes could impact the stock market. In those discussions, we felt there was a greater than 50/50 probability that there would be a negative outcome with respect to fiscal cliff deliberations which  would most likely result in a decline in the stock market. As a result of this assessment, we reduced equity allocations and set a trigger for putting money back to work once we had greater “clarity” relating to the fiscal cliff.

We got that improved clarity through the announcement of a Congressional compromise on the fiscal cliff on January 2. We got even further clarity on Federal budget policy when the House of Representatives passed legislation to temporarily raise the federal debt ceiling. On January 24, we acted on our trigger to put money back into equities based on several factors: improved clarity relating to federal budget and debt issues, continued positive news on the economy, continued low inflation, and a continued positive outlook for corporate profits. All of these lend support to a more positive environment for stocks.

From a financial planning perspective the most important objective in using triggers is protecting client capital. The process of setting a trigger is one way of managing risk of events that could negatively impact client capital. Some other ways financial planners manage risk include portfolio diversification, security selection, a sound investment process, fundamental analysis, understanding of macro risks, and asset allocation. Each of these play an important role in the risk management process and each involve a high degree of human or intuitive judgment which, at least as of now, computers cannot provide.

Increased volatility in 2013 ?

There has been a fair amount of discussion in the investment industry recently regarding the potential for increased market volatility in 2013. One recent article discussed a mathematical model that implies there is a high potential for an increase in volatility. What may cause this increased market volatility? We think increased investor focus on the debt ceiling debate, which will come more into focus in late February. The U.S. federal debt ceiling needs to be raised again to accommodate additional debt issuance by the U.S. Treasury in March. We think the tone and nature of the debate over the next couple of months could get quite ugly and increase investor anxiety, which could lead to rising market volatility (meaning “downside”).

 

One widely-used indicator that market analysts watch to gauge market volatility is the VIX index. VIX stands for “CBOE Volatility Index”. The VIX measures expectations of near-term market volatility reflected in changes in forward stock index option prices. It is sometimes referred to as the market “fear” index. Large increases in the VIX index have tended to be associated with declines or corrections in the market. Over the past several years, major spikes in the VIX have occurred following periods of 8-12 months of low volatility or quiescence in the index. We have been in one of these “quiescent” periods for about the past 12 months. If history is any guide, the odds of a major increase in volatility may be rising.

 

 

A swing in the VIX may or may not have any long-term investment significance. So what does this all mean for financial planning and investing? As financial planners there are things we can do to protect client assets from increased market volatility. One of the ways is through diversifying investment holdings by asset class. This reduces portfolio volatility because different asset classes behave differently in varying market conditions. Another way to reduce volatility is by holding larger proportions of dividend-paying stocks as they tend to be less sensitive to harsh swings in the market. A disciplined investment process or model can also help to keep investment decisions within rational bounds and help avoid the temptation to make emotionally-based decisions. Finally, having a sound financial plan that incorporates reasonable and reasoned spending, income and investment return assumptions can also greatly help clients remain on course with their financial goals and avoid the temptation to either time the market or make detrimental decisions with regard to portfolio risk and/or risk assumptions. All of these, plus a long-term approach to investing can help to mitigate portfolio risk.