A New Paradigm

Our last post dealt with the mechanics, or “financial engineering”, available to capitalists currently in which low cost debt can be used to improve return on invested capital (ROIC) by using debt to buy back or reduce outstanding shares (or equity capital). As we explained, the reason for this is the current arbitrage that exists between the cost of debt and equity capital.

In addition to repurchasing or reducing equity capital, availability of low cost debt capital can be used to acquire undervalued businesses. This is what happened in the 1980s in the great “leveraged buy out” (LBO) wave, which lasted from 1982-1989. During that period there was a significant number of corporate takeovers fueled largely by debt. Some of the larger examples of takeovers during that period included Beatrice Companies, Revco Corp, Jim Walter Industries, Federated Department Stores, Uniroyal Goodrich, and Hospital Corporation of America. Capitalists realized that these businesses were under-earning their cost of capital and through restructuring and re-capitalization of the businesses, ROIC could be significantly improved, hence greater return potential for equity holders.

We have something similar to the 1980s occurring in today’s environment. There are many large companies trading at historically low valuations relative to their cash flow potential. The technology sector, for example, is one in which there are a number of large companies trading at very low valuations relative to sustainable cash flow. This can cause a couple of things to happen both of which can be fueled using low cost debt: 1) acquisition of the undervalued companies through an LBO; and/or 2) restructuring and reduction of equity capital base to boost return to equity shareholders.

We believe we are in a “new paradigm” similar to the 1980s. M&A activity has increased in 2013 and is expected to increase further in 2014. Leveraged loans are rising significantly, providing significant capital to fuel this activity. There are a number of very recent examples of M&A activity among large companies including: Sysco merging with U.S. Foods; American Airlines merging with U.S. Airways; and Avago Technology merging with LSI. The combination of slow global and corporate top-line growth combined with continued access to low cost debt capital should enable this new paradigm to continue for several years. This new paradigm should also help to support valuations for public equities and provide fuel for further increases in stock prices.

 

Might Financial Engineering Extend The Bull Market?

For both investing and the economy, cost of capital and return on invested capital (ROIC) are vital concepts. Generally speaking, investment capital will seek its highest return. This is partly what drives stock prices but it also is an important element in private investments and capital spending decisions by businesses.

The past several years have witnessed financial market anomalies not seen in many decades. One of those anomalies currently is the unusually wide disparity between the cost of debt capital and the cost of equity capital. Because of the long decline in interest rates, the cost of debt capital is now very low relative to the cost of equity capital.

Anomalies like this present capital opportunities. Specifically in this case, an arbitrage opportunity exists in which low cost debt can be used to boost shareholder returns (ROIC). How does this work? Say, for example, a large company has a current cost of debt capital of 2% and a cost of equity capital of 8-9%. It might make financial sense for this company to take on debt and use that capital to reduce equity capital through share buybacks. The result of this is higher ROIC.

The potential for exploiting the current debt/equity arbitrage has positive implications for the stock market and the economy. Why? First, it means that capital heretofore not invested in equities can come into the market via acquisitions and share buybacks; and second, capital is allocated more efficiently in the economy, an important benefit.

History repeats itself. We saw something like this in the early and mid-1980s. As interest rates (cost of debt capital) came down during the 1980/81 recession, it allowed strong companies to take on debt and acquire undervalued companies through leveraged buyouts (LBOs). This “financial engineering” process is occurring again and could be further fueled by this debt/equity arbitrage.

From a financial planning perspective, to the extent this arbitrage opportunity can continue over the next year or two, it reflects positively on stocks as an important vehicle for enabling clients to grow their financial assets, meet long-term financial goals, and keep up with inflation.

 

Twitter and Animal Spirits

It seems like our little “correction” appears to be over. The stock market indexes are all at or near all-time highs. Investors continue to remain comfortable with the “goldilocks” environment (not too hot, not too cold) for stocks: rising earnings, low inflation, and reduced fears over Federal Reserve policies. The situation in Syria? De-fused for now. Debt ceiling debate? It may get ugly for a while, but ultimately there will be a resolution to the debt ceiling.

Of greater concern of late is the “Twitter” and rising animal spirits. “New age” internet stocks, like Zillow, Netflix, and Facebook, have been on a tear lately, some of them up by over 200% in the last year. On top of this, Twitter, a social media company, recently announced it will go public. Why now? Twitter and its bankers sense the market is ready for it….the “animal spirits” of the market are ready and salivating for the next quick flip IPO.

Traditionally, when we talk about “animal spirits”, it refers to the human propensity for taking on more risk when things “look good”, when the market’s been up, and, oh yes, when it now seems OK to take on more risk. That smacks of “overconfidence” and overconfidence is a problem for the stock market.

While we suspect there is more upside for the stock market in the near term, the rising animal spirits may be an early warning sign that the market is no longer be “cheap” and that market “risk”, or volatility, may be increasing. From a financial planning perspective, the best way to protect retirement and investment portfolios from volatility is through appropriate asset allocation and diversification. Holding multiple asset classes in a portfolio reduces risk because different asset classes typically behave differently in different parts of a cycle (for example, bond prices usually go up when stocks go down). Sticking to a long-term financial and investment plan also lowers risk by reducing the temptation to “time” the market and buy or sell at the worst possible time in the cycle.

 

Three Terrible Days

Did you see this on the news? We were amused earlier this week when a commentator on a daily stock market program declared in horror that the stock market had been down three days in a row……Three days in a row!! Wow…...like it was the beginning of the apocalypse….or was it the beginning of a new, dreaded market correction? You know as well as I do that three days of a trend in the markets really doesn’t mean much. But it sounded so “daunting”. It perpetuates the “fear factor” and creates confusion. But, financial media know this is what keeps people watching and, of course, sells commercials.

Let’s look at what’s really happening. As bull stock markets go, the current one, which began in March 2009, has been pretty average or “normal”. There have been five corrections (market pullback) since March 2009 that have averaged about 13% and have lasted about 3.5 months. This is very much in line with the long-term averages. Corrections are normal and are healthy for the markets because they curb excesses and help maintain balance.

Granted, there have been some legitimate concerns lately about the potential for a correction based on a change in Federal Reserve policy and renewed debate over Federal debt ceiling. One thing we do know absolutely is that the market will correct again at some point. But we also know that the market has rebounded from every correction and bear market and that general stock market fundamentals remain sound.

So should you fear the coming correction or lay awake worrying about it? One of the best ways to protect an investment portfolio from inevitable pullbacks is through appropriate asset allocation and reasoned sector exposure. Holding multiple asset classes can help lower portfolio volatility and moderate losses in a correction. Reducing exposures to stocks and sectors that have performed extremely well is another way in which investors can mitigate the impact of a potential correction. The advice we give to clients is to develop a sound investment strategy or financial plan and stick to that strategy throughout the market vicissitudes. This helps to reduce the temptation to time the market and buy or sell at exactly the worst time.

Q3 Investment Committee Meeting Summary

We held our third quarter Investment Committee meeting on June 27. There was general agreement on a number of issues following our meeting, namely: we believe the U.S. economy continues in a slow but stable recovery; we believe inflationary pressures remain low; we continue to hold a positive view towards equities; we believe equity market leadership is shifting from a value/yield focus to growth; and general agreement that investor psychology toward interest rates is shifting to the view that a more sustained rise in rates is increasingly probable.   

Our longer-term view towards equities remains positive. We believe stocks should continue to perform well in a rising interest rate environment as long as 1) inflation remains moderate and 2) Fed policy remains gradualistic. We think leadership in stocks is shifting away from yield-oriented or value, to growth.  We think growth stocks can do better in a rising interest rate environment because of their perceived ability to grow both earnings and dividends at an above average pace.

Within equities, we meaningfully changed our allocation in favor of growth. We eliminated our holdings of higher yield stocks and added new positions in technology and dividend achiever stocks. These groups have the attributes of very large cash positions, attractive valuations, and large growing cash flows which place them in a position to grow dividends at an above average rate. We also increased allocations to small and mid-cap growth, which have historically delivered higher returns than large caps and we expect should do well in an environment that favors growth.

Within bonds, we reduced our exposure to intermediate bonds, slightly increased our exposure to short-term bonds, and repositioned our long-term bonds by substituting preferred stocks for long corporates. The preferreds provide a significant boost in yield and have demonstrated lower volatility. Our allocations to intermediate and long-term bonds are now at the low end of our allocation range while our allocation to short term bonds is neutral within our allocation range.  

Rising Interest Rate Concerns

Of increasing concern for the stock market of late has been anxious focus on the potential wind-down of the Federal Reserve’s long-standing monetary policy known as quantitative easing, or “QE”. QE has involved massive bond purchases by the Fed to keep interest rates low and stimulate economic growth. Some investors are concerned that ending this program would result in a rapid rise in interest rates which would be damaging for the valuations of financial assets, especially bonds.

While there is a clear and visible risk for bonds in a rising interest rate environment, history shows this is  not necessarily the case for stocks. Historically, stocks have been able to overcome rising interest rates and continue to appreciate in the face of rising interest rates. We recently analyzed seven (rising) interest rate cycles going back to 1967. What we found was that, on average over these seven rate cycles, the stock market was up 7.7% in the twelve months and up 17.7% in the twenty-four months following the bottom in rates. 

Why would stocks go up during a period of rising interest rates? There are several reasons for this:

1.       In most of the periods analyzed, the economy was either strong or recovering and, therefore, corporate earnings were rising.

2.       Stocks are viewed as a hedge against inflation because corporations can raise prices for their products and pass some of this on to investors via growth in earnings and dividends.

3.       Growth companies have greater potential to increase their book value faster than inflation and thereby provide better return potential relative to fixed income investments (i.e. bonds).

From a financial planning perspective, the analysis leads us to believe that this cycle should probably not be much different from earlier cycles. There may be a period of market “turbulence” or even a market correction as the Fed begins to taper its QE program; however, as of now, the economy appears to show little sign of recession, we believe corporate earnings will continue to grow, and we expect inflation will remain moderate. This leads us to conclude that equities, particularly growth stocks, should continue to remain an important component of a diversified portfolio.

Are The Skeptics Right ?

There are still plenty of people who are complete skeptics on the stock market and who still believe the market is going to crash. This is normal for this point in a secular bull market. Investor psychology has gone from a “total fear and loathing” phase in 2008/2009 to a “disbelief, distrust” phase more recently. And we are probably still a long way from the “euphoric stage”. To be fair, it is true that the market could crash at any time for some unforeseen reason or shock, but right now the financial fundamentals still look reasonable.

The fact that many people are still skeptical is actually bullish because of the lack of consensus. Once there is unanimity of opinion, it usually means we are at or near the end of the trend.  The market is kind of a “reverse psychology” animal: many times you have to “fight” the consensus to be successful and this is difficult to do. The ability to approach investing in a systematic and unemotional way is one of the key reasons why great investors like Warren Buffet do so well over long periods.

We all know the market goes through bull and bear phases; that is normal and predictable but these cycles trigger emotional responses. What causes these phases or cycles? Changes in the outlook for corporate profits has a significant bearing on stock prices. When the market perceives or is comfortable that corporate earnings will rise, it will bid the prices of stocks up in anticipation of improving earnings, as it has been doing for some time now. And vice versa, when the market anticipates or becomes concerned corporate profits may slow or decline (such as in a recession), it will bid the prices of stocks down.

Another key driver of stock prices is valuation. A lot of factors go into valuation, such as investor confidence, the outlook for the economy and inflation, Federal Reserve policy, health of foreign economies, geopolitical factors, energy prices, and a myriad other factors. Market cycles can be further exacerbated by “shocks”, such as financial bubbles (think “housing” in 2006/07) or bubbles within a market sector (think tulips in 1637, or technology in 2000). These “bubbles” create imbalances which are eventually normalized through severe market corrections.

So how do we deal with market cycles from a financial planning perspective? Like Warren Buffett, one way is to take “emotion” out of the process. This is accomplished through a sound financial plan. The plan acts as a long-term roadmap for both personal finances and investments and helps the client approach investments in a systematic and unemotional way.  A good plan will help a client “stay in the game” and avoid the temptation to make emotionally-based decisions at the worst possible time.

 

The “New Goldilocks”….. Not

In our last post, we discussed the “new goldilocks” economy. But it may be “goldilocks” for the wrong reason. Why? It may be “goldilocks” (not too hot, not too cold) for investors in financial assets (for a while anyway), but it remains a pretty cold bowl of lumpy porridge for many people who are either struggling to make ends meet or find a new job. The economy is operating well below its theoretical potential because of slow consumption and companies’ reluctance to ramp up new hiring because of this slow growth. In our last blog, we talked a bit about why, in this “new goldilocks” economy, money is shifting to equities from bonds in a search of higher yield. This is raising systematic risk because equities are inherently more volatile than bonds. To the extent more people are relying on higher volatility investments to provide more of their retirement income, the risk of many people falling short of requisite retirement capital is increased.

 So the point is, while it may be a “goldilocks” environment for stock investors right now, it is not “goldilocks” for the economy. We are still mired in a very slow growth environment which is part and parcel of a de-leveraging environment following a massive 30-year credit binge. It’s like a “hangover” and this is the “payback”. In the meantime, as long as global central banks maintain their super-easy money policies (which they appear to be doing), the “goldilocks” environment for stocks will also probably continue as excess liquidity is channeled into higher yielding equity securities.  But it does raise systematic risk and is unlike anything we’ve seen in the post-World War 2 environment. How does one protect themselves in this environment of increased systematic risk? Diversification of investment portfolios by both asset class and market sectors. Diversification provides the insulation or “shock absorber” when markets become more volatile or decline because assets that are not highly correlated to stocks may hold up better or actually increase when stocks decline. Diversification is probably the only “free lunch” in investing; it is one of the ways to obtain portfolio “insurance” without having to pay for expensive hedging or alternative investment strategies.

“Goldilocks….Slow Mo”

There used to be a phrase commonly used by economists and market analysts when discussing the economy which you don’t hear much anymore. The phrase was the “goldilocks economy”. It meant that the economy was growing at a reasonably good pace, enough to support rising corporate earnings, without generating high inflation and, therefore, was “not too hot and not too cold”, but “just right” to keep the stock market happy. That was back in times when “normal” economic growth was something like 3-4% real GDP, like we had in the 80s and 90s.

 Today, we have a “new normal”, which is slow (1-2%) growth, slow job creation, slow consumption, and low inflation…..and what one could describe as a “goldilocks economy” in slow motion, which appears to be just fine with investors, thank you, as the stock market moves to record highs. Why are investors happy? In this case, it is primarily because slow growth is causing the global central banks to maintain a highly accommodative monetary policy. In fact, today (April 29), it appears the European Central Bank may be prepared to lower interest rates. This on top of what we expect will be continued highly accommodative policy stance on the part of the U.S. Federal Reserve.

The market likes this “goldilocks economy” because the “easy money” policies appear to have no end in sight. The idea is excess liquidity pumped into the financial system by the central banks will find its way into the stock market, with the U.S. right now being the market of choice for most global investors. This has favored, and continues to favor, large-cap dividend –paying stocks which are highly sought-after in the current environment of very low interest rates. Bond yields have become so low, that fixed income investors have been seeking higher returns in higher yielding blue chip stocks. This “reallocation” of assets has changed the investment risk paradigm and actually increases financial system risk, as stocks are inherently more volatile than bonds.

The good news is the “new goldilocks” economy appears to be doing reasonably well, albeit still at a slow pace. Within this backdrop, we don’t see the new “risk paradigm” changing much in the near term, which is positive for stocks. From a financial planning perspective, one of the best ways to protect against higher systematic risk is through diversification: holding a portfolio that includes a number of asset classes that are not highly correlated. While this will result in growth that may be slightly below that of the stock market when stocks are rising, it protects the portfolio through reduced downside risk when stocks are declining and should result in higher risk-adjusted returns over the long term.

 

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.