A “New Paradigm” ?

The Wall Street Journal recently ran an interesting op ed written by Burton Malkiel entitled “Even Amid the Current Turmoil, Stocks Still Beat Bonds”. Malkiel is the Princeton prof who wrote the book “A Random Walk Down Wall Street” and is considered one of the pillars of the Efficient Market Hypothesis (EMH). EMH states that the stock market is completely efficient, discounts all that is known about a stock in the current price, and that it is impossible to outperform the market through trading or investment schemes.

To be sure, EMH has come under question in recent years but Malkiel has been around a long time and is well respected in our industry and I believe his opinions carry some weight. The important points about Malkiel’s article were these:

1.       He believes equities today are more attractive relative to bonds than at any other time in history.

2.       He believes fixed income investments will never earn the returns necessary to meet retirement or pension fund planning objectives.

3.       He believes “the only hope” for generating returns necessary to meet retirement planning goals is to increase investment allocation to equities.

While we agree with Malkiel, the notion of holding more equities at or near retirement flies in the face of a long-held “law” of retirement planning, namely that one should hold a large fixed income allocation at or near retirement. While holding more equities may increase long-term returns, higher equity weightings will result in greater portfolio volatility which increases investment risk.

So for us as financial planners, we are sort of in a “new paradigm”: while increasing equity weightings for retirees may now present a more expedient strategy, the question becomes how do we mitigate the risk of higher volatility which would accompany higher equity exposure? We do this in a number of ways:

§  Make sure client portfolios are adequately diversified both by asset class and market sectors

§  Emphasize income in our investment model as higher portfolio income helps to reduce volatility

§  Take care to understand the risk tolerance of our clients and how this translates to their investments

§  Base investment decisions on fundamental research and reasoned logic

§  Identify and invest in undervalued sector opportunities

§  Make sure all clients have a sound financial plan that keeps them on the proper roadmap particularly with regard to their investments. This reduces the risk of emotionally-driven decisions that can destroy the effectiveness of a sound financial plan.

Encouraging Economic News

We were encouraged by several pieces of economic news today: 1) Private employment, which excludes government jobs, climbed by 206,000 this month, according to data today from ADP Employer Services survey. This is the highest growth level so far this year. 2) The Institute for Supply Management-Chicago Inc.’s business barometer (PMI) increased to 62.6 in November from 58.4 in October led by strengthening industrial orders and production. The PMI new order index, an important leading indicator, rose to the highest level since March. 3) The German Federal Labor Agency reported that unemployment in Germany dropped more than forecast in November to 6.9%. Also, German business and consumer confidence rose in November. 4) The National Association of Realtors’ index of pending home sales increased 10.4%, the most since November 2010. 5) Today’s global central bank actions are positive for liquidity of the European banking system. This data supports a continued improved outlook for the U.S. economy and bodes well for acceleration in U.S. GDP growth in Q4 and 2012, in our view, and also supports the outlook for further growth in U.S. corporate earnings in 2012, a positive for U.S. equities.

What’s the downside? As it has been for some time: risk of a meltdown of the European financial system resulting in collapse of the Euro and implosion of the European economy. This has global financial and economic risk implications. Today’s actions by both Italy and global central banks are an encouraging sign that 1) European leaders understand the urgency of their situation, and 2) we are seeing more concrete measures being taken to address the problems in Europe. We remain concerned that the Eurozone countries continue to face massive headwinds in reaching a workable solution that will maintain both the integrity of the European Union and the Euro as viable currency.

Implications for financial planning: While today’s rise in the stock market is encouraging, we by no means believe volatility is going away. Western economies, including the U.S., are facing massive debt and fiscal problems that will take years to fully address and that will continue to present significant risk to the financial environment. From a portfolio perspective, we continue to advocate above average cash holdings and broad diversification with respect to asset class and geographic and sector allocation in order to mitigate portfolio volatility.  We would also add that today’s rise in the market is a perfect example of why we believe people need a sound financial plan and should stick to it, rather than trying to time the market.

BT for S.R. Schill & Associates, Mercer Island, WA

C’mon. Did anyone really expect an outcome other than what happened with the Super committee deliberations? Perhaps if you were on another planet. This was “political expediency” at its best: avoid tough decisions that could roil voters and seek political “cover” by pushing the issue on to the entire Congress. So now what? The President has said he will veto any attempts to avoid the automatic spending cuts that kick in in 2013, setting the stage for more DC high stakes political drama. You know it’s going to be an ugly process. Market implications? Continued news-driven volatility. The economy? It will most likely continue to muddle along as will corporate earnings, which offers support for equities, in our view. We are encouraged that recent U.S. economic data supports a moderately improving outlook. Outside the U.S., the ugly process of European debt restructuring will take more time and, of course, adds another element of uncertainty and volatility. So what does it mean for financial planning? While we think the long-term outlook for the U.S. is bright, the level of investment uncertainty near term remains high.  With higher market volatility expected to be around for awhile, we advocate having a financial plan that provides a long-term roadmap for your investments and portfolio strategy. It means keeping your eye on the long-term goal and not being overly influenced by short-term swings in the market, both up and down. A sound financial plan can help you stay on course for the long term. It’s like planning anything else in your life: would you start a business without a business plan? And a sound financial plan can address and mitigate portfolio volatility through appropriate asset allocation, sector diversification, and regular plan reviews.

 BT for S.R. Schill & Associates, Mercer Island, WA