Executive Summary
We are at a very interesting point in time in a historically unusual economic environment. Obviously that environment influences investment returns because the investments in your portfolio represent the productive assets of the economy. Positive stock market returns go hand in hand with a growing economy. While some data indicates that we could be near the end of the third longest economic expansion in history, there is evidence of continued economic expansion; especially considering an accommodative Fed. A more robust economy with expanding wages will be necessary to justify markets that have become expensive. Janet Yellen recently remarked that she could make a case, given how tepid inflation has remained, to let the economy run a bit "hot" and maintain accommodative policy. If the economy stops expanding, stock returns are very likely to be negative. No one, not even Nobel Prize winning economists, have in the past shown the ability to identify the turning point of the stock market while it is happening (market timing does not work, since you are more likely to miss a positive stock market return). Positive bond market returns depend on the current yield environment and no movement in interest rates or a future path of declining interest rates across bond maturities. As interest rates decline, bond prices go up. During the last quarter, interest rates hit all-time lows in the U.S. and Europe. Rates have rebounded since then. When rates increase, bond prices decline and the longer the bond maturity (duration), the larger the loss. The U.S. Federal Reserve has two objectives in setting short term interest rates: full employment and price stability (primarily avoiding inflation). Due to the fully employed U.S. economy and expectation of future inflation, the Federal Reserve Board may decide to raise rates another quarter percent at their December meeting, irrespective of the aforementioned comment by Fed Chair Janet Yellen. The stock and bond markets have been adjusting to the fluid interest rate expectations. There have been many times in history that stock returns have been positive with increasing interest rates, but interest rates have never been this low before. So we are in the middle of an interesting time in history that is worth keeping a sharp eye on many economic indicators.
At the moment, we are lukewarm on what we see in the markets as we are not excited about the expensive valuations of stocks or bonds, but we are pleasantly surprised by some of the economic data that has surfaced . Based on the new information, we believe the timing of recession in the U.S. has been extended further out into the future; but the future is uncertain and forecasts are more often wrong than right. As a reminder (and we can’t say this enough), the first step in portfolio management is to try to achieve the target return for goal attainment with the lowest amount of risk possible. This is known as mean-variance optimization (mean return and the variance or standard deviation of that return). Dialing portfolios in along the “efficient frontier” helps us better match our client portfolios to their financial plans with the objective of increasing the probability of goal achievement over the long term. These portfolios are created with the knowledge that recessions and bear markets occur, therefore are expected; and we do not abandon the portfolio based on news, guesswork or prognostications as markets cannot be timed. We build portfolios to be robust and resilient through all market conditions (although negative volatility cannot be removed completely), including recessions and market corrections, based on a globally diversified asset allocation of stocks and bonds. Further, we employ a strict, disciplined methodology that is empirically based and academically scrutinized for making buying and selling decisions during periods of market ups and downs. In other words, we know what our strategy will be in a given environment ahead of time; and we are ready to implement when the strategy is triggered.
With that said, we believe to be more important to have the ability to answer the question, “What is the money there for, and how do I get there?” than to focus on portfolios and returns. There is a purpose behind saving money; whether it is for education, retirement, to create a legacy, or any other dream one may have. We optimize the probability of achieving one’s financial goals using stochastic modeling of thousands of different investment return possibilities combined with one’s expected cash flows by identifying a prudent asset allocation; and also by helping with decision making on items under one’s control, such as saving and spending behaviors and tax decisions. Once a prudent asset allocation is identified, we create an investment policy statement for our client so they understand the process in written detail. We help our clients become successful investors that understand how their portfolio ties to their goals, that markets pull back at times, and that those times provide opportunity over the long run.
Some of our clients have expressed concerns about this election and its effects on portfolio returns. In short, do not worry about any knee jerk reactions. Let our process, capitalism, and the markets do the work for you over the long run. Rest assured, our investment team plans to be cautious during these historic times; as evidenced in our cash management for client portfolios.
For those who want to dive deeper into our market and economic commentary:
World Asset Class Index Returns
Third quarter index returns were positive for equities, especially international and emerging market stocks. International and emerging market stocks recovered from their under performance during the second quarter that were due to the Brexit vote results. We recently discussed the volatility of the Brexit vote in our special blog here, http://www.laketahoewealthmanagement.com/blog/dont-serve-detention-brexit-club-weekend. The U.S. and international stock market indices have more than recovered from the negative volatility unleashed by Britain’s decision to leave the EU. While stocks have performed well, it is worth taking another look at valuation levels; which we will do in our “Deeper Look” section.
A larger sample of asset class returns in the U.S. shows the strength of small cap stocks, the Russell 2000 index was up 9.05%, just ahead of emerging market stocks (up 9.03%). Small cap stocks have a higher standard deviation and more volatility (risk) than large cap stocks. When the small cap asset class is outperforming by such a large margin, it is a signal of investor preference for increased market participant risk appetite. This may be fueled by continued positive employment expansion and consumer spending data points, along with tempered interest rate increase expectations compared to the beginning of the year.
Bond yields have increased across the yield curve, except for at the very short end and tail long end. The 10-year Treasury Bond ended the quarter up 11 basis points to 1.60% after hitting at an all-time low yield of 1.35% on Tuesday, July 6th. While the nominal yield curve has increased across most of the curve, and is generally most important to investors; it is interesting to note that the real, or inflation-adjusted yield curve has flattened across the curve, with the low end increasing slightly and the long end decreasing. This is likely due to expectations that with the U.S. nearing “full employment” that inflation may increase, and investors will be watching inflation closely while trying to anticipate a Federal Reserve rate increase.
When the yield curve shifts up across most time periods, the longer duration bonds are going to perform worse. The leading bond sector is no longer long term government bonds, as it was in the second quarter. It is high yield bonds, up over 15% year to date, which is another sign of investor preference for riskier securities.
One cannot time markets and typically the short term is just noise. Do you recall in January that 2016 was the worst U.S. stock market start in history? Notice how stocks have recovered from the February 11th low in the picture below. It is a sample of how the world stock market responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term).
A Deeper Look
The third quarter stock market rally is fueled and supported by central bank quantitative easing around the globe, including the Federal Reserve backing away from its rate hike decision in September and communicating a decrease in the path of future rate hikes in 2017. The Federal Reserve has one meeting left in December for voting to raise short term interest rates for a second time in 2016 (current level is 0.25%). Recent economic data out of Europe, Japan, China and the U.S. helped the rally of risky assets. In summary, the data points were not strong enough to stop central bank monetary policy of quantitative easing and not weak enough to increase the discussion of a stagflation / deflation scenario.
Low interest rates support higher stock valuations. Price to Earnings (P/E) ratios have historically displayed a negative correlation with interest rates. As long as interest rates are low, there is an argument that P/E ratios are not elevated; and could actually expand, driving stock prices higher. We are by no means pushing this argument, we simply point out its existence. It would be foolish to believe the probability of a stock market decline is approaching certainty based on valuation alone; as the past has shown, valuations can become much loftier and remain extended for long periods of time. During the third quarter, we have seen another expansion of the P/E ratio. The S&P 500 Trailing Twelve Month (TTM) P/E ratio is 23.8 (for the end of Q3) and the P/E ratio for expected 2016 year-end earnings is 19.7 vs. the average historical P/E of 17. Now, the P/E ratio has never had much predictive power on its own, so it is worthwhile to look at valuation measures that do. The multiple least manipulated by accounting, the Price to Sales ratio, for the S&P 500, hit a new record high of 1.94 during the third quarter, up from 1.84 at the end of June (a previous record) and currently sits at 1.91. Revenue growth for the S&P 500 is closely tied with GDP growth, which is below the historical trend and expected to stay low into the future. The informative P/E 10 or CAPE (cyclically adjusted P/E) using 10 years of earnings is 27, near the same peak level as February, 2015 and near two standard deviations above its historical average. Tobin’s Q, which is a measure of the entire stock market’s price to book ratio is also near two standard deviations above its historical average. There is little doubt that valuations are stretched for U.S. stocks, but not quite stretched enough for us to take action.
Conclusion
Economic data in the U.S. and around the globe was positive enough to reduce expectations of a developed market recession in the next 12 months. Valuations are elevated in all risky asset classes, including bonds and approaching highs last reached in 2007 (prior to the great financial crisis). Global growth is very low, global debt levels are very high. It is wise to be prudent and we will be prudent in our investment committee decisions in the coming weeks. If valuation multiples continue to expand, we may take action. During the next quarter, the U.S. will elect a new president and the financial media will be attempting to forecast the impact to asset prices, so we would like to get ahead of it with a bit of historical context from our friends at Dimensional:
Click to read Presidential Elections and the Stock Market.
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 credit worthiness of the issuer.
Principal Risks:
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, Inc. (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.
Lake Tahoe Wealth Management, Inc. Registered Investment Advisory Firm with the Securities Exchange Commission.
