Up, Up and Away – Why Not to Fear New Market Highs

2018 started off with NYE fireworks that have continued. It took only 3 trading days in the New Year for the Dow to surpass 25,000. It took another 8 trading days to close above 26,000.

Do you take your money off the table or do you say, laissez le bon temps rouler?

I’m not a soothsayer (more of a historian), so let’s step back and remember that a day or a month does not make a year.

Performance-wise, 2018 marks a phenomenal start for the Dow index. As of January 16th, the Dow was up ~ 5% YTD, on the heels of being up ~ 25% in 2017. The Dow jumping from 25k to 26k was the quickest 1,000 point move ever. Wow! The Dow is like the Golden State Warriors (as of recent) – we’re seeing some outstanding moves and records achieved.

It’s best to keep everything in check though. We only have to look back 2 years to the beginning of 2016 – the Dow had its worst 10 day start since 1897. The Dow lost 5.5% in January 2016 and 93% of investors lost money, if not more than the Dow that month, according to CNN_Money.

Back then, global economic worries pushed investors away from risky assets. Now an apparent synchronized global pick-up has investors jumping in and seeking risky assets, such as stocks, fearing they’re missing out on the next leg up. It’s a melt-up, the opposite of a market melt-down.

When people know that I’m a wealth manager, they often ask me what I think about the stock market. Often it’s along the lines of “I have cash that I could/should put to work but have been waiting for a pull back as the market is at an all-time high, so I just sit tight.”

I often proffer that “the best time to invest was yesterday and the second best time is today,” in addition to, “it’s about time in the market, not timing the market.”

We’ve been constantly hitting new highs since taking out the old high on the Dow back in October 2007 (Dow 14,093) in early 2013, a span of ~ 5 ½ years to be back in black. Now we’re close to another 5 years since then, and close to 9 years in on a really impressive bull market run.

For those old enough to remember the Nifty 50’s, the Dow climbed 240% during the decade of the 1950s. For me, I remember the Roaring 90’s and the spectacular run we had during that decade. In 1999 alone, the Nasdaq composite rose 86%, the biggest annual gain for a major market index in U.S. history, while the Dow gained 25%, a record 5th year in a row that the index posted a double-digit percentage gain. That’s what a market topping process looks like.

Historically, the stock market has had its share of peaks and troughs, from bull to bear back to bull again, taking out previous highs and setting new ones. How long does that take? It depends on many circumstances but I would say that while the past is no fortune teller, it does offer clues.

Wharton School Professor Jeremy Siegel studied the ‘Nifty 50’ stocks of the early 1970’s. These were much sought-after stocks that got to ‘nose bleed’ valuation levels and then had a melt-down. However, they ultimately turned around and by 1996, they had offered up annualized double digit returns. (you can read the full study here: https://www.aaii.com/journal/article/valuing-growth-stocks-revisiting-the-nifty-fifty)

So even if you believe you are purchasing stocks at high valuation metrics, over a long period of time those securities will reward investors (caveats of diversification, etc. are always warranted).

There will be bubbles – Dutch tulip bulbs, dot-com stocks, and now we’re in the throws of a cryptocurrency craze. And yes, many U.S. stocks are currently stretched, valuation-wise, and probably will be for a while longer as there’s momentum from investors adding to stocks and away from bonds.

As economist John Maynard Keynes stated back in the 1930s, “The market can stay irrational longer than you can stay solvent.” At this juncture, that means a tricky part of putting money into a bearish bet is the timing. You can be right that a market or sector is overvalued but wrong on the timing.

My best answer to investing near or at market highs is to stay steadfast – continue to invest or get started in doing so. Dollar-cost averaging helps as well. Investors with a long runway before they need to draw on their assets should hold a good amount in stocks in their overall asset allocation.

One should take a diversified investment approach and forgo timing entry points. One’s time and energy is better served on focusing on a factor that has been shown to have a greater impact on returns – one’s asset allocation. That should be based on one’s long-range financial goals and needs as well as knowing one’s limitations. A wealth manager who has an informed view of a client’s total financial picture can then position the client to best hew to his or her overall financial plan.

In financial literature we often speak of a “rational investor” but we all know that humans are emotional beings (we’re not Vulcans!). It’s really difficult for human beings to envision what might happen in the future. That’s why we have a very tough time taking money we earn today and saving or investing it for some far-off point. But doing exactly that is what’s required if you want to reach big financial goals.

If you want to get or stay on track to reach your long term goals, feel free to reach out to me (or a fellow Naples Asset Management advisor in your local area) about any adjustments your plan may need.

A creative man is motivated by the desire to achieve, not by the desire to beat others.” ~ Ayn Rand

Observations and Outlook January 2018

Investors have not been as fully invested in the stock market since 2000.  Does this mean anything?

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)

I102YTYS_IEFFRND_I30YTR_chart

The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA

What is the “JOBS ACT”?

Typically, when a company raises capital, it has to register its securities (basically the shares/interests that they are offering for sale).  Registration is expensive and takes a long time.  Most companies look for an exemption from registration. The most common exemption used by companies for this purpose is the private placement exemption, which basically meant the companies couldn’t publicly solicit or advertise.

The “Jumpstart Our Business Startups Act”, or the “JOBS Act” changed that.  The JOBS Act allows companies to publicly solicit for funds and advertise while still conducting a private offering.  However, it comes with a major catch.  The only investors allowed to invest must be “accredited investors”, and the company raising money has to verify that their investors are truly accredited investors.

A simple questionnaire is no longer sufficient – instead, companies must take further “reasonable steps” to prove their investors are accredited investors.  Failure to comply is a violation of federal laws and may subject the company to enforcement action and the obligation to return money raised.  That’s obviously bad for companies, but it’s also bad for investors who don’t know if the companies they invested in will suddenly have to return a portion of its capital to other disgruntled investors.

What is an “Accredited Investor”?

An “accredited investor” is a type of investor. Generally, sales of securities must be registered with the SEC unless an exemption is found. Some of the exemptions require sales to be made to accredited investors. Our application lists out the various categories of accredited investor.

The Securities and Exchange Commission also has a helpful page on accredited investors here: https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-accredited-investors

For more information, please contact Paul McIntyre at pmcintyre@namcoa.com

401(k) and Retirement Plan Limits for the Tax Year 2018

On October 19, 2017, the Internal Revenue Service announced cost of living adjustments affecting dollar limitations for pension plans and other retirement-related items for the tax year of 2018.

Highlights of Changes for 2018

The contribution limit for employees who participate in 401k, 403b, most 457 plans, and the federal government’s Thrift Savings Plan is increased from $18,000 to $18,500.

The income ranges for determining eligibility to make deductible contributions to traditional Individual Retirement Arrangements (IRAs), to contribute to Roth IRAs and to claim the saver’s credit all increased for 2018.

Click here to view the  2018_plan_limits

Money for Nothing: from QE to QT

During the crisis, central banks lowered interest rates dramatically during the stock market crash.  The Fed Funds Rate went from 5.25% July 2007 to 3.0% March 2008 (when Bear Stearns failed, most people remember Lehman, which failed in September).   That summer Freddie Mac and Fannie Mae failed and the FFR was lowered to 2% and then 1% in September and finally 0% was the official rate in December 2008.  All the while financial asset prices kept falling and the economy was hemorrhaging.  Soon after hitting 0% as the cost of money to the banking system, the Federal Reserve started Quantitative Easing, where the Federal Reserve would buy mortgage backed securities (as well as other tax-payer insured instruments) to provide ‘liquidity’ to the markets.   The stated goal was to increase the prices of assets (stocks, real estate, bonds) so that the “wealth effect” would spur people to spend money rather than save it.  Given the anemic pace of economic expansion, the primary effect QE has had has been to push up stock prices well beyond normal valuations.

While the US has ceased QE, raised interest rates off the 0% mark, and laid out a plan to shrink its balance sheet (taking liquidity away from the market); the European and Japanese central banks continue to buy assets. The Europeans buy corporate bonds and the Japanese buy everything including equities.  The ECB has expressed a desire to cease its purchases (stopping new liquidity into the market) starting in 2018, but have not committed to a schedule.  The chart above combines all the central bank’s asset purchases and projections into 2019 overlaid with global equities.  On the chart below, notice how the EM (emerging markets withdrew liquidity late 2015 to 2017—emerging market stock indices (EEM) fell 39% from Sept 2014 through Jan 2016).  Additionally we can observe the effect central bank purchases have had on interest rate spreads, giving investors the most meager additional interest for taking on additional risk.

The chart shows the Fed’s net reductions in liquidity and the Swiss, Japanese and Europeans declining levels of new liquidity to the marketplace.   Given that adding liquidity boosted asset prices, as additional liquidity slows and possibly reverses, it is not unreasonable to assume markets will become much more volatile as we approach that time.  We will likely see the effects of Quantitative Tightening (QT) beginning in, and throughout 2018.  One way to counteract this, would be for private investors to save/invest rather than spend this difference (approx. $1.2 trillion), but a reduction in consumer spending would bring its own problems.

central bank purchases 2019

 

What is a SMA?

Also known as a SMA (“Separately Managed Account”), is a single investment account comprised of individual stocks, bonds, cash or other securities, tailored to achieve specific investment objectives.

Your portfolio manager oversees the investments according to your specific investment objectives and in an investment style with which you are comfortable.  Put simply, a SMA is for demanding investors who:
  • Seek the comfort of professional investment guidance and a heightened level of personal service
  • Still want to take an active role in their financial life
  • Desire the flexibility to invest in different strategies or styles, while seeking the liquidity and potential tax benefits that come from owning individual securities in separate accounts, versus mutual funds
  • May want a single fee to cover ALL account costs, including trading costs and performance reporting.
  • Low-cost, transparency and 24/7 online access

For those with more than $100,000 a SMA may be the smart way to manage portfolio assets, due to lower costs, greater tax efficiency and transparency.

Why the growth in Cash Balance Plans?

The Pension Protection Act of 2006 (PPA) is long and hard to read, but it played a crucial role in establishing cash balance plans as a viable and legally recognized retirement savings option. Before 2006, cash balance plans faced frequent legal challenges. Those bringing the suits argued that cash balance plans violated established rules for benefit accrual and discriminated against older workers. The rulings on these cases were inconsistent, and many business owners were reluctant to risk establishing a plan that just didn’t have firm legal footing.

The Pension Protection Act ended this uncertainty about the legality of cash balance plans. The legislation set specific requirements for cash balance plans, including:

  • A vesting requirement: Any employee who has worked for their company for at least three years must be 100% vested in their accrued benefits from employer contributions.
  • A change in the calculation of lump sum payments: Participants in a cash balance plan can usually choose to receive a lump sum upon retirement or upon the termination of employment instead of receiving their money as a lifetime annuity. Before 2006, some plans used one interest rate to calculate out the anticipated account balance upon retirement, but, when participants opted to receive an earlier lump sum, the plan called for using a different interest rate to discount the anticipated retirement balance back to the date of the lump sum payment. This could lead to discrepancies between the hypothetical balance of the account (as determined by employer contributions and accumulated interest credits) and the actual lump sum payout, an effect known as “whipsaw”. The PPA eliminated the whipsaw effect by allowing the lump sum payout to simply equal the hypothetical account balance.
  • Clarification on age discrimination claims: A cash balance plan does not violate age discrimination legislation if the account balance of an older employee is compared with that of a similarly situated younger employee (i.e. with the same length of employment, pay, job title, date of hire, and work history), and the older employee’s balance is equal to or greater than the younger employee’s.

There are, of course, many other points included in this lengthy piece of legislation, but the takeaway is this: the Pension Protection Act of 2006 removed the legal uncertainty surrounding cash balance plans and made them a much more appealing option for small business owners.

The number of cash balance plans in America more than tripled after the implementation of the PPA. Additional regulations in 2010 and 2014 made these hybrid plans an even better option, and we anticipate that their popularity will continue to grow. There are thousands of high-earning business owners out there who can reap huge, tax-crushing benefits from implementing cash balance plan – they just have to know about them first.