It’s All “Greek” to Me
There’s a lot going on in the world right now. In fact, there is always a lot going on in the world, so in reality, things are pretty much normal. The investment markets have been all over the place without really going anywhere, and for many of us, our portfolios have acted the same way. While it is easy to get frustrated when choppy markets lead to mixed market results in the near term, it is always important to keep things in perspective.
As many of you know, Tim Kenkel, Chief Compliance Officer of Cascade, races mountain bikes for the Tokyo Joe’s Team here in Denver. In a recent investment committee meeting he was quick to draw an analogy between the Tour de France and investing. He stated: “I liken the markets to the Tour, thinking about short time periods as if they were the individual stages, or the “Race within the Race”. Do you want to win this stage, or is it more important to come out on top of the entire Tour? Not too many people can remember who won Stage 7 in 1990…but everyone knows who Greg Lemond is.”
For the past several months, our financial news media and market traders have been focused on one topic: Greece. I have received more calls and e-mails about the Greek debacle than any other in recent memory. Our news media has done an excellent job of making this “The” topic of conversation, and traders religiously speculate on the outcome of the discussions, resulting in wildly vacillating equity market prices. Many have agonized over the implications of a possible “Grexit” on their retirement, and have lost sleep and stomach lining over the subject.
While there is no shortage of market pundits who will loudly disagree with me…I fail to see the long term importance of the whole discussion. Indeed, I think my friend Mike Williams of Genesis Asset Management said it best when he recently wrote:
I’d like us to consider a few things:
Nothing in Greece will change how many millions of people will leave their homes and form new households in the next 5 to 10 years here in the US….nothing.
Nothing in Greece will change how many millions and millions of first car buyers will hit the scene over the next 5 years.
Nothing in Greece will change how many millions and millions of new couples will form their own families in the next 3, 5 or 7 years.
Nothing in Greece will change the massive impact of a gigantic wave of people who will enter our economy in a new way – building the next phase of their lives in a relatively predictable manner.
I think Mike hit the nail on the head with his commentary, and while I don’t mean to diminish the severity of the economic situation in Greece, we as investment professionals need to keep these types of events in perspective, and not let the media event of the week (or quarter, in this case) drive our decision making. More importantly, while we in the US gnashed our teeth over the media coverage regarding the concerns with the Eurozone, the Euro itself didn’t collapse… on March 1, the EUR was worth $1.1191. On July 1, it was worth $1.1181. For all the supposed shock and terror associated with Greece, the Euro is essentially unchanged. Likewise, the EAFE stock index slipped only moderately, from 1880.83 to 1856.10 (see footnote). At the same time the S&P went from 2099.60 to 2077.42… approximately a 1% move. Retrospectively, it appears that quite the mountain has been made of this molehill via the media…which is another good reason to ignore everything you see on television (Except those Emergency Alert System notices… Pay attention to those! Particularly when the deadpan little robot voice says “Act now to protect your life”. I take those seriously!)
So, while the markets were relatively stable, what did investors do? According to ICI fund flow information, between March 1 and July 9 investors removed in excess of $65 BILLION from domestic equity funds. Flows were negative every month, with over $19bn flowing out of domestic equities in April alone. Apparently, something spooked domestic investors… but as I look around I honestly can’t tell you what it was. As always, I maintain that major market corrections don’t take place while everyone is running scared… they are more likely to occur when investors believe the sky is the limit.
Indeed, our observations lead us to believe that the domestic economic situation continues to improve, albeit slowly. Economist David Rosenberg likes to call this the “Rodney Dangerfield Recovery”, as it truly gets no respect, and points out that the continuing media narrative of this recovery has been decidedly bearish. He makes the important point, however, that what this recovery has lacked in magnitude, it has made up for in duration, being now in its sixth year. Already, this is the sixth longest economic expansion since the civil war, and has the potential to exceed the length of the recovery in the 90’s, which lasted a full 10 years. I agree with David in thinking that as investors, we likely much prefer a long, slow recovery to a shorter and more volatile one.
As this letter goes to press, it appears there has been progress on the Greek crisis, and the President announced an agreement with Iran. While there will be much ranting and raving on both over the next several weeks, it is likely that both of these issues will be leaving the front page soon. Next up: The Fed’s desire to raise interest rates. Chairwomen Yellen has made no secret that she wants to raise rates, and many pundits expect that process to start in September if not earlier. So what happens to stocks when rates go up? Turning to Rosenberg’s research again… bull markets won’t end. See the table below:
What this shows is that on average, the S&P continues to rise after the first rate hike, with the average peak coming 38 months after the first hike, and the first glimpse of recession following that by a few months. What’s more important to notice is the peak after the last rate hike… where the Fed sufficiently chokes off liquidity to the point of creating an inverted yield curve, which in turn slows down the economy and a recession shortly ensues. The inversion of the curve is a key thing to watch for in determining economic cycles, and in fact often signals an appropriate time to add bonds back to your portfolio with the potential for not only higher coupon rates, but capital appreciation as the curve normalizes over the months to come. Rosenberg comments that there has never been an expansion cycle end on hike one, two or three…but only after the Fed stops raising rates. We haven’t even started raising yet. More importantly, if there is a “panic” reaction to a potential rate increase, (Think of the “Taper Tantrum” a while back), we would view that as an opportunity to add to your equity allocation.
Speaking of rates naturally leads the conversation to bonds. The bond market continues to offer little, if any, opportunity to the individual investor. Part of the problem is that because there are so many institutions that are essentially obligated to buy treasury bonds the market has become price and yield insensitive. Buyers like pension funds, commercial banks, central banks, and, to a lesser extent, insurance companies are structurally required to hold a certain percentage of assets in treasury bonds, regardless of the price. Thus, their buying eliminates investment opportunities for the individual. With the 10 yr. treasury currently yielding about 2.4%, an individual buyer will likely lose purchasing power to inflation by investing. Corporate bonds, CD rates and other traditional fixed income investments are only slightly better, and many investors are taking large credit risks to achieve a small amount of additional return, which can end badly (i.e. return-free risk).
So what’s an investor to do?
I continue to believe that the best possible returns, both for income and capital appreciation exist in the equity markets. Many argue that stocks are expensive, and in absolute terms, I wouldn’t completely disagree. In fact, the chart below makes them look quite expensive:
However, we are operating in a much lower interest rate environment than in any of the historical periods by which we measure valuation – leading to a skewed valuation perspective. Remember, the value of an investment is best determined by the future expectations of cash flow from that investment, and that cash flow is “discounted” by the periodic rate of return (aka the “discount rate” or “required rate of return”) to determine a present value. If we apply the risk-free rate in today’s market to the valuation process, the picture changes dramatically:
Many investors will leap to point out that there is risk in the stock market. I’ll add that there is risk in the bond market too, such as interest rate risk, credit quality risk, inflation risk, etc. The big difference is there is an opportunity for return with stocks…which is something bonds just do not offer in today’s environment, unless you believe we are headed quickly into a deflationary environment, which I find hard to make a case for.
• The media is not helping investment decision making. Watch it for entertainment only!
• Bull markets typically do not end when investors are scared, but when the sky is the limit.
• Economic expansions do not end on geopolitical events, oil events, dollar strength events, or when the Fed starts tightening. They end when the Fed over-tightens and inverts the yield curve.
• When bike racing, Tim doesn’t race against the guy next to him… he races for his team. He points out that he is often passed by someone who is clearly not in the physical condition that he is, but reminds himself that while he may be on mile 75 of a hundred mile leg, the guy next to him might only be on mile 6. Your team is your family, and your financial goals define your race… not what the other market participants are doing.
I hope you find these points thought provoking. Please do not hesitate to call your Cascade advisor to discuss how this impacts your portfolio design.
Take time to get outside in this fabulous summer weather. Ride your bike… and Enjoy Life!