Monthly Archives: September 2019

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Dog Days – Investors are becoming desensitized to news headlines, promises, and threats. They want action as we enter a favorable season for the stock market.
  • Financial Plumbing II – Repo madness from last week has died down temporarily, but below are suggestions on what the Fed can do to prevent a real calamity in the next recession.
  • Behavioral Finance – I encourage you to listen to my colleague’s podcast, where I was a guest the past two weeks discussing the investment implications of Loss Aversion and Overconfidence.

Last Week Today. Germany’s manufacturing Purchasing Managers Index (PMI) fell to its lowest level since the Financial Crisis, and the services PMI declined as well, indicating Germany is on the cusp of a recession. | U.S. Consumer Confidence dropped in September as trade tensions “rattled” consumers. In contrast, Consumer Sentiment (a different survey) rose as consumers anticipate higher incomes, particularly in the middle-income brackets. | U.S. Durable Goods orders in August rose for the third consecutive month. | The third, and final estimate of Q2 GDP was unchanged at 2.0%, and the Atlanta Fed’s GDPNow forecast for Q3 rose to 2.1% (from 1.9% last week). | Political theater in the U.S. and Britain reached new peaks as politicians from each side of impeachment and Brexit, respectively, squared off in session and the media.

Dog Days. Typically reserved for summer, we feel like market-wise this September (and last week in particular) represent the dog days of Fall. Usually, the summer is pretty dull as traders hit pause and head out on vacation, but this year trade tensions and the Federal Reserve cutting interest rates (for the first time in more than ten years) kept things pretty lively. Now we find ourselves entering the Fall, and while trade remains an issue, the impact of trade news (good and bad) and the news de jour (impeaching President Donald Trump) are less impactful. Indeed, it feels like the market is in a “show me state.” In other words, investors are somewhat desensitized from what has become the norm in the tit-for-tat sniping between the U.S. and Chinese trade delegations, and yet a new front for the Democrats and Republican politicians to find a reason to disagree. Investors want results, not promises and threats, and the market’s muted reaction function reflects that thinking.

This past week the market was listless. Domestic equities seemed to want to move higher as overnight futures on the major indices often indicated higher opens, but those paper gains were typically given up as the day wore on. This is partly due to a vacuum of economic and corporate news. The Fed is not scheduled to meet until the end of October, economic data has been light, and the Q3 earnings season is a couple of weeks away.

Seasonally, September marks the transition from Summer to Fall; a point in time when the leaves change color, the weather gets colder (except apparently in Texas this year), and investors begin to look forward to a more promising environment for risk assets. Over the last 30 years, September has, on average, produced slightly negative returns for the S&P 500. The market may give back the monthly gains today, but thus far the S&P 500 is up more than 1% and near record highs. For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

With Q4 2018 fresh in many investors’ minds, and some notably difficult Octobers historically, it’s worth noting that over the last 30 years the fourth quarter is the strongest season (on average) for the stock market with the S&P 500 averaging monthly gains of greater than 1.25% in each of October, November, and December. The heat map below shows monthly performance for the S&P 500 over the last 30 years. Click on the chart for a larger, clearer view.

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Financial Plumbing II. The previous week’s issue with interest rates on overnight bank lending continued to garner headlines, even as the Fed stepped in with funding to alleviate the squeeze. Indeed, towards the end of the week, banks stopped taking down the full capacity of the Fed’s largesse each day, indicating the liquidity squeeze was abating. However, the problem has not been resolved. As JP Morgan CEO Jamie Dimon explained, last week’s disruption was small and nothing of real concern. However, in the next recession, the disruptions will not be small. Dimon went on to say that banks have tremendous liquidity, but they are also under tremendous constraints in how they can use their liquidity.

It’s as if you have $5,000 in your checking account, $50,000 in your savings account, and write a check for $6,000. Easy, you think, I’ll transfer $1,000 to cover the shortfall in my checking account.  Unfortunately, that can’t happen because (in this analogy) the Fed disallows the transfer because they mandate you maintain a $50,000 balance in your savings account. You’re not insolvent, but you are facing a liquidity squeeze because you are unable to access a portion of your assets.  Banks are facing a similar situation.

The Fed needs to solve the problem, and FTN Financial suggests three potential solutions to avoid a funding squeeze in a tougher economic environment:

  • Begin increasing the size of the Fed’s balance sheet. The Fed always knew they would need to grow the balance sheet because the demand for cash in circulation is continually increasing; they just didn’t think they would need to address this so soon.
  • Cut the Fed Funds rate. Because of the inverted yield curve, currently, interest earned on bank reserves is higher than what banks can earn by investing in U.S. Treasuries. Banks are thus incentivized to earn riskless interest on reserves, vs. purchasing more liquid U.S. Treasuries and taking on interest rate risk. If the interest paid on reserves was lower, the situation would be reversed.
  • Reduce capital and liquidity restraints on banks to free-up more of their reserves. This would require an act of Congress, and our Senators and Representatives are focused on the impeachment currently.

The issue is a minor consideration for now, but it needs to be addressed before the next recession to avoid a technical glitch from becoming a financial crisis.

Behavioral Finance. Rather than detail another behavioral finance bias this week in our ongoing series, please listen to my colleague’s podcast on www.CreatingRicherLives.com. Karl Eggerss has had me on as a guest the last two weeks to discuss the investment implications of two important biases: Loss Aversion and Overconfidence.

Be well,

Justin

Karl Eggerss was on CBS this morning with Sharon Ko discussing the recent intervention in the banking system by the Federal Reserve.  Is it a sign of bigger things and problems to come?

Karl Eggerss:                      … Bottom line is these banks had a shortage of cash and you go, “Oh my gosh, what is going on with the banks?” Keep in mind, after the financial crisis, which was a lot of banks had issues in the financial crisis, to try to prevent that from happening in the future, they require banks have a lot of regulations. So they require them to keep more money in the banks now than they ever have, so they’re very heavily regulated. So the banks literally have to keep so much sitting around.

Karl Eggerss:                      So I’ll give you an example. Let’s say somebody has a check that they need to write for $2,000 and they only have a thousand in their checking account. They don’t have enough money to write that check, but they have 55,000 in their savings account. All they have to do is move the money over. That’s kind of what was happening. But the caveat is the regulations state that the bank may have to keep 50,000 at all times. So if I told you you have to keep 50,000 in your savings account, no matter what, you can’t use it. You have the money, you just can’t use it. That’s really what happened, so the banks had the money but they weren’t able to use it. So the fed comes in and saves the day, injects money into the banking system to make sure that money is still flowing properly where it needs to go.

Karl Eggerss:                      And there are several reasons why people were thinking, “Why is this happening now? Why are the banks short cash all of a sudden? Why did this come to a head recently?” And it’s primarily because of a few things that may have come together, and a lot of this was speculation, but some ideas that are floating around is that corporations have taxes to pay coming up, so they were withdrawing money out of the banks to go pay their taxes. Number two is a lot of people are refinancing right now. A lot of our viewers are probably buying a home or refinancing because interest rates are so low, so banks are lending the money out to go purchase a home or refinance. So the banks were short cash. And where do they have to do that? They go to the federal reserve and get the cash to replenish themselves.

Karl Eggerss:                      So a few other issues. Oil prices have been volatile. So there was several different things that may have led to a sudden shortage of cash for banks. But most people watching maybe thinking, “Oh my gosh, we haven’t seen stuff like this happen since the financial crisis. Are we going to have that again?” And my answer is probably not. This is more of a technical glitch and a shortage of money from one place to there. It’s like I had money in this pocket but I didn’t have enough in the other and I had to move it quickly.

Karl Eggerss:                      So having said all of that, I don’t think that this will be something that reverberates into the economy and causes something major. In fact, we didn’t see the stock market move very much. We didn’t see the bond market move very much. We didn’t see a lot of things move that normally would if this was a serious issue.

Sharon Ko:                         Do you think it puts into question just banks in general and how much money they have?

Karl Eggerss:                      I think for the viewers they’re probably wondering, is my bank safe? Because that was a big question in 2007 and eight, is my bank safe? And I think the banks are safer now than they were, but usually with regulation is it sometimes goes too far. We’re going to make them really safe and make sure that the banks have all these regulations so this doesn’t happen again, unfortunately this is the repercussions which is it’s too strict and the banks are trying to lend out, because that’s what they do, and they don’t have enough money sitting around to lend. And so that’s why there was this disruption, if you will.

Karl Eggerss:                      And probably what’s going to happen, and we’ve already seen this, is that the federal reserve is going to continue to put money into the banking system all the way through October just to make sure. So they’re kind of the shock absorber to the banking system right now.

Sharon Ko:                         As always, thank you to Karl Eggerss. We appreciate your time. If you’d like to get more information on Covenant, contact them through that number or website you see there on your screen.

On this week’s show, Karl discusses how overconfidence in trading can hurt results and impact financial plans.  Plus, the week that wasn’t.

Karl Eggerss:                      Hey, good morning everybody. Welcome to the podcast. It’s Creating Richer Lives. Thanks for joining me as always. Our telephone number, (210) 526-0057. Our website, creatingricherlives.com. And don’t forget, this podcast is brought to you by Covenant Lifestyle, Legacy, Philanthropy. And at Covenant, our goal is to unburden clients from the daily cares of financial management. Again, creatingricherlives.com. If you’re not getting our information, our podcast, any of those things, if you’re listening and this is your first time and you stumbled upon it, all you have to do is go to our website and you can sign up to get that information. And we just launched, last week was the first week we did it. We just launched Covenant You.

Karl Eggerss:                      We’re calling it Covenant You, because we’re really trying to give you the latest information and educate you to help you with your finances. So therefore, what we’ve done is each and every week, Monday afternoons, you will receive an email from us with anything we’ve posted on our site, anything we want to communicate to you, and it’s in one email. You can choose how you want to watch it, listen to it, read it, totally up to you. We know some people like to read things, some people like to watch things, and we are putting a lot of information out there to help you, and we have it in one distribution now for you. So if you want to sign up for Covenant You just go to creatingricherlives.com and you can do that.

Karl Eggerss:                      All right, in just a little bit, we will be having a guest in the studio. We had Justin Pawl Covenant’s chief investment officer in here last week. I’ve invited him back to cover another investment bias or mistake that he sees people making when it comes to their investments. So we’re going to go over that in just a minute, but before we do, let’s go over the markets here. We had, really, a boring week, so we’re not going to spend a lot of time talking about the markets this week, because it was kind of quiet. I mean, the biggest news obviously was this impeachment stuff going on, which didn’t relate to the market, and it shouldn’t have, and it didn’t. So what we have right now is the market was, on balance, down a little bit, but a pretty boring week.

Karl Eggerss:                      We’re in that part of the year where stocks seasonality will tend to kind of meander, and we’re certainly doing that. We’re not very far off of all time highs of course, but it’s almost as if we can’t bust through the new highs. What are we waiting for? Is it the next earning cycle? Is it a trade deal? We don’t know, but we do know we’re not off the highs very much, and we don’t want to force the action. When there’s nothing to do, don’t do it. This is how people make mistakes. Be patient and wait, and that’s what we’re doing. We’re in a situation where we obviously have a Fed that differs on interest rate policy. Some believe rate should be risen, some believe there should be more cuts, some believe they should do nothing.

Karl Eggerss:                      We have a very bifurcated Federal Reserve Open Market Committee, and we’re still waiting on a trade deal. I mentioned this the last couple of weeks, there seems to be less movement in the markets when there’s positive news, it’s kind of wearing off. Used to be, “Hey, there are talks scheduled for a month from now, and the market would jump up two, three hundred points. Now, we see talks are scheduled to resume October 10th or whatever the date, and we don’t see a big jump in the markets like we used to, and it’s because people are in a show me state, right? We’ve seen this before, we’ve heard this before. It’s as if you’re watching a ping pong match and you’re like, “Oh, she’s going to win. No, no, he’s going to win. No, she’s definitely going to win.” This back and forth when there’s nothing really happening.

Karl Eggerss:                      We’re having a little bit of progress I guess, but it’s not big enough to get anybody to really get excited about, “I need to buy stocks, because a trade deal is going to get done.” We’re not seeing that. So that is something that we’ll see as the weeks progress here if there’s real progress made and how the markets react to that. But we’re kind of in the doldrums of what was summer now turning into fall, but there’s nothing to do. It’s a pretty boring week overall. Usually there’s a lot of activity, and we did have some positive economic news, but nothing to write home about. So again, be patient and let’s realize that we have news coming to us every two minutes.

Karl Eggerss:                      If you have the new iPhone 11 Pro Max, which sounds like a medical drug, but if you have the Pro Max, you obviously get things dinging and chiming and buzzing and vibrating every two minutes, because there’s news coming your way, and that news makes you want to do something, but there’s really nothing to do. And so in this day and age, it’s really easy to get that information and say, “I’ve got to act on that. There’s a potential impeachment. There’s this, there’s that.” And what really affects the stock market over the longterm? It’s profits of companies. What affects bonds? Interest rates, right? There’s inflation, there’s growth.

Karl Eggerss:                      That’s what’s going to drive the stock market over the longterm. It’s not these little news bites, it’s not tweets. That will call some vibration, but it’s not going to move the needle over the longterm. So just stay focused. There’s not a lot to do right now. We always encourage looking over a portfolio, making sure you own the things that make the most sense, regardless of maybe where you bought them. Don’t make that mistake of, “Well, I have to get up to a certain level just to get even.” That’s not a good path to go on. You need to look at each investment. Is it still a good deal of where you would own it today? And that’s why we’re spending some time talking to Justin Pawl last week and coming up here in a few minutes about some of the mistakes he sees people making, because we’re trying to help you look at it from a different angle so that you don’t make those mistakes.

Karl Eggerss:                      As mentioned at the top of the show, we do have a guest today. His name is Justin Pawl. He is the chief investment officer at Covenant. Justin, you came in last week to discuss this whole, really, it’s a series we’re trying to do on some of the mistakes people make that are really up in their head, right? They’re psychological, mental mistakes, behavioral finance, behavioral economics, it’s got a lot of different terms. Last week, I wanted you to cover a couple of them. It turned out we covered one because it’s such a fascinating topic, each one of them and why these things happen. So last week, we talked about loss aversion, and you had the example of a coin toss and ran through some of the statistical evidence of what people choose versus maybe what they should be choosing.

Karl Eggerss:                      What is another mistake that you see investors make when it comes to looking at their investments or acting on their investments?

Justin Pawl:                       Yeah, this one’s actually-

Karl Eggerss:                      By the way, welcome back.

Justin Pawl:                       Yeah. By the way, I forgot to thank you for having me back again, Karl. It’s a pleasure, again, to be here. So this morning I thought we’d talk about overconfidence. Overconfidence is something that is prevalent throughout human beings. We’re all confident in certain skills and certain decisions that we make, and that’s fine, but it’s when that confidence turns into overconfidence that investment decisions or investment errors occur. So if you think about it from a group setting, I’m sure you’ve been in these situations where you’ll be in a large auditorium and the person who’s speaking will say, “Raise your hand if you think you’re better than the average driver?” Well, how many people raise their hand? Nearly everybody raises their hand, right?

Karl Eggerss:                      Right.

Justin Pawl:                       Well, statistically you know 50% of those people can only be better than the other drivers in the room. So that’s an idea that people have this inflated view of their decision making capabilities, of their skillsets, and it’s this overconfidence that causes problems to occur in all facets of decision making, but specifically when it comes to investments. Now, taking a step back, I mean, confidence is important. Confidence is what allowed societies to develop. If people way back when weren’t confident in the future, they wouldn’t have stored food for future consumption, they would’ve consumed it all right then, right?

Karl Eggerss:                      Yeah.

Justin Pawl:                       So confidence is an important facet of being a human being, but it’s that thin red line where you cross from confidence into overconfidence that the problems start.

Karl Eggerss:                      It’s interesting, when it comes to investments though, it seems like, at least some people that I’ve met, they don’t know they’re being overconfident. Does that make sense?

Justin Pawl:                       It does.

Karl Eggerss:                      In other words, let’s just say somebody comes in and they have 75% of their net worth in one stock, a lot of those people literally don’t know the risks they’re taking, so I wouldn’t necessarily categorize that as overconfidence. And maybe that’s another behavioral issue we’ll talk about another time. But you understand what I’m saying? That’s not overconfidence, that’s just a lack of really understanding the risks they’re taking.

Justin Pawl:                       Well, I think it actually does have roots in overconfidence, Karl. And the reason is that they, for whatever reason, believe that they have better information than the market does about that particular stock, and they therefore believe that that stock price is not currently reflect the intrinsic value of that stock, so that over time they expect to make a lot of money off that particular position.

Karl Eggerss:                      And when do we see that particular situation? It’s either, “I work at the company, so therefore I see that we’re doing really well,” which they don’t. They don’t really know what higher up management may be about to do or not do, or it’s an inheritance, “I just can’t let the stock go because my grandfather told me never to sell it.” Usually when you see that concentrated position. But again, I don’t want to get off track from overconfidence. So give me some other examples. I mean, obviously, again, a concentrated position is overconfidence.

Justin Pawl:                       Well, let’s talk about a real life example. You’ve probably heard of Peter Lynch, he was the famous portfolio manager for Fidelity’s Magellan Fund, and he did that from 1977 through 1990. And over that timeframe, his fund, the Magellan Fund, appreciated by an average of 29% per year, remarkable returns. Now, the underlying stock market did well also. It appreciated by about 20% per year or 19%, so he basically outperformed on an annualized pace of 10% for an extended period of time. But if Fidelity-

Karl Eggerss:                      Which puts you in the Hall of Fame.

Justin Pawl:                       Absolutely.

Karl Eggerss:                      Mike drop, he’s a Hall of Famer.

Justin Pawl:                       He’s done. I mean, absolutely-

Karl Eggerss:                      He literally was done, because I haven’t heard from him since.

Justin Pawl:                       No. I mean, he retired at the peak of his game, and all the accolades, he deserves. He did really, really well.

Karl Eggerss:                      Yeah, absolutely.

Justin Pawl:                       Unfortunately, the average investor in that fund only earned about 7% over that timeframe.

Karl Eggerss:                      So that would tell you that they did not stay in it the whole time.

Justin Pawl:                       That’s exactly right. The average investor only earned 7%, because they would sell at the bottom after the stock had gone down, or they would buy at the top after the stock had appreciated. So there’s a lot of behavioral-

Karl Eggerss:                      The mutual fund in this case.

Justin Pawl:                       The mutual fund, yeah, I’m sorry.

Karl Eggerss:                      That’s okay.

Justin Pawl:                       The mutual fund in this case. And so there’s a lot of behavioral finance errors that were made in that process, but from an overconfidence standpoint, people became overly confident in their ability to predict which way the mutual fund was going to continue to go. And so when it would start to go down, they would think, “Hey, this thing’s going to keep going down, and so I’m going to sell out here and preserve the gains that I have.” Likewise, after it ran up for awhile, they would then jump on board and buy the fund, and think that it was going to continue to move ahead.

Karl Eggerss:                      Well, and that’s really what happened in 2008. When you start to see your portfolio drop because you have a lot of stocks, and it’s dropping and dropping like it did in ’08, the natural inclination is to look at that and extrapolate and say, “It’s going to zero.” And it did feel that way. It feels like it’s going … I mean, every day, the market’s done another 1%, 2%. And so people make dramatic moves as opposed to saying, “wait a second, I’m getting a discount. I’m getting this thing 20 or 30% cheaper.” This is the only industry I know that people want to pay a premium for something willingly, knowing they’re paying a premium, because everybody else is paying a premium versus, “Hey, something’s on sale, go buy it.”

Karl Eggerss:                      It’s the only industry I know that that happens in. It doesn’t happen at the malls.

Justin Pawl:                       That’s a great observation.

Karl Eggerss:                      Can I even say malls nowadays? Are malls a things still?

Justin Pawl:                       Maybe for some of the teenagers out there. There’s not a lot left though.

Karl Eggerss:                      Well the teenagers certainly don’t know what a mall is, they don’t call it a mall.

Justin Pawl:                       Fair enough.

Karl Eggerss:                      I don’t know what to call it nowadays, Justin and I are roughly the same age. But it is like that. You’re not watching a particular watch for example, and you’re watching the price of it and it’s $100, all of a sudden it goes to 60, you don’t go, “I don’t want that anymore. In fact, I need to get rid of all my watches.” No, you say, “This is an awesome deal, I want to go buy it. Stock market, not so much. And ’08 was an example of that. So I think there’s this kind of extrapolating, looking at the lines, and that’s what was happening with Magellan.

Justin Pawl:                       That’s right Karl. So when you think about overconfidence and what it translates into in an investment standpoint, people have a mistaken belief in their own ability to outsmart the market, to outguess the direction of the market. That leads to excessive trading. It leads to underestimating the downside risks in their portfolio, and it leads, as we talked at the outset here, to overly concentrated portfolio positions.

Karl Eggerss:                      Yeah. And I talk about that a lot on this podcast. I think what’s underrated is really portfolio construction, “Oh, why do I own this particular position and how much I own?” You need to be looking at how much that is relative to what else is in the portfolio, because how do they interact with each other?

Justin Pawl:                       That’s right. If you think of portfolio construction the way a conductor manages a symphony, you have your woodwinds, you have your horns, you have your percussion instruments. The conductor isn’t going to compose a complete song or a melody out of just percussion instruments or just the horn section. He’s going to expertly blend those together to create harmonious sound. The same idea translates into portfolio construction, where you’re trying not to overweight any individual risk in the portfolio, but rather to blend those risks to deliver the returns that someone’s looking for.

Karl Eggerss:                      So is overconfidence just about a lack of diversification?

Justin Pawl:                       No, not always. It can certainly lead to overtrading, because you’re constantly thinking that you have better information than the market, yesterday, the market went down a little bit, so today you think it’s going to go down more, so it leads you to sell your positions in your portfolio or some portion of it, and then oh, the market goes back the other way and you say, “Oh, wait, I was wrong, but now the market’s going up. I better not miss out on this, so I’m going to go ahead and I’m going to load up on stocks again.”

Karl Eggerss:                      Yeah. And really, I mean again, we’re not advocating for the rotisserie chicken machine, the set it and forget it.

Justin Pawl:                       No.

Karl Eggerss:                      We’re not advocating that, what we’re advocating for is making strategic allocation changes over time based on certain parameters. You and I have been talking off mic, the last few weeks I’ve been talking on mic about this whole growth versus value for example. That doesn’t mean you completely abandon every growth stock you own, because it could keep going that way for a while. All it means is you shift maybe and take advantage of the fact that value stocks are cheaper and have underperformed, then you weight a little more towards that within your equity allocation. But oftentimes, when people hear stuff like that, like growths underperformed or values underperformed, they take big, big moves. It could be well, growths outperform and I’m going to continue to do that. Some people may hear, “Oh, are you saying to sell all my growth stocks and go buy value?” And that’s absolutely not the case. We’re talking about strategic moves within a diversified portfolio.

Justin Pawl:                       Yeah. I think a good way to think about it is a tilt in a portfolio rather than wholesale shifts in a portfolio. To think about changing your portfolio in an evolutionary fashion as opposed to a revolutionary fashion, so that you’re not whipsawed, because yes, for a handful of days, value outperformed growth after 10 years of under-performance by value. Now, in recent days, we’ve seen that kind of flip around again already where growth outperformed value again. So trying to catch each whipsaw or each wiggle in the marketplace, that’s a losing proposition that leads to overtrading, leads to second guessing yourself and then making decisions that compound prior poor decisions.

Karl Eggerss:                      Yeah. So to kind of put a bow on it, how do people overcome this overconfidence? I mean, first you need to recognize it, right? So what’s the first thing to do to make sure that you’re not somebody listening saying, “Oh wait, that’s me.”?

Justin Pawl:                       Yeah. I think part of it begins with taking a humble pill. You need to-

Karl Eggerss:                      Where do they sell those? Out on CVS?

Justin Pawl:                       You need to have a humility about you that you’re not always going to be right in the marketplace, and that in spite of your strong convictions that aren’t based on true fundamentals, and even if they are based on fundamentals, I should say that the market sometimes takes it out of your hands. There are stocks that can look tremendously undervalued and just get cheaper and cheaper and cheaper. You need to recognize that sometimes you have to acquiesce to the views of the marketplace and cut those losers before you hold on and it goes to zero essentially, or you take on catastrophic losses of some percentage point.

Karl Eggerss:                      Yeah. And there are stocks that go up and you can’t really explain it, and then maybe five years down the road you look back and say, “Oh, now I see what it was.” Maybe somebody else saw that at the time, they just caught it before you did. Be transparent about that and understand. And I think, doesn’t it go back to really creating that financial plan and trying to figure out, what are you trying to do first?

Justin Pawl:                       It does.

Karl Eggerss:                      And then building a diversified portfolio. And again, some of this stuff sounds cliche, but there’s no way around it, there just isn’t. Now, are there people that have made a lot of money by being overconfident? Yeah. There’s people that have most of their net worth in their own personal business that they are confident in, maybe even overconfident, and they have made millions of dollars. That does happen. For most of the people listening, overconfidence can be a killer at times.

Justin Pawl:                       Absolutely. On your point about financial plans, if you’re on the golf course, the saying is, if you don’t have a target, you’ll hit it, right?

Karl Eggerss:                      Yeah.

Justin Pawl:                       So if you don’t have a financial plan, you don’t know what you’re aiming for. You’re basically just striking out in different directions that aren’t necessarily going to serve your longterm interests. And so that’s why the financial plan combined with sound investment management are such a powerful combination.

Karl Eggerss:                      Yeah, absolutely. In fact, when I sit down with folks most of the time, and I’m looking at a portfolio they may already have, it’s interesting because as I question, not to be hostile, but when I question like, “How did this portfolio come to be?” There’s usually not a real good answer, it’s like, “Well, I watched a bald guy on TV that throws stuffed animals at the screen and he said this was good.” And, “I listened to a guy on the radio that said to cut out my credit card, so I did that.” It’s kind of in piecemeal as opposed to being intentional about it and thoughtful about it and saying, “Okay, let me work backwards. Let me figure out, what am I trying to do?”

Karl Eggerss:                      Work backwards to say, “Okay, I know I need to own this much in the stock market for the longterm. Okay, what type of stocks? ETFs, mutual funds, individual stocks?” And then you’re building a portfolio. But to have 17% of your portfolio in one stock just because you got it from an uncle, that’s not your plan. That has nothing to do with your plan.

Justin Pawl:                       I think that’s called hope. Hope it goes up.

Karl Eggerss:                      It is hope. Yeah, it does. Justin, appreciate it. We’re going to have you back soon to talk about more of these, because these are probably, to me, the most important thing is how we think about our money and how intentional we are about it, because again, if you’re going to create a richer life for yourself, it starts by avoiding some of these biases and behavioral problems that a lot of people are doing every day.

Justin Pawl:                       That’s right. So basically, through this process of sharing this information about these biases, we’re trying to create a community of better decision makers. Obviously, in our lives it’s around financial decisions, but being a better decision maker is important throughout the other aspects of your life as well. And so hopefully by bringing this information to our listeners, to the readers of our weekly blog, we’ll make that community of better decision makers together.

Karl Eggerss:                      Sure. Now, before you get out of here, I keep seeing biases, you’re saying biases, which ones right? Should we put it out for people to vote on? We want some feedback. Which ones right? Justin sounds more academic, mine sounds maybe more Texan, I don’t know.

Justin Pawl:                       I think it’s a good combination.

Karl Eggerss:                      All right, Justin Pawl, he is the chief investment officer at Covenant. Thanks for coming in, and come back soon.

Justin Pawl:                       Absolutely.

Karl Eggerss:                      All right, that’ll wrap up today’s podcast. Just a reminder, go to creatingricherlives.com. And if you’re getting our Covenant You distribution on Monday afternoons, feel free to share it with anybody you would like, and we appreciate you listening. And if you need our help to ten five (210) 526-0057. And again, this podcast brought to you by Covenant Lifestyle, Legacy, Philanthropy. Hey, have a good weekend everybody and we’ll see you back here next week on Creating Richer Lives.

Speaker 1:                          Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy or product, including the investments and/or investment strategies recommended or undertaken by Covenant Multi-Family Offices, LLC, Covenant, or any non-investment related content will be profitable. Equal, any corresponding indicated historical performance levels be suitable for your portfolio or individual situation or prove successful.  Moreover, you should not assume that any discussion or information serves as the receipt of, or as a substitute for personalized investment advice from Covenant. To the extent that a listener has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with a professional advisor of his/her choosing. Covenant is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of our current written disclosure brochure discussing our advisory services and fees is available upon request or at creatingricherlives.com.

On this morning’s Trey Ware Show, Karl explained why the Federal Reserve was needed to help the banking system last week. The pipes were clogged and the plumber was called. Karl breaks down the bounce in REPO rates.

Trey Ware:                         Creatingricherlives.com. Here is my friend Karl Eggerss. Let’s talk about the markets this week. And I was reading a Future’s report this morning that says, “Market expected to open up higher this morning.” Is that right Karl? What do you think?

Karl Eggerss:                      Yeah, it’s bouncing around pretty flat. But really the big news last week was the good old federal reserve. We had all the, we’ll call them, air quotes, “Issues,” in 2008, with all the banks. And so, now what they’ve done is they’ve regulated them so much that it’s causing some issue that we saw last week where certain banks can’t get enough cash to do their daily operations because they’re forced to hold so much in cash. In other words, the regulators are saying, “You guys don’t know what you’re doing and we don’t want another financial crisis,” which we don’t, but they’re over-regulated now. And so, what’s happening is these banks are required to hold a ton of cash sitting around.

Trey Ware:                         Right.

Karl Eggerss:                      And because of that, there was some issues last week. And so, the rate that banks charge each other to borrow and so forth spiked way, way up and the fed had to jump in and inject a bunch of money. We’re talking billions and billions of dollars to make sure that the plumbing, so to speak, was flowing properly. Now, it was a big headline, “Hey, is this another financial crisis coming or the market, something’s wrong.” It was really a function of too much regulation. A lot of companies had to make tax payments, and there were some other issues going on. So there was a shortage of cash, literally.

Karl Eggerss:                      So the fed jumped in, injected all this money. So it’s really more of an issue of being like, “Hey, Trey Ware has $1,000 in his checking account and he needs to write a $2,000 check. Now over in a savings account, he’s got plenty of money, he wrote a hot check. He just needs time to move that money back from the savings account to the checking. So that’s mainly what happened last week. But it got a lot of headlines and it got a lot of people a little scared to go, “Hey, what’s going on? Why is the fed getting involved like they did in ’08, to that extent?” And that’s really what it was, was more of a short-term shortage of cash, which was pretty interesting and catches your attention. But it was more a function of just where the cash was at the moment and then a lot of regulation.

Trey Ware:                         Very good. Thank you, Karl. Karl Eggerss is with us every Monday at this time to talk about the market and your money right here.

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Financial Plumbing – What happened with short-term interest rates last week?
  • Better News Ahead? – Easier financial conditions globally, may lead to improved economic activity.
  • Behavioral Finance – Confirmation Bias, people like to believe what they believe.

Last Week Today. The Fed cut interest rates by 0.25% as expected. At the follow-up press conference, Fed Chair Powell did an excellent job of remaining vague about the direction of future monetary policy repeatedly stating the Fed will be data-dependent. Powell’s lack of specificity was a refreshing change from comments his previous comments like “We’re a long way from neutral” (last October) and “Low inflation is transitory” (May). Those comments suggested a preordained and hawkish path for interest rates, roiling markets. | The Bank of Japan elected to hold overnight interest rates unchanged at -0.1% and to continue its asset purchase program of 80 Trillion yen annually – yes, the BOJ is still engaged in Quantitative Easing. | The Organization for Economic Development revised its 2019 global growth estimate down from 3.7% to 2.9% (the lowest in 10 years).

It was a reasonably quiet week for equities despite news of the drone attack on Saudia Arabia’s largest refinery and the Federal Reserve cutting interest rates. Domestic equities declined by about -0.5% with Growth stocks slightly outperforming Value stocks, and small-capitalization stocks underperforming large-caps as the Russell 2000 fell -1.1%. Equities were cruising toward modest gains on the week when trade tensions once again intervened mid-day Friday as China announced its team was canceling plans to visit with farmers in Montana. The only bright spots for equities were Europe and Japan, which each posted weekly gains of +0.3%). Interest rates declined following the Fed’s announcement to cut rates, as investors were hoping for a more dovish message from the Fed. After wild price swings early in the week, crude oil settled into a +5.9% gain for the week, closing at $58.09 per barrel. For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

Financial Plumbing. A clog in the plumbing of the financial market led to a sharp increase in ultra-short-term interest rates early last week. Interest rates on overnight loans called repurchase agreements or “repos,” and money markets spiked making for scary headlines. Sharply rising rates in an obscure but vital part of the financial market’s plumbing system brought back bad memories from the Financial Crisis when the credit markets froze. Yet, last week’s event was mostly technical in nature and not reminiscent of the counterparty risk that prevailed during the Financial Crisis nor an indication that banks are insolvent. The cash squeeze came about due to a confluence of events:

  • Unintended consequences of post-Financial Crisis bank regulations and Quantitative Easing: 1)Since the Financial Crisis, new regulations require banks to hold more cash reserves, which reduces their ability to meet short-term spikes in demand for cash. In essence, the Fed became the responsible party for meeting liquidity demands in the banking system, but they responded too slowly on Tuesday. Ultimately, the Fed showed up with a $75 billion plunger (in the form of repurchase agreements) to clear the liquidity clog, but even that was delayed by 25 minutes due to technical difficulties. 2) As the Fed shrinks its balance sheet (i.e., Quantitative Tightening), it reduces liquidity in the financial system by not reinvesting proceeds from its maturing bonds. Operating in uncharted territory, the Fed has openly discussed the question of the appropriate size for its balance sheet to maintain a smoothly functioning financial system. It appears the Fed found its answer.
  • Treasury Auction. The U.S. Treasury recently sold a large block of bonds, and the transaction settled on Monday.  The cash required to settle the trades on Monday, further reduced the amount of cash banks had on hand.
  • Tax Day. U.S. corporations made an estimated $100 billion in tax payments on Monday, drawing cash from money market funds held at banks to pay the IRS. To meet short-term funding requirements, banks pledge U.S. Treasuries held at the Federal Reserve as collateral for overnight loans and pay interest for doing so. This so-called “repo rate” is typically in line with the Federal Funds Rate, but because of the high demand for cash, the interest rate jumped as high as 10% for some borrowers (more than 4x the Fed Funds rate).

While the Fed stepped in to provide funding and calm the markets, it wasn’t until Friday the Fed announced an interim solution. Technically, they will provide three separate 2-week term repo facilities of at least $30 billion and $75 billion in daily liquidity through October 10th. You can think of it as a “short-term liquidity injection,” while the Fed contemplates a longer-term solution. As the chart of overnight repo rates shows, though late to the game, the Fed’s actions calmed markets.

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Better News Ahead? The outlook for global growth remains tenuous, and global economic news flow is as negative as it’s been since the Financial Crisis, a topic we covered last week. However, governments and central bankers are responding to the weak economic conditions with various monetary and fiscal measures. As a result, Global Financial Conditions are once again “easy” as measured by market-based indicators such as interest rate levels and credit spreads.

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If past is prologue, easy financial conditions should catalyze economic activity in the coming quarters. Trade tensions and geopolitical events can counteract some of the effects of easier financial conditions, but this is one reason to believe we can avoid a global recession. Perhaps the economic surprise indices, which compare actual data to expectations, are an early indicator of increasing economic activity:

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How the Mind Works Against Successful Investing – Confirmation Bias

(Entry #8 in a series on Behavioral Finance)

Psychologically, people are hard-wired to want to be correct in our beliefs, our decisions, and our perspectives. Indeed, the human mind has evolved with a natural ability to convince ourselves of whatever it is we want to believe. In other words, people see what they want to see.

The simplest way to achieve this objective is to emphasize data and events that support our thinking and ignore or reject that which is contrary. Researchers call this behavior confirmation bias, and it relates to the concept of cognitive dissonance we discussed in the last entry. Confirmation bias arises because of the psychological stress (i.e., dissonance) people encounter when a decision or belief is challenged by conflicting information. For example, who hasn’t acted like the guy in the comic below at some point?

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For investors, confirmation bias can reduce one’s wealth through poor investment decisions. Because the natural tendency is for humans is to seek out information that confirms their existing opinions and ignore any information that refutes them, investors are vulnerable to reducing the value of their research and, as a result, the accuracy of buy and sell decisions. At a broader level, this phenomenon explains why perma-bulls and perma-bears hold onto their belief that the market will rise or fall, respectively, regardless of the facts and circumstances. Each side is guilty of ignoring relevant data resulting in an irrational market view. On the bright side, irrational human behavior leads to mispriced securities and a market that is not perfectly efficient, providing opportunities for skilled investors.

When investors fail to address confirmation bias, it can lead to sub-optimal situations, such as:

  • Failing to diversify portfolio risk. For example, a mutual fund or stock that performs exceptionally well over a several year timeframe can create an unbalanced portfolio. Even when presented with information that the prospects for that holding are waning, naïve investors ignore the negative data and look for other data supporting their view that the position will continue to perform.
  • Employees over-concentrating in their company’s stock. The energy and enthusiasm about the company, often reinforced by other employees at work, can cause investors to ignore negative news about the company’s prospects. It’s much easier to believe what you hear around the watercooler than to accept an outsider’s perspective, no matter how well researched, especially when it paints an adverse scenario about the source of your livelihood.

The good news is remedies for confirmation bias are well known. The bad news is that the corrective actions are not easy to implement and require critical thinking. Furthermore, they involve subjecting yourself to the mental stress of seeking out opinions and data that disagree with your view and impartially analyzing the information.

One method for combating confirmation bias is for investors to ask questions that would disprove their thesis rather than confirm it. For example, an investor interested in buying a stock because it has a cheap valuation (e.g., a low price-to-earnings ratio), shouldn’t ask his advisor about the valuation of the company. Instead, he should ask for information about the company’s operations, the potential for new product launches, and competitive threats. Answers to these questions are unlikely to directly affirm your existing belief that the stock is “cheap” and provide a broader perspective on the stock’s potential.

Another effective countermeasure is to surround yourself with people of different backgrounds and diverse opinions. Listen openly to dissenting views to determine if you’ve missed something in your research, the revelation of which may allow you to avoid making a poor investment decision.

Again, intentionally subjecting yourself to psychological stress is something that most people avoid because it’s uncomfortable. Yet, operating outside of one’s comfort zone is how people grow intellectually and make better decisions.

Be well,

Justin

Karl Eggerss was on CBS this morning discussing the SECURE Act and how that bill will require more planning for individuals.

Transcription:

Sharon Ko:                         A bill sitting in the Senate could soon become the most significant retirement reform in more than a decade. The Setting Every Community Up for Retirement Enhancement act has several benefits. Here’s the top three.

Sharon Ko:                         So the first benefit is going to help part time workers.

Karl Eggerss:                      Yeah. In this country everybody’s living longer, not everybody, but most people on average are living longer. That puts a bigger strain on their savings and therefore a lot of folks are working part time, so they’re kind of phasing into retirement. They’re going from full time to part time and then they’re going into full time retirement. If they’re working part time, a lot of employers can exclude them from their 401k plan. Under the SECURE Act, that would not be the case. So that’s going to be a benefit for those part time workers that could actually participate in a 401K plan at their company.

Sharon Ko:                         Second benefit, IRAs.

Karl Eggerss:                      Yeah, IRAs. Right now, if you have an individual retirement account, which is an IRA. At 70 and a half, you have to start taking out a portion of your balance per year based on your life expectancy, which are some national tables. When you do that, of course you pay taxes to the IRS because the IRS has never been given their tax money. You’ve never paid taxes on that money.

Karl Eggerss:                      Currently, the rules at age 70 and a half, that has been the case for a number of years. The SECURE Act would push it to age 72, so it allows you another year and a half for that money to grow. So that’s a good thing.

Sharon Ko:                         And the third benefit is the inherited IRAs.

Karl Eggerss:                      Yeah. So if you have a, a classic example would be a parent that leaves you their IRA. Under the current rules, you can take it out over your lifetime. You have to take it out over your lifetime. Again, life expectancy, actuarial tables, and when you take it out, you have to take out a portion of it each year based on your life expectancy.

Karl Eggerss:                      Under the SECURE Act, this would be shrunk down to 10 years. So you would have to take all of it out over a 10 year period. That’s one of the negatives, but that’s a way that the SECURE Act is getting funded. That’s how it’s getting paid for because remember, if you take it out over a 10 year period as opposed to your lifetime, the IRS gets more tax money quicker.

Sharon Ko:                         Really overall, the SECURE Act, do you think it’s just to fix the flawed retirement system?

Karl Eggerss:                      We have a problem in this country, not enough people have adequate savings to support their lifestyle. Again, people are living longer. We’re healthier generally speaking, technologies allowing people to live longer and we have a shortage of savings. So they’re trying to attempt to help people with their savings. However, the Senate, some people in the Senate, and the reason it’s kind of stuck there right now is that they believe that there’s too many negatives to this SECURE Act. So it passed in the house, now it’s waiting for the Senate. So we could see some modifications ultimately until this gets done. But it passed the house pretty overwhelming. I think only three were against it, but the Senate has some big issues with it because they feel like, yes, it’s helping some folks out, but it’s hurting some others and trying to help everybody and that’s hard to do.

Sharon Ko:                         Really a bright side of it, bipartisan support with this.

Karl Eggerss:                      Yeah, there is support for doing something and so ultimately something will get done. But usually with these, they go in one place and they get talked about and debated, they get modified, something gets tossed out, something gets added, there’s some negotiation, there’s a lot of lobbying, et cetera. And then ultimately you get something that generally speaking, not everybody’s happy with, but if they can help folks save for retirement more, that’s a good thing.

Sharon Ko:                         Thank you Karl Eggerss for helping us get money smart. The SECURE Act is expected to be signed into law by the end of this year. It would take effect 2020.

 

 

On this week’s show, Karl welcomes guest Justin Pawl, CFA to the studio to discuss a topic most would rather avoid, losses. Nobody likes to lose money, but it’s part of investing. Justin explains the best way to handle it.

Karl Eggerss:                      Hey. Good morning, everybody. Welcome to Creating Richer Lives. My name is Karl Eggerss. Just a reminder, you can give us a call at (210) 526-0057, and our website is creatingricherlives.com.

Karl Eggerss:                      This show is brought to you by Covenant. Lifestyle, legacy philanthropy, and of course, at Covenant, our goal is to unburden clients from the daily cares of financial management. So again, if you need any help or you know somebody that does, (210) 526-0057 or creatingricherlives.com, and you’ll notice on there that we have a lot of information right on the front page now, including the podcast. We have our Chief Investment Officer’s weekly blog on there. We have articles, we have radio interviews, television interviews, all in an effort to help you get a little more educated about the financial markets, financial planning, and anything else going on in your life in the financial realm.

Karl Eggerss:                      So, we do have a guest in studio today, which we will get to in just one minute. We did have some interesting things this week. The two biggest things that happened earlier in the week was, of course, we had the drone attack in Saudi Arabia. Course, took a lot of the oil production offline. We saw oil prices spike Sunday night. The futures popped up over 17%. It was one of the largest jumps, I think, if not the largest jump ever. Kind of stabilized Monday, as we heard rumors about when they might come back online. Oil’s in the 10 to 12% range up pretty huge day and I think it finished up around 14%. and of course, the next day, they came out with comments, they being Saudi Arabia, “Hey, we’re going to be able to put those back online sooner than we thought.”

Karl Eggerss:                      Oil prices came down a bit, but still a pretty big shock to the system and pretty scary when you think about how it actually happened in this new age of technology and warfare, given that this was a drone attack. The other thing that happened, you might’ve heard a little bit about it, was the federal reserve, which of course, they have a targeted rate, and as of Tuesday, they had a rate between two and 2.25% was their overnight lending rate.

Karl Eggerss:                      That repo rate, they call it, jumped as high as 9%, roughly, on Monday, Tuesday, and I believe even came down a little bit on Wednesday. This caught everybody’s attention because this overnight lending rate spiking reeked of something that we may have seen during the financial crisis in 2008. And a lot has been written about it. A lot of fear-mongers out there saying, Oh my gosh, something is broken in the system. After a tremendous amount of research here at Covenant, the bottom line is that there was more demand for cash and not enough supply. That was number one. That is really the reason for it.

Karl Eggerss:                      And partly why there wasn’t enough cash is because this all goes back to the financial crisis. After 2008, of course, the banks were right in the heart of it, all the regulations changed. Banks are now required to keep a ton of money sitting around. They have a lot of ratios to make sure they’re liquid right? They’re too big to fail, so they have to be very, very liquid. And so, there was a need for cash. They simply didn’t have it. They had to go borrow the money and that caused rates to spike up.

Karl Eggerss:                      Now, there’s a lot of reasons why that … Why did they need the money? The fear was, is a hedge fund blowing up or what is going on? Lot of reasons. Some blame it on corporate tax payments coming up and the bank, the corporations needed money to make those payments, so they were pulling money out of the banking system too quickly. Of course, we had the oil prices spiking. So again, that could have had some repercussions with some financial entities maybe. And we’ve also seen companies that were issuing a lot of debt, taking advantage of low interest rates and so some of the banks may have bought those bonds, leaving them short of cash.

Karl Eggerss:                      These are all reasons why that could have happened, but at the end of the day, it was probably more of a technical glitch. And I would say one symptom, you know, if your child sneezes, you don’t go rush and do surgery, right? You wait for the second sneeze, you wait for a fever. This was a symptom we had to figure out why this was going on, but many believed it was a technical glitch.

Karl Eggerss:                      And furthermore, we did not see any volatility in terms of the stock market. We didn’t see the volatility index spike up. We didn’t see credit spreads bust out, as they would say. We didn’t see gold move dramatically. The “safe haven” BitCoin, of course, which it’s not. We didn’t see that move. So, we didn’t see any repercussions. This was pretty much confined to the banks of this lending. So, the federal reserve came in and injected money back into the system. So really, a lot of it has to do with the 2008 regulation.

Karl Eggerss:                      Now, to help maybe give an analogy to this and put it into even more layman’s terms, Justin Pawl, P-A-W-L, not to be confused with another Justin Paul of having two first names, right? P-A-U-L. So, Justin Pawl is the Chief Investment Officer at Covenant. Excited to bring them in. We talk pretty much 24/7 about the markets. It’s very fun to be teaming up with you now, getting different perspectives, collaborating on a ton of stuff. Welcome to your first ever … Well, it’s probably your first ever podcast, but certainly to the Creating Richer Lives podcast.

Justin Pawl:                       It certainly is, Karl. Thank you so much for having me here today. It’s a real pleasure to sit down and talk with you about what we’re seeing in the economy and some of the behavioral finance stuff that we’re going to get into a little bit later. But when it comes to this banking situation, we heard from a lot of different clients, we heard … or we read in a lot of different media outlets that, “Hey, the financial system’s fracturing. It’s 2008 all over again. Should I pull my money from equities?”

Justin Pawl:                       And you did a great job of explaining the technical aspect of it and the fact that banking system’s tremendously complex, and so to try to distill it down into something that, hopefully, my mom can understand would be to make the analogy to a household that has a banking account. They have a savings account and they have a checking account. And let’s say, hypothetically, that this household has $5,000 in their checking account and maybe only $50,000 in their savings account.

Justin Pawl:                       And this household experiences some sort of calamity in the house where a pipe breaks, water goes everywhere. They had to pay service providers to come and repair the pipe, repair the damage that transcended from that pipe burst, and they stroke a check for $6,000. Now, $6,000 is more than they have in their checking account, but it’s not more than their overall net worth. So while the check might bounce or be an overdraft charge for having written that check, the fact is the household is not insolvent.

Karl Eggerss:                      They had the money. They needed to move it from one pocket to another, and it was really a cashflow timing issue more than anything.

Justin Pawl:                       That’s exactly right. And it wasn’t systematic … or it wasn’t system-wide in the banking system. It was probably one bank, or maybe a small group of banks that experienced liquidity squeeze. And so, the media and the headlines that came out about, “This is the end. Here we go again.” It was just misplaced. It caused a lot of unnecessary fear in the marketplace.

Karl Eggerss:                      Yeah. And it did. And look, anytime you have a chart that has a little squiggly line on it and at the very end it shoots straight up, it’s a concern, right? It’s looks like … Go look at an oil chart. Something’s going on. And so, it is something to investigate in, and everybody did, but I would caution you and I caution you almost every week, where are you getting your information from in terms of the folks that feast on doom and gloom and bear markets and that sells the headline risk and all that fear-mongering does sell and it gets media attention.

Karl Eggerss:                      And so, a lot of those folks were out there like, “Here we go, 2008,” but a lot of the levelheaded folks that look at this objectively and agnostically, all agreed that this was more of a technical glitch and you saw as the week progressed, it calmed down a little bit.

Karl Eggerss:                      Is it something for us to investigate? Absolutely. You don’t ignore something like that, but you have to see the reasons why, and the world has dramatically changed pre-2008 and post-2008. It is very different now.

Justin Pawl:                       Very different.

Karl Eggerss:                      Yeah, so thanks for commenting on that because that was a big item this week. The reason I wanted to bring you in this week was, you know, we talk … Really, our goal here is to help people become better investors, better with their money from a financial planning aspect, and really, again, we call it Creating Richer Lives because whatever your goals are and whatever you want to do with your money, how do you optimize that and make it better? One of the biggest things we do is help people not make certain mistakes. And a lot of these are psychological mistakes. In our world, it’s called behavioral economics, behavioral finance, but these are common mistakes we see.

Karl Eggerss:                      And by the way, Justin, you and I are humans that may have these feelings. Like, I don’t like seeing the market go down 3% in one day. I don’t like that. I own equities. You own equities, clients … We don’t like that, but what we do know is what sometimes that leads to or doesn’t and what to do about it, or more importantly, what not to do about it. So, I wanted to bring it here and talk about a few different mistakes you see that are pretty common in and then really put some practical examples around it or case studies or whatever you want to call it so that people listening can say, “Yeah, I’ve done that. I need to stop doing that.”

Justin Pawl:                       And we’ve all done that.

Karl Eggerss:                      We’ve all done it. We have, and you and I, the only reason that I think we’ve learned from it, it’s probably because we’ve been doing it a hundred times more than the people listening because we’re dealing with so much money on a daily basis and we’re dealing with a lot of people’s emotions.

Karl Eggerss:                      We have all types of clients, right? All over the spectrum.

Justin Pawl:                       All over the spectrum, and every human being is different.

Karl Eggerss:                      Absolutely. So, let’s start with just the broad, I guess the aspect of this, and then we can get into to maybe a couple of examples of-

Justin Pawl:                       Sure.

Karl Eggerss:                      … put a name on them, so to speak.

Justin Pawl:                       Sure, sure. So, behavioral finance at its core is the application of psychology to how financial decisions are made. In other words, is the process that your brain goes through when you’re trying to make a decision around something that is related to finance. The difference between traditional financial models and behavioral financial models is that in

Justin Pawl:                       Traditional financial models, people are assumed to be rational, that they’re logical. They’re going to make decisions that are in their best financial interests.

Karl Eggerss:                      Sure.

Justin Pawl:                       Behavioral finance in the other side or other hand considers the people to be normal. That is their decisions are made in the context of their experiences, their preconceived notions, their influences throughout their life. It’s not… They’re not automatons.

Karl Eggerss:                      These are biases.

Justin Pawl:                       They’re absolutely biases because human beings are not computers. We’re not ruled by zeros and ones that binary switches that turn on and off. Our brains are tremendously complex and there’s a lot of power in that, but there’s also a lot of room for making mistakes within that power.

Karl Eggerss:                      Yeah, and I think that’s interesting because as we obviously get more technologically advanced, we can use computers to help us to at least say this is what you should be doing because the computer is not taking emotions into it. It’s only taking numbers, so it tells us the answer and a lot of times our financial planning tools do that. We know what the right answer is to optimize somebody’s finances. However, we do have to take in consideration their history, their emotions, their experiences. If somebody had a horrible experience in ’08, I can’t ignore that they went through that.

Justin Pawl:                       That’s right.

Karl Eggerss:                      So we have to be sensitive to that, even if we know what the right answer is in terms of stock allocation, for example. Let’s explore that a little further. So what would be the name of, a common name of one of these biases we’ll call them, or mistakes, if you will?

Justin Pawl:                       Sure. One of the ones that most people are probably familiar with is loss aversion. Not necessarily that they know the technical name of loss aversion, but essentially human beings has been shown throughout a number of different research studies. People hate to lose twice as much as they like to win, and that has some very important implications for how they make decisions in life.

Karl Eggerss:                      Yeah. So you’re basically saying if somebody would rather… The joy of making $10,000 is not as great as the magnitude of fear if they lost $10,000 like you’re experiencing twice the negative feelings about that.

Justin Pawl:                       That’s exactly right. For example, Karl, if I gave you the option of investing $50,000 and you are guaranteed a return of $51,000, so a $1,000 profit; or you had a 50-50 chance of getting back $70,000, a $20,000 profit; or only $35,000 meaning you’re losing $15,000, what is your immediate reaction to what you would like to do in that situation?

Karl Eggerss:                      So let me clarify that. You could lose 15 or you could make 20-

Justin Pawl:                       Yep.

Karl Eggerss:                      … and you have a 50-50 chance of doing that.

Justin Pawl:                       That’s right.

Karl Eggerss:                      Or I get a thousand bucks, no questions asked I’ll walk out the door. Which one would most people take? Probably the 51,000, I would say.

Justin Pawl:                       Yeah, that’s right, but if you actually do the math around it from a statistical standpoint, from a probability-weighted standpoint, the second investment is actually superior because statistically you should get $52,500. That’s the expected outcome. Yet people would much rather avoid the potential for a loss and steer towards the sure thing of earning $1,000.

Karl Eggerss:                      Yeah, and there’s software out there that asked these types of questions now in our industry. They’re good questions to ask because people don’t ever think about it like you hear a lot of people say, “How much can somebody afford to lose percentage wise?”

Justin Pawl:                       Yeah.

Karl Eggerss:                      Well, I wouldn’t want to lose more than 15%. That doesn’t really help because I didn’t put any context around it and number two, it doesn’t put real dollars to it.

Justin Pawl:                       That’s exactly right.

Karl Eggerss:                      So what you did in your example is to say, “When I walk away with a thousand, then I would be giving up a potential 19,000 extra dollars.” Like you said statistically, it comes out better even with a 50-50 chance, which is a random-

Justin Pawl:                       Coin flip.

Karl Eggerss:                      Yeah, coin flip, exactly.

Justin Pawl:                       Exactly. The way this plays out in terms of investing is it’s somewhat counterintuitive because when people are afraid of losing money, they’re more likely to sell their winners too soon. So let’s say you have a stock, XYZ stock, it’s gone up 10%, most human beings have a natural bias towards wanting to crystallize that gain, sell that stock, realize that gain and move on. So with a losing position, because people are afraid of losses, they’re afraid to admit a mistake by selling the position. They’re much more likely to hold onto that position. Regardless of the financial prospects for the stock, they might be down $10,000 in the stock. They think, hey, it’s going to go back and I’m going to get back to break even. They’re very afraid, very concerned, mentally it causes them to be distressed is the word I’m looking for there, mental distressed to actually admit the mistake that they made in making that investment and to realize that loss.

Karl Eggerss:                      I have a question for you. Do you know what the difference between an unrealized loss and a realized losses?

Justin Pawl:                       I do technically, but I’m thinking you’re going somewhere else.

Karl Eggerss:                      The realized losses is the one you tell your wife about.

Justin Pawl:                       Very good.

Karl Eggerss:                      I’ve heard it said there’s an old probably a saying on Wall Street that when you’re holding a losing position that you know you should not be in, you know the fundamentals have changed, it’s just not a good deal at this point, it’s called pain to be right. It kind of goes into this other finance term called anchoring, which is holding onto like where you bought the stock. Because you’re down on it, really doesn’t matter where you bought it. That has no bearing. Wall Street does not care where you, Justin, bought your stock. It’s worth what it’s worth for a particular reason. Now it may be undervalued or overvalued, but where you bought it is meaningless. A lot of people anchor and they hold on to that cost basis. If I put 10,000, I got to get back up to 10 at least and then I’ll get out. That has nothing to do with the strategy. That is not a good strategy.

Justin Pawl:                       No. That’s one of the worst strategies. When you do anchor-

Karl Eggerss:                      It’s common.

Justin Pawl:                       It’s absolutely common as is this loss aversion situation. The reason loss aversion is so damaging to the long-term ability to compound wealth is that when you’re selling winners too fast and you’re holding on to losers too long, you’re losing both ways in your portfolio. Everybody knows that not every investor is going to get every investment decision right. It’s important that you maximize those gains on your winners and that you cut your losers as soon as you can.

Karl Eggerss:                      I’ve got a lot of Wall Street scenes in my head. One of them that sticks out is you don’t always trim the flowers to water the weeds. There’s some people that are quick to take profits on their gains and they don’t want to have a losing position. So they take those profits and they keep adding to their losers, which there is a benefit sometimes of dollar cost average and of course into something that’s down.

Justin Pawl:                       Absolutely.

Karl Eggerss:                      Just to simply do it because you’re down is not the right answer, and a lot of people do that. It’s called trimming the flowers to water the weeds.

Justin Pawl:                       I like that. It’s a good one.

Karl Eggerss:                      Yeah, and just like why would you buy a stock when you’re up 20% on it. Well, what if there’s some new news and it’s undervalued? You may be just as good averaging into that stock that’s up already versus taking that money and adding to a stock that you’re down on.

Justin Pawl:                       Yes, and that’s exactly right, but you’re applying logic to the situation, right? Most people divert to their or revert to their emotional bias around it.

Karl Eggerss:                      Absolutely.

Justin Pawl:                       That’s where the behavioral finance is so important is we try to educate our clients about these behavioral biases to make them better investors. Karl, you and I, we mentioned this before, I mean, we’re subject to these behavioral biases like anybody else’s. However, by studying them, by understanding them, by experiencing them, we’re able to overcome a lot of that, take a more clinical approach to the market so that we’re not driven by the swings of the market to allow to drive our emotions to swing just as why, because that’s no good for anybody.

Karl Eggerss:                      No, it’s not, and it’s interesting because I do believe people are kind of wired a certain way. I mean, you’re going to get some people that are just a little more conservative, a little more aggressive they’re wired. Also, I believe their past experiences play a huge part in this. It’s not just necessarily they made a bad decision four years ago in their portfolio. It could be their upbringing. I will ask clients that sometimes, like tell me about growing up, like what did it look like in your world, did you talk about money at the dinner table or, and it may come out that father was a habitual gambler or… In my experience, and I’ll tell you because my father passed away when I was seven, my mother therefore kind of went in protection mode in terms of keeping what she had because also she’s a single mother with three young kids.

Karl Eggerss:                      CDs at the time in the late ’70s were paying a tremendous amount, so she was always very scared of the stock market. It took me coming into the profession to teach her and to show her you can actually make good money in a safe manner longer term. So it was her experience that she grew up kind of conservative and her situation made her more conservative than perhaps she should have been. So I like to have those conversations and for those listening really examine that. Think about what was my upbringing? Did I have a family that invested? Because more than likely if you did, you saw how that went and you are comfortable with it.

Karl Eggerss:                      So past experience plus not only that upbringing but, again, looking back to the ’08. One thing we ask our clients when they first come in is tell me what you did in 2000 through the 2002 bear market, in the 2007 through 2009 bear market.

Justin Pawl:                       Tremendously illuminating.

Karl Eggerss:                      Not how did you feel, what did you do? We have answers that range from, I sold and I’m still trying to figure out how to get back in. Then on the other end it’s, I didn’t do anything; I just kept buying. That tells us everything we need to know about their risk, but it’s a great teaching moment. So why did you sell? Why didn’t want to lose it all? Let’s examine that.

Justin Pawl:                       Exploring that with clients is so much better than a risk questionnaire because it’s very easy in a theoretical sense to answer, hey, if the stock market is going down, I know I’m going to be a buyer because their prices are better here now than they were a month ago or two months ago. If you go back, and you remember what happened during the financial crisis, people were scared. People thought that the financial markets were unraveling and that [crosstalk 00:21:22].

Karl Eggerss:                      They were unraveling, but they also unraveled in the great depression.

Justin Pawl:                       Yes.

Karl Eggerss:                      I mean, when we will look at the stock market, not in the past four years or five years, when we look back the past 100 years, we’ve got a lot of different scenarios in there. What I know is that stocks are near an all time high right now.

Justin Pawl:                       They are. They are at all time high right now.

Karl Eggerss:                      That tells me everything I need to know right there.

Justin Pawl:                       No, you’re right, but not every downdraft in the market is a buy necessarily. Timing is everything, and it’s about turning off those emotional switches and taking a more fundamental, rational approach in evaluating the data to make a decision about when is the right time to get back in.

Karl Eggerss:                      Sure, yeah, which is difficult

Karl Eggerss:                      … if you’re making large swings to get “out” and then now you have another decision to make, when to get back in. So you have two decisions you have to be right on.

Justin Pawl:                       That’s right.

Karl Eggerss:                      So to me it’s about modification of a portfolio over time, and it all boils down to when do you need the money?

Justin Pawl:                       Correct.

Karl Eggerss:                      Right? If somebody didn’t need the money for 50 years, I feel pretty good about that. If somebody says, “Hey, I need this money in two years. Should we invest it in stocks?” That’s a totally different conversation.

Justin Pawl:                       Much, much-

Karl Eggerss:                      And the answer’s probably no.

Justin Pawl:                       Probably not. Well, at least not 100% in stocks. And that’s really where portfolio diversification comes into play, where you’re looking at different risk and return drivers in a portfolio. Fixed income investments move a different way than equities for different reasons. Equities and alternative investment strategies move differently from one another. And as the combination of those, that makes for a smoother ride for the client, that keeps them within their risk parameters and keeps them, most importantly, emotionally stable through a period so that they can stay invested to ride out the short-term whips of the marketplace.

Karl Eggerss:                      Yeah, and I would say, I’ll use the analogy, but you’re a California boy, but I’ll use a different analogy.

Justin Pawl:                       Don’t hold that against me. I’m here now.

Karl Eggerss:                      Hey, dude. But here’s the thing, I think, and this is an analogy that I think makes a lot of sense. If you go from San Antonio to Dallas and you take 281 north, you can get to Dallas. If you take I-35 north and you go to Dallas and you split the family up into two and two, a family of four, it’s safer for y’all to take two different paths to get there and you’re going to have different experiences. Traffic, no traffic, accidents, but it is safer to split the family up and do that. Which one’s faster? Which one’s better? I don’t know. You tell me where the wrecks are. You tell me who’s doing construction and I’ll tell you which one’s faster. That’s what portfolio diversification is to me. It is a different path to try to get to the same place and it smooths it out.

Karl Eggerss:                      We’ve spent a lot of time the last few weeks on the podcast talking about people have a very short-term view in terms of looking at recency of the last two or three years and assuming that it’s going to stay that way forever versus people in the ’70s may have had a totally different view and thought it was going to stay that way forever. And how about the Great Depression? That caused probably two generations to not ever invest in stocks again, right?

Justin Pawl:                       That’s right, and it’s not just about a particular asset class. It comes down to diversification by geography, for example. In the ’80s it was all about the Japanese stock market. That stock market could do no wrong, and so people continued to pile money into it. Well, that came to a screeching halt and the Nikkei, the Japanese stock market index, has not reached its old highs in what, 30 years now?

Karl Eggerss:                      30 years.

Justin Pawl:                       35 years. Same thing was repeated with emerging markets. It was repeated with the European stock market and that very well could be the case for the U.S. equity market going forward, where at some point in time there is a pullback in the market and the other geographies take the lead in driving the global indices forward.

Karl Eggerss:                      Yeah, and that’s, again, it’s cliche, but it goes back to diversification. You’re not saying that’s going to happen. You’re saying, “Is it possible?” Yes, because you and I have studied history and most of our listeners have, that have looked and said, “Are we the next Japan? Could it happen?” Absolutely, it could happen. But what’s interesting about diversification is four years ago there was like 60 economists that were surveyed if rates were going to go up. Every one of them said yes and rates went down that year, and it just tells you we don’t know and so that’s why diversification … We think we have better odds because we study it, but the point is that look at the bond market in 2019. How many people were betting against bonds and saying, “I don’t want bonds. I’d rather not diversify because I know that bonds are going to lose money,” when here they are having a fantastic year.

Justin Pawl:                       One of their best. One of their best years.

Karl Eggerss:                      One of the best. We wouldn’t have thought that. So even if you want to underweight something, I think to not go to the extremes and say, “I’m getting out of the stock market,” or, “I’m not going to own any bonds.” To me, just like right now, people not owning international. I see it every day, severely under-allocated to international. Why? Because it has not done well. That’s not a great strategy going forward. So it is little cliche to talk about diversification, but it’s absolutely works over the longterm.

Justin Pawl:                       So diversification is … The reason that you hear so many advisors talking about it, at least the ones that I give credence to in the marketplace, is because we don’t know what’s going to happen next. The world’s a big complex system and anything can happen as we’ve seen repeatedly over time. And oftentimes it happens without any sort of preconditions that are immediately evident to anybody. To the economists, to the financial marketers, to the financial media. And so, that’s why it’s important to basically, if you already have a substantial wealth or even enough wealth where you think you can retire within several years, to diversify those assets to reduce the probability of some individual outcome taking you out and taking out your portfolio so that it forces you to have to go back to work.

Karl Eggerss:                      No, that’s right. I mean, I like analogies and this is … You’re driving down the road. Some people are driving down the road right now, they’re not having to use brakes, they’re not having to use a steering wheel and everything’s straight. At some point a car’s going to come in front of you. You’re going to have to use the brakes and steering wheel. And we see that through a lack of diversification because whatever they’re heavily weighted in, it could be stocks, bonds, commodities, could’ve been oil back in 2013-

Justin Pawl:                       Could have been Bitcoin for a while.

Karl Eggerss:                      Could have been Bitcoin for a while. At some point it doesn’t continue that way and you have to diversify. And again, I think what we try to do is match the goals with what people are trying to accomplish, but also there are several tools in the tool belt we have access to and a lot of people do. They’re just not utilized a lot for whatever reason. And I think it’s kind of been shortsighted in terms of looking what’s recently happened to them or the markets.

Justin Pawl:                       You’re right, Karl, about the different tools in your belt and one of the things that we’re always evaluating in the marketplace is what are the new investment options that are available to people out there? It’s important to be aware of these because as time goes on, technology advances and there’s new opportunities in the marketplace. And I mentioned alternative investments in passing earlier in our conversation, that’s a topic unto itself that I’ll come back to talk with you about later on.

Karl Eggerss:                      Yeah, that sounds good. And you can see, I mean, there are many different biases, mistakes. Again, most of these are psychological. I want to have you back because we really covered one, which is loss aversion, but you can see what happens is we talk about something like this and it’s a full conversation because there are several examples and people need to understand, again, what does loss aversion mean? It’s not just about, “Yeah, I don’t like to lose money.” Nobody does, but what are the real impacts of that, especially when you put it into some statistical numbers like you did with the coin toss analogy. So, Justin Pawl, thank you for joining us. Again, Justin is chief investment officer at Covenant and we will have him back to talk about more of these investment biases and so forth in the weeks ahead. Justin, thanks for coming in. Appreciate it.

Justin Pawl:                       Thank you, Karl.

Karl Eggerss:                      All right, that will wrap it up for today’s show. But before we go, I did want to let you guys know that starting Monday, we’re excited to unveil Covenant You. Covenant You is meant to bring you all of Covenant’s ideas, blogs, videos, podcasts, anything that we have written about, our insights during the week. We’re going to start sending one communication once per week, Monday afternoons, and it’s going to include everything. So it’s very simple as opposed to sending you something as it’s produced and sending you something maybe multiple times during the week, it will be sent on Monday afternoons.

Karl Eggerss:                      Now, here’s what this means for the podcast. For the podcast, if you want to continue getting the podcast as soon as it comes out on Saturdays, which is when we send them out, on Saturday mornings, then you can do it a couple of ways. Number one, they will still go out on social media through the Covenant Facebook page or the Covenant LinkedIn page on Twitter. So you will still get it that way. Or you can also get it through various podcasting services. So you have Apple podcast, Spotify, Stitcher, Overcast, and all the others. Those will be released on Saturday mornings. But in terms of getting an email, which some of you listen to the podcast with an email notification from us, that won’t come until Monday afternoon, so just take that into consideration. Same information, just we wanted to simplify things for you and that way you will have a choice of things that you want to read, watch, listen to, lots of different formats and information coming from collectively Covenant.

Karl Eggerss:                      Obviously my podcast, we’re going to have our chief investment officer’s blog in there included every Monday afternoon as well. So really excited about Covenant You and bringing that to you guys on Monday afternoons. Nothing you have to do different than you’re currently doing, but I did want to make that distinction between when the podcast will be available. Again, Saturday mornings continuously, just available on social media and through podcasting services, but the emails will come on Monday afternoon. So just wanted to clarify that.

Karl Eggerss:                      All right, everybody, thanks for joining me here on the Creating Richer Lives podcast. Don’t forget if you need our help, (210) 526-0057 or visit creatingricherlives.com. Have a great weekend, everybody.

Speaker 1:                          Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy or product, including the investments and/or investment strategies recommended or undertaken by Covenant Multifamily Offices LLC, Covenant, or any non-investment related content will be profitable, equal any corresponding indicated historical performance levels, be suitable for your portfolio or individual situation, or proved successful. Moreover, you should not assume that any discussion or information serves as the receipt of or as a substitute for personalized investment advice from Covenant. To the extent that a listener has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with a professional advisor of his/her choosing. Covenant is neither a law firm nor certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of our current written disclosure brochure discussing our advisory services and fees is available upon request or at creatingricherlives.com.

Oil Blasts High

September 16, 2019

On this morning’s Trey Ware Show, Karl and Trey discussed the huge surge in oil prices and the importance of our oil independence.

Trey Ware:                         Well, I hope that you gassed up your car, or let’s find out if Karl Eggerss thinks that that’s necessary. Now, I do that on Monday mornings on the way in anyway. I feel it full, and it lasts me the entire week, but maybe it’s a good idea to do that this morning based on what happened in Iran over the weekend with Iran and Saudi Arabia. Karl Eggerss is joining me now. Karl, your website is …

Karl Eggerss:                    Creatingricherlives.com.

Trey Ware:                        Creatingricherlives.com. Let’s talk a little bit, Karl, about what did happen in Saudi Arabia and what you expect to happen at the gas pump, if anything.

Karl Eggerss:                      Do you really fill up your car every Monday?

Trey Ware:                         I do, seriously.

Karl Eggerss:                      That’s interesting. That’s a pretty routine, a pretty scheduled routine right there.

Trey Ware:                         My life is strictly scheduled and routine, baby.

Karl Eggerss:                      Well, it’s a good thing you did. I mean, there’s been reports of, obviously, oil being up 10% this morning, was up 19% globally last night. It’s come down a little bit, but there’s been reports of how soon can they get this production back online, and nobody really knows. I think it’s going to be a few weeks. Of course, a few weeks means we probably will see higher gasoline prices trickle down. I think this is really important why we have been establishing our independence in terms of-

Trey Ware:                         That’s right.

Karl Eggerss:                      Oil production the last few years, and this is exactly why we want to do this. Let’s use their oil when we can, and when we don’t have to, let’s use our oil. That’s the name of the game, but, look, I’ve been talking about the last few months that our economy has been slowing a bit and globally, as well, and any type of shock to the system, whether it was a government shutdown in December or something like this, could slow it down even more. What’s interesting about oil, though, is high oil prices sometimes, while they may be bad for us at the pump, they do help produce jobs, as well. You’ve got this chicken and the egg deal, just like when oil prices are cratering. Everybody said, “This is great,” and then they start worrying about a recession. So higher oil prices could be a shot in the arm, at least for for Texas and Louisiana at places around here in terms of employment.

Trey Ware:                         Well, I think also that you’re going to have a lot of speculation. It’s going to go on particularly today until they realize the President has authorized release from the strategic reserves. We are independent at this point. In fact, we’re the world leader in oil production right now, although Saudi Arabia is about 5%. Their production is about 5%, 5.7 million barrels every day now being taken off the market. So it’s going to be big, and there’s no doubt about it in other parts around the world, but the President has said that you can go after the reserves in a to be determined amount that we need to pull out of there to make sure that our gas prices don’t shoot up to some ridiculous number, like $4, $5, $6 a gallon overnight, that we’re going to be pretty much okay, but the World Futures, I saw, Karl, were talking about going immediately to about $100 a barrel. So I don’t know what that means or how long that’s going to last, but that’s what I saw happening.

Karl Eggerss:                      We’re sitting at around $60 a barrel right now, up about 10%. We were at around 54, 55 last Friday. Don’t forget that we were at $120 a barrel just a few years ago. We went all the way down to 26. When we’re at around $50 to $60, it seems like everybody, there’s just enough people that are a little unhappy, but pretty much everybody’s okay with it. Gasoline prices aren’t ridiculous, and we have enough. The oil prices are high enough to where, again, we don’t see massive layoffs and energy patch and things like that. So, again, natural reaction, let’s not forget, I mean, again, these Futures opened up 17 to 20% higher last night and were up about 9 to 10, so they’ve already pulled back quite a bit from last night after the initial reaction. Again, it’s because of how soon can they get this back online. We’ve heard a couple of weeks, we’ve heard half of their production going back online in a few days, maybe a third. Nobody really knows. That’s a lot of sophisticated equipment to get back online. It’s pretty unbelievable, but this does show still our vulnerability when something like this happens, to what happens to oil prices, and, of course, that trickles down to our gasoline prices, as well.

Trey Ware:                         Quickly, one last thing, will the UAW strike mean anything as far as stock market and money is concerned?

Karl Eggerss:                      The keynote’s interesting. I was doing a little research this weekend. The last several stock market peaks have been around times where there’s been strikes. So there’s usually a negative impact, meaning when there are strikes, we tend to get a stock market [inaudible 00:04:51]. I think that’s kind of coincidental myself. I think that was just the coincidental timing of that. Again, I don’t think that will naturally lead to an economy. The bigger issue is trade, interest rates, and just how the economy is doing. Right now, we’re kind of in a Goldilocks where the economy is slowing, but not so much that we’re in a recession, and it’s also causing the Fed to drop interest rates, which is, again, for those that are our borrowing is a good thing around the globe.

Trey Ware:                         Karl Eggerss, thank you, Karl. Appreciate it. He’s with us every Monday at this time to talk about money and talk about the markets and what we can expect.

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Butterfly Effect – Sometimes large moves in the market start with the smallest of impulses.
  • Bad News – Media is as negative as it was during the Financial Crisis, causing some investors to back away from markets.
  • Behavioral Finance – A look at Cognitive Dissonance and how to make better decisions.

Last Week Today. Central banks were on the easing-train last week. China cut its banks’ reserve ratios by 50bps, freeing up $126 billion in available lending. The European Central Bank pushed its official borrowing rate further into negative territory by 0.1% to -0.5% and went back to the QE-crutch, promising to buy €20 billion per month for as long as it takes to get inflation and growth prospects back on track. The Fed is meeting this week and expected to cut rates by 0.25%. | “He said, Xi-said” saw a bit of a détente as China’s President Xi exempted 16 types of U.S. imports from tariffs and encouraged its stated-owned enterprises to purchase soybeans from US farmers. President Trump reciprocated by pushing out scheduled tariffs on Chinese imports by two weeks. | U.S. inflation data from August showed signs of life as both the Producer Price Index and Consumer Price Index rose slightly more than expected. The overall level of each remains contained with little risk of breaking out to levels that would damage the economy. | On Saturday, a coordinated attack on the world’s largest oil refinery cut global supply by 5%. Iran-backed Houthi rebels claimed responsibility for the attack, but U.S. officials suspect Iran may have played a more direct role. Oil futures immediately jumped 13%, but this morning are closer to +9% as the initial shock wore off.

For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

Butterfly Effect. Chaos theory holds that small changes in unstable systems can have significant effects. For example, Chaos Theory holds that a butterfly flapping its wings at the right time in Brazil can cause a hurricane in the Atlantic Ocean. This “Butterfly Effect” can be applied to financial markets in which small changes at the margin can produce large changes in the prices of financial assets. We saw two such cases last week. While at the surface the equity market was rather calm, with the S&P 500 rising more than 1% and the VIX Index at a low 13.7, the internals of the market were convulsing. The types of stocks performing best over the last one-year, two-year (and in some cases longer) suddenly became the worst performers. Momentum stocks (i.e., stocks with strong upward trending prices), which had gained +23% YTD before last week, were suddenly shunned and fell -2.3% (as measured by a momentum ETF: MTUM). Value stocks, which have underperformed Growth stocks for ten years (to the chagrin of active portfolio managers everywhere) reversed and outperformed +2.4% to -0.5% for the week.

The tumult was not limited to equities, and after a period of sharply declining interest rates, fixed income investors found themselves in unfamiliar territory as rates backed up with the yield on the benchmark 10-year US Treasury rising more than 0.3% in a week. The chart below shows the upward shift of the US Treasury curve (green = curve as of Friday, yellow = curve one week prior). It’s also worth noting the flattening of the curve, which took much of the curve out of inversion (i.e., longer-maturity bonds yielding more than shorter-maturity bonds).

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Sources: Bloomberg, L.P. .and Covenant Investment Research.

What caused this sudden shift in market sentiment? It wasn’t a news event, and no one rang a bell signaling investors to sell Momentum stocks and Treasury bonds. In all likelihood, it was one or more investors independently taking risk off the table because, in their view, these types of assets were overpriced. Other investors (and investment algorithms) seeing a decline in prices followed suit and the Butterfly Effect took hold. This happens fairly regularly in markets. Sometimes they are nothing more than a sector rotation that is barely noticeable at the surface like we saw last week. Other times they are impossible to miss, such as the pricking of an asset bubble (e.g., the Dot.com and mortgage bubbles). For all of the regulation, financial markets are inherently unstable systems subject to wide price fluctuations, and last week is a good reminder of why portfolio diversification remains as crucial as ever.

 

Bad News. As the chart below illustrates, even as the stock market approaches all-time highs, investors have been running in the other direction, pulling money from equity investments and charging into bonds and money market investments. What’s remarkable about this chart is that the flows accelerated right about the time the Fed cut interest rates, directly reducing the yield on money market funds which received the highest capital flows. What were these investors thinking?

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Source: Deutsche Bank Research

The chart below offers an explanation. Day in and day out, investors are bludgeoned with negative news about the economy and financial markets. I’m not saying this is fake news per se, but often media sources report on the most sensational and fear-mongering data points to get Internet clicks and viewers to sell more advertisements. Just take a look at the chart, as they say in the media, “If it bleeds, it leads.”

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Anecdotally, I see a lot of negative news every day as I track financial markets. Currently, the negative news is outweighing the positive by a wide margin, and the chart above confirms my experience. Great Justin, but what’s your point? The point is that news headlines can move markets in the short run, but fundamentals drive financial market prices in the long term. Unfortunately, negative news, which has reached levels last seen in the Financial Crisis, is causing people to make questionable investment decisions.

Are the U.S. and global economies slowing? Yes, they are. However, the economies aren’t contracting, and the current data does not suggest either is on the cusp of doing so. This is not a call to get overly aggressive with your portfolio allocation. Instead, it’s a call to know what you own, why you own it, to calibrate your expectations based on the fundamentals, and to pay less attention to the media whose fortunes are tied to selling advertisements – an endeavor that is critical for their survival but is irrelevant to your financial interests.

 

How the Mind Works Against Successful Investing – Cognitive Dissonance

(Entry #7 in a series on Behavioral Finance)

We have concluded our section on Emotional Biases, and will now turn our attention to the other broad category of Behavioral Finance Biases called Cognitive Biases. As a reminder, the taxonomy we are following is:

  • Emotional Biases – irrational decisions based on instinct or impulse, rather than conscious calculations. Emotional Biases emerge from peoples’ personal experiences and are based on how they feel rather than how they think.
  • Cognitive Biases – systematic errors in thinking that cause us to act irrationally repeatedly. Cognitive Biases often occur because of heuristics, mental shortcuts we have developed to make decisions when time is limited.

In simple terms, Emotional Biases lead to poor decisions based on feelings, whereas Cognitive Biases produce suboptimal decisions based on faulty logic. Generally speaking, Cognitive Biases are easier to correct because the resulting errors can be illustrated as illogical. Humans are much more willing to accept they made a mistake in logic than to admit their feelings about a topic are questionable. Following author Michael Pompian’s lead, we divide Cognitive Biases into two categories: Belief Perseverance – sticking with the status quo, even as newly available information conflicts with that decision; Information Processing – assimilating data illogically.

The first Belief Perseverance bias we cover is cognitive dissonance, which serves as the psychological concept from which all other Belief Perseverance biases stem. In sum, cognitive dissonance is the mental discomfort or natural alarm someone feels when new information contradicts previously held beliefs, ideas, or values. Said differently, new information that conflicts with existing thinking makes people so mentally uncomfortable they will go to great lengths to convince themselves they are right, often through means that lead to poor decisions.

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Source: The Daily Star

This Orwellian-sounding term was coined by American social psychologist Leon Festinger and has a fascinating origin. Festinger began to develop the concept in a 1950’s study of a cult whose participants believed the earth was about to be destroyed by a flood. When the flood’s predicted date came and went, and the world was still intact, Festinger’s ensuing interviews revealed that fringe members of the cult were more likely to acknowledge they had made fools of themselves. However, the committed cult members who had given up homes and jobs to work for the cult re-interpreted the evidence. These cult zealots believed their faithfulness prevented the flood from occurring and hence they were right all along.

Most would identify the zealots’ reactions as self-delusional. Indeed, self-delusion is how most people cope with cognitive dissonance as we are apt to reject anything contrary to our beliefs once we form an opinion on a specific topic. Self-delusion rarely leads to good decisions. Instead, it leads to decision-making errors as humans attempt to resolve the mental discomfort (i.e., reduce the dissonance) from the inconsistency of their beliefs and the new information by one of two shortcuts:

  • Add confirming beliefs – try to build a case to support your view by finding evidence that outweighs the conflicting information. For example, if Mr. X purchases a stock that subsequently declines in price, rather than acknowledging he made a mistake, Mr. X instead seeks out opinions from others that support his original purchase decision.
  • Ignoring information – simply disregard any information that does not support your belief. For example, continuing to add to a losing investment in spite of increasing evidence that the prospects for the holding are deteriorating, i.e., “throwing good money after bad.”

Neither of these actions is rational nor representative of a good decision-making process, even if they reduce the discomfort of the decision itself. Rather, better paths to decision-making that maximize one’s self-interest while minimizing dissonance are illustrated in the other three boxes of the chart below: Change the Behavior, Change the Belief, or Analyze the new information and Dismiss it as invalid.

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In real life, changing your behavior or belief is easier said than done (smoking is a good example, as despite the scientific evidence of its health effects, many people won’t give it up). Moreover, not all new information is valid, especially in today’s world, where the Internet gives everyone a megaphone to broadcast their views. Therefore, sometimes the correct decision is to dismiss the new information, just don’t do so on the initial premise that it conflicts with your view or belief.

More than ever, it’s critical that through self-introspection, each of us understands the origin of our beliefs and the data that supports them, so when presented with conflicting information we can assess its validity and whether it merits a change in our thinking. As we sift through the myriad of data points, we need to guard against the mental shortcuts to reducing dissonance and be open to new ideas that challenge our thinking to evolve emotionally and intellectually.

Be well,

Justin