Last Week Today: Former Fed Chair Ben Bernanke warned that the US economy will face a “Wile E. Coyote moment” in 2020 as the double-whammy of fading effects from the tax-cut stimulus are met with the impact of Fed interest rate hikes. | Mexico placed tariffs on $3 billion of U.S. goods (e.g., apples and potatoes) in retaliation for President Trump’s tariffs on aluminum and steel imports. | Data from the Bureau of Labor Statistics showed that there are more job openings than unemployed workers, a rare event and further evidence of a tight labor market. | The G-7 Summit kicked-off on Friday and it was reportedly a tense meeting with President Trump leaving early for his summit meeting with Kim Jung-un. Trade tariffs are the focal point of the G-7 this year, and little seems to have been resolved. Indeed, China’s President Xi Jinping stated during a speech “We reject selfish, shortsighted, closed, narrow policies, (we) uphold World Trade Organization rules, support a multilateral trade system, and building an open world economy,” in a thinly veiled swipe at the U.S.
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This Week Today: On Tuesday, President Trump and Kim Jung-un will meet in Singapore to discuss denuclearizing North Korea. | Also on Tuesday, a U.S. District Court is expected to announce whether it will allow AT&T to merge with Time Warner, setting a significant precedent for the administration’s regulatory policy. Given the President’s words and actions favoring deregulation, interfering with this merger seems counterintuitive. | Even so, the odds of approving the merger are lower than the odds of the Fed hiking the target Fed Funds rate on Wednesday for the seventh time in this cycle by 0.25%– the futures market this morning is pricing in an 86% probability of the Fed moving their target rate up to 2%. | On Thursday, the ECB is expected to announce whether they will continue their QE program beyond 2018. Having cut their purchases from €60 billion to €30 billion per month in January, the market expects the ECB to wind down the program by the end of this year removing another significant source of liquidity that has fueled the historic rally in financial asset prices. On that note, the Fed will increase the pace of its balance sheet reduction from $30 billion per month to $50 billion per month by October.
Mean Reversion – Financial markets are wonderful, fantastically confounding systems. Prices can move (both higher and lower) for long periods of time, sometimes bordering on lunacy which gave rise to John Maynard Keynes’s most relevant quote on risk management in investing “Markets can remain irrational longer than you can remain solvent.” However, even as financial asset prices move to extremes, they always, eventually, revert to the mean and often below the mean, be it Tulips in 1637, Dotcom stocks in 2001, the S&P 500 in March 2009, or Bitcoin in December 2017. The question facing investors is that of timing. Unfortunately, attempts to time the market have probably contributed more wealth destruction throughout history than any other non-economic human endeavor. It is for this reason that having an investment plan, remaining disciplined to the plan, and maintaining a diversified portfolio are vital facets of long-term wealth generation and preservation. This statement should not be interpreted as an endorsement of pure buy-and-hold investing. Indeed, your plan should include regular rebalancing and tilting your portfolio to take advantage of opportunities when they present themselves (e.g., stocks in March 2009). But, swinging your portfolio around wildly to what has worked recently or concentrating your portfolio in just a few holdings is unwise. Indeed, it is often better to shift modestly away from what has worked lately (sell high) in favor of what has not worked (buy low). With that in mind, below are two examples of extreme market conditions present today.
Source: Capital Economics
Technology stocks are not at their most extreme level relative to their proportion of market capitalization in history, but they are higher than at any point since the Dotcom Bubble. The rise in prices of IT stocks is also contributing to the performance divergence between Value and Growth stocks, which is at the widest level in over ten years.
On the topic of diversification, the math is straightforward. The chart below shows the total real (inflation-adjusted) return of the S&P 500 including reinvestment of dividends and highlights the time required to get back to break even following major market peaks.
Source: Real Investment Advice
This reality of investing in equities is that these investments will be underwater a significant portion of your investing life when inflation is considered. Yes, markets move higher over time, but they do not move in a straight line. Indeed, while pensions and endowments operate with an infinite investment horizon, most investors don’t enjoy that same luxury hampered by the inconvenient truth of actuarial tables in which we all have finite lives.
To this point, what the chart doesn’t contemplate is the effect that spending out of your portfolio has on the recovery time to new portfolio value highs. As you sell securities to fund your lifestyle or other life-events during a market drawdown, you reduce the amount of money available in your portfolio that will benefit from a market recovery following a crash. Hence market losses act as a “volatility tax,” in which progressively high downside volatility reduces your long-term net worth disproportionately to your spending rate. This “volatility tax” extends the timeframe to recover. In fact, if you only spent 5% of your portfolio each year since 1999, you would still be underwater today (more than 18 years after the Dotcom Bubble peak), despite the historic bull market we have experienced.
It is for this reason that significant losses in a portfolio are so devastating to accumulating wealth. Indeed, Warren Buffet’s two most important rules of investing are:
1. Don’t lose money.
2. Refer to Rule #1
While losses cannot be avoided entirely in financial markets, one can reduce the chances of experiencing substantial losses through thoughtful diversification. By spreading your portfolio exposures across a variety of investments with different return drivers (equities, fixed income, absolute return strategies, hard assets, etc.), you improve your probability of generating long-term wealth by reducing the size of portfolio drawdowns. The ride may not be as exciting, but in the end, it is the result that matters.