Markets, Noises, Long Term Strategies …
We are writing this newsletter in the midst of a market downturn. By market downturn, we mean literally a stock market sell-off that’s currently retesting/under cutting the lows made in June this year for market indexes like S&P 500. Let’s first review the current state of markets and then focus on investment methodology.
Stocks and bonds diversification broke down
Well, for most people who haven’t really experienced anything before 1990s (those who are under 60 years old), it’s shocking to see that the ‘long held’ stock bond diversification concept finally broke down in this year. The 60% stocks and 40% bonds (60/40) model (represented by Vanguard balance index fund VBINX) championed by indexing investors like Vanguard has lost a great deal, not that far behind a 100% stock fund like VTI:
Notice also our moderate tactical portfolio MPIQ ETF Allocation Moderate has outperformed VBINX for the past 1, 3, 5, 15 and 20 years or longer. We expect this outperformance to continue.
In fact, year to date, bonds have had their worst year since 1949. On the other hand, corporate bonds have behaved better than Treasury bonds, an anomaly as Treasury debts are considered ‘safer’:
|1Yr AR||3Yr AR||5Yr AR||10Yr AR|
|IEF (iShares 7-10 Year Treasury Bond)||-15.4%||-15.4%||-3.7%||-0.5%||0.7%|
|IGIB (iShares Intermediate Term Corp)||-15.5%||-15.5%||-2.8%||0.6%||1.5%|
|JNK (SPDR Barclays High Yield Bond ETF)||-12.9%||-11.4%||-0.4%||1.4%||2.8%|
Surprisingly, ‘junk’ bonds are doing better than both credit bonds and ‘safe’ Treasury bonds year to date. This shows that markets likely have not fully priced in credit and business risk. In fact, we first noticed this several years ago in Treasury bills vs. CDs (Certificates of Deposits mostly invest in short term Treasuries, loans and ultra short term corporate bonds) rates. We’ll have more discussion on this later.
In the meantime, stocks are breaking their June’s lows:
Entering phase 2 decline
It does seem like that stock markets are entering phase 2: So far in phase 1, stocks’ decline is mostly because of price/earnings PE multiple compression as higher interest rates made investors demand higher earnings yields (the inverse of PE) or lower PEs in relative to bond yields. As we have seem so far, corporate earnings haven’t been affected much. Furthermore, corporate debt structure is still extremely strong. In fact, corporate bankruptcies are at two decade low:
Higher interest rates will dramatically increase borrowing cost for businesses. In addition, they are also now starting to severely affect consumers spending. For example, the average 30-year mortgage rate is now more than 6.29%, compared with 2.88% a year ago. This means a $400k 30-year fixed mortgage loan’s monthly payment is increased from $1661 to $2473. Or put it another way, the same $1661 monthly payment can only service $270K loan today (if compared with 2 years ago, the mortgage cost is effectively doubled). So a 33% house price reduction is called for to maintain the same housing spending for the same house or consumers need to opt for a much lower standard house.
The other headwind is that strong US dollar has made corporate earnings les. Based on Morgan Stanley, it’s estimated that the currency impact will be about 10% or more on S&P 500 earnings in Q4.
It’s also worth pointing out that currently, the US is not in a recession. But as higher and higher interest rates will continue to impact businesses and consumers alike, it’s highly likely that eventually, we will be in a recession by the end of this year or next year. Of course, technically, it’s still possible that the Fed will be able to suppress inflation just right without causing a recession (a so called ‘soft’ landing). However, the odds seem to be low.
Simply put, at the moment, businesses haven’t been fully impacted by the rapidly rising interest rates (and rising US dollars). We have some way to go. Phase 2 is about earnings reduction/impact.
How low is low?
Well, Dr. Hussman just published another excellent commentary. We quote here his comment on where S&P 500 index is right now, in terms of valuation compared with bond yields (emphasis are ours):
The dark blue line in the chart below shows the S&P 500 Index since 1928. The dotted black line is the one many of you are familiar with – it shows the level of the S&P 500 that we associate with historically run-of-the-mill valuations (and expected returns of about 10% annually). It’s currently near the 1600 level, about 57% down from here. The green line (closest to that dotted black line) is the level of the S&P 500 that we estimate would be associated with expected returns 5% above Treasury bond yields. It’s currently near the 1900 level, about 49% lower from here. The red line is the level of the S&P 500 that we estimate would be associated with a zero risk-premium – that is, market returns no greater than 10-year Treasury bond yields. It’s currently near the 2900 level, implying that a further market decline of over 20% would be required simply to restore a positive risk-premium for the S&P 500, relative to bonds.
So from the current 3655 level, S&P 500 will need to drop 20% to 2900 to be considered to be on par to bonds. Of course, the next magic number 1900 would imply S&P has another 48% loss to go!
Regardless, the message is clear, at the moment, it’s likely the current weakness is still not over.
We are often amused by emotional speeches made by many famous experts, traders or collectively market participants. Everyone has some strong opinions on their belief. They show strong conviction. In reality, as what we have repetitively said, no one has an absolute clue on the future. Investors would be much better served by listening to some rational analysis with both possible outcomes (as future is unknown at present, we know for sure one needs to be prepared for both ‘RIGHT’ and ‘WRONG’ possibilities). What’s more important is that how to deal with the WRONG outcome. For example, if one strongly believes stocks are wrongly punished right now and it’s a good opportunity to buy them, the most important question would be what happens if this turns out to be wrong in the near term, in the intermediate term or even in the long term?
How to deal with or cover all possible outcomes is far more important than some animated, emotional rants in CNBC, in our opinion.
How to deal with the outcome of your actions (buy/sell) is essentially a strategy or a program that’s constructed from a collection of rules. Furthermore, they should possess strong intuitive and theoretical backings as well as being employed in practice for a while. Without such a ‘program’, it’s essentially operating on a whim and history has convincingly shown us that doing so will most likely deliver a bad long term result.
So we ask our readers whenever you are reading an article (ours included) or listening or watching CNBC or Bloomberg or Twitter, put on an additional filter to ask hard questions: do their arguments have strong fundamental support and what happens if these guys are wrong.
The other amusing thing is that we have seen so many people brush off central banks and other professionals as if they can do much better. Things like ‘The Fed(eral Reserve) doesn’t know what they are doing. They absolutely will wreak havoc the economy’. Conspiracy theory aside, we see that it’s far more likely that they (we) are facing some tough situations that might not be easily solved. In reality, one should instead ask how you would do better and why? Trying to answer these types of hard self critical questions will often yield much better understanding on the (hard and uncertain) nature of the economy and markets. That’ll enable you to be better prepared for the possible outcomes that might not go your way (and often they are).
Human nature tends to dismiss authorities as often they are wrong. However, without properly understanding and putting yourself to the shoes of these authorities, your behavior would be just ignorant, to say the least.
There is no short term strategy
Over times, we have noticed that people are often confused with long term strategy vs. long/short term tradings or activities. People are told that it’s better to buy and hold stocks for a long time to yield a better result. This is actually mostly correct so long as 1). you are buying some solid and broad base stock funds such as S&P 500 index fund SPY or Vanguard total stock index fund VTI and 2). you are holding them for a very very long time, preferably longer than 20 years (see April 6, 2020: Long Term Stock Market Timing Since 1871 Revisited, for example).
To be precise, buying and holding an index fund like SPY means you are consistently putting your money into the stocks of the companies in the index. As financial markets are inherently statistical, only the large enough samples (days in this case, for example) will lead your action (holding stocks) converge to stock indexes’ long term averages. Again, this can only be achieved if you hold stocks for a long time.
Similarly (but less straightforward), supposedly your strategy is an active (or semi active) ‘tactical’ strategy that might call for some buys and sells monthly (not every month, maybe 2-3 times a year on average), or in an extreme case, your strategy is a ‘day trade’ strategy that actively trades daily. Since we are operating on a highly statistical or random process, you have to consistently perform the strategy (based on a set of pre well defined rules or a program) for a long time to go through large enough number of samples (days for example) to converge to the long term average outcome. So here, you can be a long term ‘investor’ or ‘trader’ as long as you consistently stick to some well-defined strategies, regardless whether you are trading within seconds, minutes, days, months or years. Long term here means one follows a strategy for a long time, not necessarily just buy and hold funds for a long time (which is only one example of ‘long term’).
The point here is that a strategy, by definition, is long term. Otherwise, you are not playing for the average outcome (that can only be attained by going through large samples, in investing, long time periods), you are essentially speculating or gambling within a few instances.
Unfortunately, financial education and media have long ignored the above concept which we consider the key for investors to fully grasp what’s needed to be successful. In fact, even many so called ‘active’ traders and/or investors don’t fully understand this and often falter by changing their ‘strategies’ based on market conditions (or so called ‘mistakes’).
Stocks have staged a fast drop since the CPI inflation number was released two weeks ago. However, we want to alert our readers that they are still only weakened in some orderly fashion. This can be seen that CBOE Volatility Index (VIX), a popular measure of the stock market’s expectation of volatility based on S&P 500 index options:
This index is also called ‘fear’ index. So far, it’s no where near the 40-80 levels reached in a bear market.
As always, even though we express some subjective discussions in the above (and our previous newsletters), we want to emphasize that our investing strategies do not rely on our subjective ‘reads’ on the economy and markets. We will stick to the strategies and respond to market and economic conditions based on their well defined rules as time goes:
- For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or preferably much longer given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
- For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.
Stock valuation has dropped and now valuation is becoming less hostile. However, it is still relatively high by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.
We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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- January 30, 2017: Brokerage Specific Conservative Portfolios
- January 23, 2017: Fixed Income Portfolio Review
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- January 9, 2017: Tactical Asset Allocation Review
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- July 18, 2016: Strategic Asset Allocation & Lazy Portfolio Review
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- June 13, 2016: Managed Futures For Portfolio Building
- June 6, 2016: Newsletter Summary
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- May 23, 2016: AAII Article And Some Web Changes
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- April 25, 2016: Tax Free Municipal Bond Funds & Portfolios
- April 18, 2016: Asset Class Trend Review
- April 11, 2016: Construction of Sound And Conservative Portfolios
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- February 22, 2016: Be Cash Smart
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- February 8, 2016: Newsletter Collection Update
- February 1, 2016: Total Return Bond Fund Portfolios In A Volatile Period
- January 25, 2016: Alternative Portfolios Review
- January 18, 2016: Strategic Asset Allocation: A Cautious Outlook
- January 11, 2016: Review Of Trend Following Tactical Asset Allocation
- January 4, 2016: What Worked And Didn’t In 2015
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- August 17, 2015: ETF or Mutual Fund Based Portfolios
- August 10, 2015: Updated Newsletter Collection
- August 3, 2015: Slippery Asset Trends
- July 27, 2015: Performance Dispersion Among Momentum Based Portfolios
- July 20, 2015: Global Balanced Portfolio Benchmarks
- July 13, 2015: Pain in Tactical Portfolios
- July 6, 2015: Fixed Income Total Return Bond Funds In Strategic Asset Allocation Portfolios
- June 29, 2015: Core ETF Commission Free Portfolios
- June 22, 2015: Secular Asset Trends
- June 15, 2015: Giving Up Bonds?
- June 1, 2015: Summer Blues?
- May 26, 2015: Cash, Bonds and Stocks In A Rising Rate Environment
- May 18, 2015: Portfolio Update
- May 11, 2015: Pain in Fixed Income?
- May 4, 2015: The Balanced Stock and Long Term Treasury Bond Portfolios
- April 27, 2015: Long Term Treasury Bond Behavior
- April 20, 2015: 529 College Savings Plan Rebalance Policy Change
- April 13, 2015: Total Return Bond Funds As Smart Cash
- April 6, 2015: The Low Return Environment
- March 30, 2015: Brokerage Specific Core Mutual Fund Portfolios 2
- March 23, 2015: Investment Arithmetic for Long Term Investments
- March 16, 2015: Brokerage Specific Core Mutual Fund Portfolios
- March 9, 2015: Newsletter Collection Update
- March 2, 2015: Total Return Bond ETFs
- February 23, 2015: Why Is Global Tactical Asset Allocation Not Popular?
- February 16, 2015: Where Are Permanent Portfolios Going?
- February 9, 2015: How Have Asset Allocation Funds Done?
- February 2, 2015: Risk Management Everywhere
- January 26, 2015: Composite Portfolios Review
- January 19, 2015: Fixed Income Investing Review
- January 12, 2015: How Does Trend Following Tactical Asset Allocation Strategy Deliver Returns
- January 5, 2015: When Forecast Fails
- December 22, 2014: Long Term Asset Returns: How Long Is Long?
- December 15, 2014: Beaten Down Assets
- December 8, 2014: Implementing Core Asset Portfolios In a Brokerage
- December 1, 2014: Two Key Issues of Investment Strategies
- November 24, 2014: Holiday Readings
- November 17, 2014: Retirement Spending Portfolios Update
- November 10, 2014: Fixed Income Or Cash
- November 3, 2014: Asset Trend Review
- October 27, 2014: Investment Loss, Mistakes And Market Cycles
- October 20, 2014: Strategic Portfolios With Managed Volatility
- October 13, 2014: Embrace Volatility
- October 6, 2014: Tips For 401k Open Enrollment
- September 29, 2014: What Can We Learn From Bill Gross’ Departure From PIMCO?
- September 22, 2014: Why Total Return Bond Funds?
- September 15, 2014: Equity And Total Return Bond Fund Composite Portfolios
- September 8, 2014: Momentum Based Portfolios Review
- September 1, 2014: Risk & Diversification: Mint.com Interview
- August 25, 2014: Remember Risk
- August 18, 2014: Consistency, The Most Important Edge In Investing: Tactical Case
- August 11, 2014: What To Do In Overvalued Stock Markets
- August 4, 2014: Is This The Peak Or Correction?
- July 28, 2014: Stock Musings
- July 21, 2014: Permanent Portfolios & Four Pillar Foundation Based Framework
- July 14, 2014: Composite Portfolios Review
- July 7, 2014: Portfolio Behavior During Market Corrections
- June 30, 2014: Half Year Brokerage ETF and Mutual Fund Portfolios Review
- June 23, 2014: Newsletter Collection Update
- June 16, 2014: There Are Always Lottery Winners
- June 9, 2014: The Arithmetic of Investment Mistakes
- June 2, 2014: Tips On Portfolio Rebalance
- May 26, 2014: In Praise Of Low Cost Core Asset Class Based Portfolios
- May 19, 2014: Consistency, The Most Important Edge In Investing: Strategic Case
- May 12, 2014: How To Handle An Elevated Overvalued Market
- May 5, 2014: Asset Allocation Funds Review
- April 28, 2014: Now The Economy Backs To The ‘Old Normal’, Should Our Investments Too?
- April 21, 2014: Total Return Bond Investing In The Current Market Environment