Month: February 2018

Hello volatility, our old friend.

By now, you’ve seen the headlines, full of scary-sounding words like rout and storm, plunge and crash.  Whatever you want to call it, investors have certainly endured a rough time over the past few days.  The Dow, dominating the media’s coverage as usual, dropped more than 600 points on February 2, and almost 1,200 points on February 5.¹  That’s a single-day decline of 4.6%, the largest since 2011.¹  The other major indexes were shaky, too.

It’s been quite some time since we’ve seen volatility like this.  The S&P 500 skyrocketed almost 20% in 2017.²  What was even more amazing last year was how calm and consistent the climb was.  Since the election, any declines have been mere blips on the radar screen.

For investors who have grown accustomed to nothing but clear skies and calm seas, all these headlines might seem rather alarming.  But in our experience, once you look at both why and how something works, it seems a lot less ominous.  So let’s examine the why and the how behind this new spate of volatility.

The Search for a Culprit

Pundits often treat volatility like a crime scene.  “Whodunnit?” they want to know.  This leads to a lot of finger pointing at various causes.

If you put all the suspects in a lineup, they would probably stretch out of the room.  So let’s focus on three of the most likely perpetrators.

The first two are all about our own economy.

“Wait a minute,” you’re probably saying, “I thought our economy was doing well.”  And you’re right, it is.  But here’s a truth too many people ignore: The economy and the markets are not the same thing.

Here’s what we mean.  The economy has been growing slowly and steadily for almost a decade.  Unemployment is currently at 4.1%, the lowest it’s been since the turn of the century.³  The labor market continues to add jobs almost every month.  Best of all, there are signs that wages are finally beginning to grow at a faster pace, up 2.9% compared to this time last year.³  This is all welcome news to workers the entire nation over.

For investors, though, this can create a bit of a dilemma.  It might seem paradoxical, but sometimes good news for the economy isn’t always good for the markets.  In this case, so much of the markets’ growth has been due to rising corporate profits.  But a low unemployment rate means that in many industries, there are more jobs available than there are workers.  That forces corporations to pay more to attract and retain talent.  That, in turn, can cut into those aforementioned profits.

Even more important is what a stronger economy means for interest rates.  Ever since the Great Recession, the Federal Reserve has worked to keep interest rates low.  This helped to stimulate more borrowing and spending, which in turn helped the economy keep chugging along.

Only in the last two years has the Fed begun raising interest rates – and their pace can best be described as glacial.  The reason for this is because the Fed didn’t want to raise rates too fast and interrupt a tenuous economic recovery.  But now, renewed economic strength has many believing that higher rates are here again.

When interest rates go up, the cost of borrowing increases.  Companies and individuals both must pay more to take out loans, which can lead to less spending.  Should this happen, economic growth could begin to stall.   Historically, low growth and high rates tend to lead to a dip in the stock market.

Inflation Leaves Its Fingerprints

A related factor is the possibility of higher inflation.

Time for a little Economics 101.  Inflation, to put it simply, is a “sustained increase in the general level of prices for goods and services.”  Put practically, if it costs $1.50 to buy a candy bar when it previously costed only a dollar, you’ve likely got inflation.

Over the last ten years, inflation has remained very low – for many economists, almost mysteriously so, given how low interest rates have been.  But now, there are signs inflation may be on the rise.

One reason for this is because wages are going up.  This is known as cost-push inflation.  When companies pay more in wages, they often raise prices on their goods and services in order to maintain their profit margin.  As we’ve already covered, a sustained rise in prices is the very definition of inflation.

One of the tools the Fed uses to control inflation is higher interest rates.  Because higher rates reduce borrowing, the supply of money circulating throughout the economy goes down.  This, in turn, can lead to less spending on goods and services, thereby prompting corporations to lower their prices.

In short, if inflation goes up, interest rates will likely go up – and we’ve already discussed what higher interest rates could mean for the markets.

Whew!  Got all that?  Good, because there’s a caveat.

Back in December, Congress passed the largest tax reform in thirty years.  A major part of that reform was a massive tax cut for businesses.  Generally, when businesses pay less in taxes, they don’t raise their prices.  But when they pay more in wages, they often do raise prices.

The question, then, is what will most corporations do with their tax cut?  Will they use a big chunk of it to pay their workers more?  If so, we may well see inflation go up.  On the other hand, if corporations use their windfall on things like expansion and new technology, inflation may well stay steady.

Now, if you squint, you’ll probably see something important buried under all this: The recent volatility isn’t because interest rates have skyrocketed, or because inflation has gone up.

It’s because they might go up.

“So what you’re saying, is that this volatility isn’t about what has happened, but about what could happen?”

Yes, that’s exactly what we’re saying.  Welcome to the markets, where almost everything is based on future expectations rather than present realities.  Which leads us to the final, and perhaps most important culprit:

The Butler Did It

Just kidding.

Volatility Has Returned Partly Because Investors Expected It to Return

For months now, analysts have been wondering how high is up.

“When will stock prices hit the ceiling?” they’ve been asking.  “Aren’t stocks going up too high, and too quickly?  When will a new market correction occur?  Aren’t we overdue?”

You see, volatility is inevitable.  Not just in the markets, but in life.  It’s normal.  Far more normal, in fact, than what we saw last year.  And because so many investors kept wondering when it would return, the moment new concerns arise – of inflation, higher interest rates, how to price in the new tax law, etc. – it’s easy to think, “This is it!  The correction is starting.”

Remember, daily swings in the markets are usually driven by expectation and momentum.  When some investors start to buy, a lot of investors often start to buy.  And the same is true when investors start to sell.

So What Should We Do Now? 

Quick story before we answer that.

Back in 1994, a 6.7-magnitude earthquake struck Los Angeles around 4:30am, knocking out power all over the city.

But not all the lights went out.  For the first time in over a century, people looked up and saw thousands of twinkling objects in the sky…and a great, milky band stretching from horizon to horizon.

Then the 911 calls started.

“What is that?” people asked, worried. “Did the earthquake cause it?”

Of course, you can guess what it was: The Milky Way.  For those who had spent their entire lives in the glow of the city, it was something new, something unexpected, something just a little bit scary.  But in truth, it was there all along.  People just couldn’t see it.

Market volatility is similar, in a way.  The factors that can cause volatility are always with us.  Sometimes they’re just hidden.

So what should we do now?

The answer is, not overreact to something just because it’s been awhile since we’ve seen it. 

It’s quite possible that this is just a brief blip.  As of this writing, the markets have already rebounded slightly.  They may continue to do so, and stock prices could continue to go up throughout the year.  Remember, the economy is strong, corporate profits are high, and taxes are low.  The ingredients are there for continued growth.  It wouldn’t be a surprise.

On the other hand, investors may continue to feel jittery.  Inflation could rise, and with it, interest rates.  This may be the start of a larger pullback or correction.

That also wouldn’t be a surprise.

Currently, we are still in the second longest bull market in history, but nothing lasts forever.  Since we can’t control what corporations will do, or what the Fed will do, or what the markets will do, we’ll do what we’ve always done: focus on what we can control.  We’ll stick to our long-term investment strategy, and not react to market volatility as if a crime has been committed.

In the meantime, please know that our team is here for you if you have any questions or concerns.  We’ll continue monitoring both the markets and the economy.  If changing conditions require changes to our strategy, we’ll let you know immediately.

As always, thank you for the continued trust you place in us.  We appreciate you and your business.  Have a great day!

Sources

¹ “The Stock Market Selloff by the Numbers,” The Wall Street Journal, February 5, 2018.  https://blogs.wsj.com/moneybeat/2018/02/05/the-stock-market-selloff-by-the-numbers/?mod=wsjan

² Ryan Vlastelica, “Stocks end otherwise stellar 2017 on a down note,” Market Watch, December 29, 2017.  https://www.marketwatch.com/story/dow-sp-set-to-power-to-fresh-record-on-2017s-last-trading-day-2017-12-29

³ Patrick Gillespie, “America gets a raise: Wage growth fastest since 2009,” CNN Money, February 2, 2018.  http://money.cnn.com/2018/02/02/news/economy/january-jobs-report-2018/index.html?iid=EL

For centuries, people have studied Shakespeare for his wit and his wisdom.  For the past few months, we’ve been sharing some of that wisdom in a series of articles called:

Shakespeare on Finance

Shakespeare never actually wrote about finance, of course.  But as we’ve seen, many of his most memorable lines contain important financial lessons.  This month, we’re going to end this series with a quote from perhaps the Bard’s greatest play of all: Hamlet.

Quote #6:

“This above all – to thine own self be true.”

Hamlet

On the surface, this might not seem to have anything to do with finances – but it does.  You see, as you work toward your financial goals, you may often be tempted – or even advised – to do or want things that aren’t true to your own goals, values, and character.

For example, it’s not uncommon for people to spend money on flashy purchases they don’t really need or want, like a boat, a sports car, or a bigger house, just for the status it brings, or because their friends and neighbors have done it.

It’s not uncommon for people to take risks with their investments which they’re not really comfortable doing, just to follow the crowd or because some loud TV pundit told them to.

It’s not uncommon for people to give up on the goals they’ve set for themselves because someone else convinced them it would be impossible.

In short, it’s not uncommon for people to wander off the path that leads to their dreams, all because they were trying to make someone else happy instead of themselves.

This may seem so elementary that it goes without saying.  But in all our years as financial advisors, it’s a mistake we’ve seen happen time and time again.  It’s why one of the most important financial lessons of all can be summed up in six monosyllabic words: to thine own self be true. 

To put it simply, you get to decide what your goals are – no one else.  You get to decide what you want to accomplish and what you want to protect.  You get to decide your personal investment style.  You get to decide what you do with your money.  You are in control of your own financial future.

There may be many people in this world that you care about, people who factor into your financial decisions.  But when it comes to setting the destination of your financial journey, the only person who matters is you.

So, whenever you make financial decisions, remember this above all:

To thine own self be true. 

We hope you’ve enjoyed reading these “Shakespeare on Finance” articles as much as we’ve enjoyed sharing them.  So, as we prepare to exit stage right, we’ll leave you with all six quotes listed together:

“Better three hours too soon than a minute too late.”

“Go wisely and slowly.  Those who rush, stumble and fall.”

“How far that little candle throws his beams!”

“Foul-cankering rust the hidden treasure frets, but gold that’s put to use more gold begets.”

“How poor are they that have not patience!  What wound did ever heal but by degrees?”

“This above all – to thine own self be true.”

The Bard once said that “all the world’s a stage.”  We firmly believe that if you apply a little Shakespearean wisdom to your finances, you can make your performance a great one.

Balancing the economy between hyperinflation and recession may sound like dangerous work, but it is the current responsibility of our Federal Reserve. The Federal Reserve (“Fed”) is the central bank of the United States, the national bank, so to speak. The Fed’s job is to keep the U.S.’s economy somewhere between growing too fast and not growing at all. To do this, they increase or decrease the money supply (they print or shred money, literally).

As short-term interest rates continue to increase, it is important to understand the effects of increasing interest rates and to understand a very important definition: the bond curve. This article will dive into the effects of interest rates and how they may even be used to predict a recession.

Suppose you have $1,000 in a Certificate of Deposit (“CD”) with a bank offering 1% interest rate. After one year of holding that CD, $10 of interest would have been earned. However, most of you know that by investing in a 3-year CD instead, you may be able to earn a higher interest rate, for example, 2%. A higher interest rate is usually given to longer-term bonds or CD’s because of two very important reasons: 1) Investors require more profit in exchange for locking in their money for longer periods of time and 2) The future is expected to be better off than the present.

The latter point is why capitalism works, why we have inflation, and why you would take $1,000 today rather than taking $1,000 one year from today. Over time, money tends to grow upwards and, hence, the future is usually expected to be worth more than the present. When this is not the case, then there are more serious worries about the economy. Let me expand.

The 10-Year Treasury Bond is debt that the U.S. sells and that almost anyone can buy. The term length is 10 years and it has an interest rate of 2.7%. The 3-Month Treasury Bill is also a type of debt that the U.S. sells; it’s term length is 3 months and its interest rate is 1.5%. The bond curve is the difference between the 10-Year and the 3-Month Treasury debt, so it is currently 1.2% (2.7% minus 1.5%). See the attached chart.  As the Bond Curve approaches 0%, the future becomes less optimistic than the present. This is dangerous grounds, as the Bond Curve has predicted a recession in the United States nearly every time since the early 1960s.

As you may have heard in the news, the Federal Reserve is increasing the interest rate of the 3-Month Treasury Bill. If you’re looking at the previous paragraph and now wondering why the Fed would increase the 1.5% short-term bond, and thus decreasing the bond curve, see next sentence. Decreasing interest rates can be used as “steam release” during an economic slowdown. Corporations always have the option to either save their money or spend it. Decreasing interest rates during an economic slowdown will decrease the amount of money corporations save (because who wants to save at 0% interest rate?). This leads to an increase in corporate spending and thereby spurring the economy. If short-term interest rates are already near 0%, and an economic slowdown occurred, there would be no “steam release” to use. Furthermore, if inflation becomes too high, increasing short-term interest rates is an important method to steady the economy. Therein lies the choice: letting the economy overheat too much and letting inflation get out of hand, or, letting the economy flounder. This is the dance of the Federal Reserve to keep the economy somewhere in the middle.

However, as evidence from the graph below, we have been headed towards zero bond curve since we left the last recession. Now is the time to realize the music could stop and that the market could leave us standing with no chair to sit on. With the stock market at near all-time highs, now may not be the time to sit down, but you should at least know where your chair is.