Investing

Cubs, Trump, Dow industrials all beat the odds. December forecast: Pigs fly?

Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group. He writes about investing for IowaBiz.com

Like many Americans, I keep looking out my window for pigs with wings ... the euphemism “when pigs fly” having been recently invoked for:

  1. The Chicago Cubs winning the World Series after a 108-year drought, finding themselves down three games to one to the Cleveland Indians on Oct. 30 (15% probability*).
  2. Donald Trump winning the United States presidential election after an aggregated index of national polls gave him less than a 3-in-10 chance to win on Nov. 8 (28.6% probability*).
  3. U.S. stock market indices reaching all-time highs within 24 hours of Nov. 8's unexpected election results, given the plummeting futures markets as election returns were tallied in the early morning hours of Nov. 9. (Dow futures down over 5% at 1:30 a.m. EST 11/9/2016.+)

For each of these three outcomes, the odds against them occurring were very long. In other words, those professions specializing in making predictions (bookies, pollsters, certain hedge funds) ended up being wrong in historically significant ways.

In the days leading up to the recent election, I had the opportunity to speak with a number of audiences and investors about what (if anything) the coming election meant for financial markets and portfolios. As tempting as it was to make a prediction, after 22 years of observing investment market behavior as a “professional,” I resisted, knowing that the odds of making anything like a correct prediction were no better than 50-50.  

Sports fans, political observers and many investors can’t seem to help themselves when it comes to the temptation of making predictions. We watch the news, talk with friends and colleagues, read the pundits, editorials and analysis, and we believe that we can “see the writing on the wall.” While it’s fun to do this with our sports loyalties, it’s potentially disastrous to act on our predictions when it comes to portfolios.

There were professional and institutional investors on the wrong side of that 5% fall in the value of Dow futures. They were predicting a very negative impact on U.S. stocks as a result of the surprising election outcome. However, as U.S. markets began the trading day Wednesday morning following the election, the Dow Jones industrials index opened down a minuscule 0.08% and closed the day up 1.4% at a new record high+. Taking investment actions in line with those negative predictions in the early hours proved very costly.

In a recent white paper on the benefits of diversification, researcher Wei Dai, Ph.D., finds that under many conditions diversification not only reduces volatility, but, “For all investment horizons, there was a substantial increase in the reliability of outperformance as the portfolios become more diversified.”++ Dai was researching U.S. stock portfolio strategies formed around varying degrees of overweighting to value and smaller company stocks and how taking a more or less diversified approach affected results.

For investors who are thinking about how to position their portfolios for higher probabilities of outperformance, Dai’s conclusion supports the idea that consistent diversification over longer time periods is a more reliable strategy for both reducing risk and enhancing return than acting on short-term predictive models using timing models and smaller numbers of stocks.

* Both according to FiveThirtyEight.com a leading statistical modeling website for sports, politics and economics.

+ Wall Street Journal, Nov. 9, 2016

++ "How Diversification Affects the Reliability of Outcomes," Wei Dai, Ph.D., Dimensional Fund Advisors LP

PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/disclosures. The above discussion should be viewed in its entirety. The use of any portion thereof without reference to the remainder could result in a loss of context. Foster Group cannot be responsible for any resulting discrepancy. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.

Vote with your ballot, not your portfolio

Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group. He writes about investing for IowaBiz.com

U.S. citizens have the privilege and responsibility of voting at polling stations on Nov. 8, or earlier via absentee ballots or early voting sites, for a variety of national, state and local officials and policy proposals. The collective will of the majority of voters will be reflected in who occupies the White House, the balance of power in Congress, as well as in state capitols, legislatures and more. The complexity of government in the U.S. can be frustrating at times, but as Winston Churchill said, “Democracy is the worst form of government, except for all the others.”

For investors, the run-up to the election always raises questions like, “What is going to happen to my investments if so-and-so wins (or loses)?” The implication is, “What should I do to protect myself from a bad electoral outcome?” A dangerous assumption in this line of thinking is the idea that a single signal or factor (e.g., who wins an election) is a direct and significant cause of stock market performance and people can position investment portfolios to take advantage of the expected outcome.

There is always so-called “evidence” presented that one outcome will be better than the other. Right now, the question du jour is which presidential candidate would be better for the stock market? Or, maybe more broadly, which political party would be better for investors?

In terms of which party’s presidents have enjoyed times of better stock market returns, (as measured by the S&P 500 stock index), since 1926 the numbers appear to heavily favor the Democratic office holder. The average yearly return for the 47 calendar years a Democrat occupied the White House was 15 percent through year-end 2015. The 43 Republican years averaged 8.6 percent. However, when a Democrat served as president alongside a Republican-controlled House and Senate (nine calendar years), the average return rises to 16.3 percent. If you compare total control years (one party controls president, House and Senate), Republicans (11 years) have the edge, 15.57 percent, over the Democrats at 14.52 percent (34 years). You can see where this is going; a creative politician can find what appears to be “evidence” for having Republicans or Democrats in control. It depends on how you measure “control.” *

Statistically, we have 90 years of data (90 calendar year data points), an extremely small sample from which to draw any conclusions. In a recent analysis by Dimensional Fund Advisors, they found when measuring monthly returns since 1926, those months in which presidential elections were held had returns (both positive and negative) that were “well within the typical range of returns regardless of which party won.” In other words, it didn’t make any difference.

In the book "Thinking Fast and Slow," Nobel Prize-winning economist and psychologist Daniel Kahneman uses the acronym “WYSIATI” to describe a common thinking error that applies to our discussion. The acronym stands for “What you see is all there is.” In the case of whether a Democrat or Republican in the White House would be better for the stock market, an investor is focusing on one signal, or data point, as though it is the primary predictive influence. What you see (“Who occupies the White House”) is all there is. In reality, as we all know, the complexity of factors influencing stock market performance is myriad. By introducing one other data point, total control of the executive and legislative branch, we get a different result. So, which one is “right” or most predictive? There is no way of knowing with any statistical certainty.

While the idea of predicting stock market performance based on a single signal is a popular diversion for the media and conversation, investors always gain the most benefit when they structure their portfolios for long-term success based on their personal financial goals, rather than who they plan to vote for in November.

*Source data from Morningstar Direct SM and www.infoplease.com

PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/disclosures. The above discussion should be viewed in its entirety. The use of any portion thereof without reference to the remainder could result in a loss of context. Foster Group cannot be responsible for any resulting discrepancy. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.

Why you (still) want international stocks

- Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group. He writes about investing for IowaBiz.com

Suppose I offered you a choice between two broadly diversified, similarly volatile, well-known investments. Investment A had increased in value 23.8 percent over the past 10 years, while Investment B had grown 78.62 percent during the same time period. If that was all the information you had available, wouldn’t you be thinking Investment B sounds like the better deal?

This is the classic “past performance is no guarantee of future results” dilemma. We’ve read this kind of scenario so many times that we are just waiting to hear that the actual results over the next five years were just the reverse, and in this case they were. Investment A grew by 77.64 percent, while Investment B increased by only 7.78 percent. 

So what were (and are) the investment options? Investment A is a broad index of most U.S. stocks. Investment B is a very broad index of most non-U.S. stocks. The time periods? The first, 10-year, window was from 2001 through 2010. The second, five-year, time period was from 2011 through 2015.

What’s an investor in 2016 to do?

There are at least three good reasons for an investor to strongly consider including international stocks in their portfolio today: global opportunity, the relative lower prices of international stocks versus their U.S. counterparts, and broader diversification of risk.

Global Opportunity

As of the end of July, the value of all publicly traded companies worldwide totaled a little over $40.5 trillion, spread over 12,588 companies. Companies headquartered in the United States represented slightly over 53 percent of that total value.* For stock market investors, this means that approximately 47 percent of the opportunity for investment in publicly traded companies is located outside the United States, in places as diverse as the United Kingdom, China, Brazil, Nigeria and Turkey, just to name a few. History indicates while not all will, there is a high likelihood some of these companies, and their country’s broad equity market, will succeed, potentially with higher returns than their U.S. counterparts.     

Stocks on Sale?

In today’s global financial environment, investment capital moves very freely across borders and between exchanges as technology links the entire world in a virtual real-time exchange of information and capital flows. This results in (among other things) stock prices that reflect the most current pooled information and expectations regarding risk and return for virtually every company in the world today. Professional investors from the most sophisticated institutions trade these stocks with each other every day in an attempt to add value to their portfolios. There must be an agreement on price that is deemed to be fair to both the buyer and the seller before any transaction is completed.

For companies (and countries) where the perceived risks are higher, buyers demand lower prices. These lower prices represent a demand for higher potential return on investment as compensation for taking on this risk of ownership.

One interesting measure used to gauge how expensive (or how cheap) a company’s stock price may be is the price-to-book (P/B) ratio. This ratio illustrates how much investors are willing to pay (price) for the underlying value (book) of a company. As of July 30, 2016, aggregate price-to-book ratios for non-U.S. stocks averaged 1.48, while price-to-book ratios for U.S. companies came in at 2.31.* This indicates global investors were demanding an approximate 36 percent discount in price to entice them to own the book value of non-U.S. companies. Investors sense many non-U.S. companies are operating in riskier financial and political environments and are, therefore, only willing to buy the shares of these companies at relative discounts (i.e., “on sale”). International investors are basically buying more book value per dollar than they can with U.S. stocks.

Diversification of Risk

Dimensional Fund Advisors LP prepares a Global Markets Overview at the end of each month. At the end of July, 2016, their overview identified 12,588 publicly traded companies with shares available to private investors. Just over 3,500 U.S. companies offered shares, while over 9,000 foreign companies offered shares. For investors wanting to spread their risk among a wide variety of competitively priced investments in economic and politically diverse markets, these numbers represent opportunity for risk management.

While there is never any guarantee regarding which investments will do well and when that may happen, there are reasonable steps investors can take, based on readily available information, to put themselves in a diversified, opportunistic position. Precisely what percentage of an investor’s portfolio should be devoted to international stocks (or U.S. stocks, for that matter) will vary and should be considered in view of an investor’s overall risk, return and liquidity preferences.

*Data from Dimensional Fund Advisors LP.

PLEASE NOTE LIMITATIONS: Please see important disclosure information and the limitations of any ranking/recognitions at www.fostergrp.com/disclosures. The above discussion should be viewed in its entirety. The use of any portion thereof without reference to the remainder could result in a loss of context. Foster Group cannot be responsible for any resulting discrepancy. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.

Investors should care about fiduciary standard

- Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group. He writes about investing for IowaBiz.com

Here’s why we care about a fiduciary standard and why all investors should as well. When receiving financial advice would you rather have a financial advisor guide you in way that is always in your best interest or something less?

The Department of Labor recently published a rule requiring financial professionals and companies who provide investment services to retirement plans to operate according to a fiduciary, or, in common language, a “best interest standard.” Why is this standard important to investors? Here’s an excerpt from the fact sheet issued by the DOL.

A White House Council of Economic Advisers analysis found that (these) conflicts of interest result in annual losses of about 1 percentage point for affected investors—or about $17 billion per year in total. To demonstrate how small differences can add up: A 1 percentage point lower return could reduce your savings by more than a quarter over 35 years. In other words, instead of a $10,000 retirement investment growing to more than $38,000 over that period after adjusting for inflation, it would be just over $27,500.

The point of the rule is to simply require financial advisors to act in the investor’s best interest and to disclose any and all compensation arrangements that may benefit the advisor (rather than the investor) in recommending one investment over another. It does not mean an advisor cannot receive reasonable compensation for their work.

The response to this rule has been varied, with a number of investment providers, lobbying groups and some politicians coming out against it, in its current form. While the implementation of the rule may need some clarification and/or modification, the goal should be embraced by industry and investors alike. All parties, investors, advisors and financial service companies will benefit by making this rule and standard easily understood and implemented.

So how would investors know today if their advisors are already operating according to this fiduciary, or “best interest” standard? Here are three standards provided by the DOL to certify compliance. The financial advisor and/or financial services firm should:

1. State in writing their firm commits to providing advice in the client’s best interest at all times.
2. State in writing their firm has adopted policies and procedures designed to mitigate conflicts of interest.
3. Clearly and prominently disclose any conflicts of interest, like hidden fees, and backdoor payments that might prevent (or provide a disincentive to) the advisor from providing advice in the client’s best interest.

While this rule currently applies to retirement plans only (e.g., Profit-sharing plans, 401(k), 403(b)), investors would be well-served to make certain all their financial advisors are operating according to this fiduciary, or best interest, standard. There will be many reasons offered by those who would rather not operate according to a fiduciary standard. When you hear this, just remember to go back to the main issue; would you rather have an advisor guide you in a way that is in your best interest or something less?

 

PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/disclosures. The above discussion should be viewed in its entirety. The use of any portion thereof without reference to the remainder could result in a loss of context. Foster Group cannot be responsible for any resulting discrepancy. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.

 

 

Brexit and global financial market response

- Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group. He writes about investing for IowaBiz.com

“It’s tough to make predictions, especially about the future.” Yogi Berra

A Yogi Berra quote may seem a bit too lighthearted as an opening thought regarding the momentous “Brexit Leave” vote and the immediate reactions, financially and politically, around the world. Though the quote is humorous, the point is an important one for investors to consider. Reliably predicting future events has been hard to impossible in the past, and there is no evidence that it is getting any easier. Just ask the bookmakers in the UK who were offering very favorable odds of a “Remain” vote just 24 hours prior to the actual vote tally.

International stock markets virtually all declined following Thursday’s vote, some more severely than others. However, these declines came on the heels of some significant gains as many traders were predicting the UK would vote “Remain,” even as polling data showed a statistical dead heat between the “Remain” and “Leave” options. On Monday, June 20, the FTSE 100 Index of British Stocks opened at 6126.27. On Friday, June 24 at close (the day after the vote), the same stock market index was at 6138.691. Actually higher than where it began the week before! Other global markets showed heightened volatility for the week, with declines on Friday and Monday reflecting the general uncertainty about “Brexit’s” longer-term effects on markets and economies.

Jason Zweig, writing in his Wall Street Journal column on Friday, reminded investors of the counter-intuitive nature of stock market returns and economic news over time:

“…investors should remember that there is a perverse correlation between economic growth and stock-market returns. Research by Prof. Dimson and his colleagues Paul Marsh and Mike Staunton of London Business School has shown that, in the long run, countries with the fastest economic growth tend to have the lowest stock-market returns, and vice versa.”

That’s because investors overpay for optimism and underpay for the value that pessimism creates.

“Just uttering the words ‘When will this pay off?’ should tell you that it will, and fairly soon,” says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn. “You don’t get bargain prices anywhere without the presence of really bad news.”

It’s important to remember, in general, financial markets do not respond positively to uncertainty or surprise. Ben Casselman, the website FiveThirtyEight’s chief economics writer, had this to say (among other things) in his Friday post, “How to Make Sense of the Brexit Turmoil”:

“Ignore the initial market reaction: The initial reaction will tell us next to nothing about the longer-run impact a Brexit will have on markets or the broader economy. Market turmoil was probably inevitable after a decision this momentous, and it will be made worse by the fact that the outcome was a surprise: Despite polls showing a close race, most investors expected the “Remain” side to prevail in the end. … Most ordinary investors are probably best off logging out of their E-Trade accounts and tossing out their 401(k) statements, at least for a couple of weeks.”

As a practical matter, Foster Group continues to advise investors to maintain a clarity of purpose around their overall portfolio. For anyone in retirement, or needing dollars from their portfolio in the next five years, these anticipated cash flows should already be invested in short-term, high-quality bonds (e.g., Short-term US Treasuries and high-grade one- and two-year corporates). These short-term reserves may actually experience some gains in the near-term as global investors, in a “flight to quality”, seek to own more US government bonds and high-quality issues. Friday, June 24 saw the price of the 10-year US Treasury rise by more than 1.5 percent1 on this increased demand.

For the longer-term growth component of portfolios, a broadly diversified allocation to global stocks, bonds, and real estate offers a much higher probability of success (growth well above future rates of inflation) than trying to predict which specific asset classes or regional stock markets may do better or worse in the coming months.

Peter Westaway, Ph.D., chief economist and head of the Investment Strategy Group for Vanguard Asset Management, Limited, Vanguard’s European entity, wrote this following the Brexit outcome:

“Of course, Vanguard discourages market-timing moves, and by now, much of this effect is already priced into asset values…Given that it may take several years for the specifics of Brexit to play out, and markets may be rattled as plans take shape, investors' best protection is to hold a portfolio that is diversified across asset classes and regions.”

It is always disconcerting to watch financial markets and portfolio values fall so quickly. We only need think back to January and February of 2016, as global stock markets declined in many cases more than 10 percent before recovering and moving into positive territory for the year. The often tough thing to do during these events is to remember that careful planning and portfolio building done in calmer days was designed to enable you to weather, and ultimately thrive, despite surprisingly unpredictable events.

  1. Index and return data as published in the Wall Street Journal Online Edition, June 24, 2016

PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/disclosures. The above discussion should be viewed in its entirety. The use of any portion thereof without reference to the remainder could result in a loss of context. Foster Group cannot be responsible for any resulting discrepancy. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.

French 50-year bonds? Puerto Rican debt? Dangers of reaching for higher yields

- Kent Kramer, CFP, AIF, is chief investment officer/lead adviser at Foster Group.

In mid-May, a quick review of the Wall Street Journal revealed the average yield on a five-year CD was 1.26% and the 10-year U.S. Treasury note was yielding 1.85%.

These low rates can lead investors to seek higher returns in other places. Two especially popular ones are longer-term bonds and high-yield bonds. While there may be a place for these in your portfolio, the age-old warning “caveat emptor,” or buyer beware, bears repeating, and here’s why.

As investors, we all want higher returns, but we also want less risk. How you balance your pursuit of these preferences will go a long way toward achieving your unique definition of a successful investing experience.

If the purpose of bonds in your portfolio is primarily to provide stability and reduce risk, then high-quality, short-term bonds make the most sense. However, as mentioned above, currently these bonds provide small returns. There are other kinds of bonds with higher current interest rates, including very long-term bonds and lower quality, “high-yield” (aka “junk”) bonds. Both are also higher risk in terms of potential price variation prior to maturity.

Bond prices move in the opposite direction of interest rates. So if the Federal Reserve does influence a rise in interest rates (someday!), the price of an investor’s bonds, all other things being equal, will decline. The longer term the bond, the greater the price variation. A graphic in the Wall Street Journal on May 19, 2016, illustrated the potential price declines of high-quality government bonds of differing maturities.

The graphic reveals how a 1% increase in interest rates causes the price of a U.S. 10-year Treasury bond to decline by 9%, while the price of a French 50-year bond would decline by 27%. The effective annual yield of the French 50-year bond is currently under 3.25%. Is an additional 1.25% in current yield worth the increased risk of an 18% price decline (or more if rates rise by more than 1%) in the next 10 to 20 years?

Bond investors also reach for higher yield by purchasing lower quality bonds. Bond buyers set the actual market price and yields on bonds with similar maturity dates according to credit quality (the likelihood the issuer will make interest payments and repay in full on time). The higher the probability of default or late or restructured payments, the higher the interest rate demanded by bond buyers.

While investors may get a higher initial interest payment, the risk of these lower quality bonds, the expected total yield to maturity, is never fully realized. This would be the case if the bond defaults or pays later and/or in lower amounts. Puerto Rican bonds provide a current example of how this can happen.

In 2012, interest rates (yields) on Puerto Rican debt was about two percentage points higher than highly rated municipal bonds of similar maturity. Not only were the yields higher than bonds of similar maturity, but the interest paid by these bonds was, and is, exempt from federal, state and local income taxes, making them very attractive. Bond investors, some of whom thought bonds were inherently “safer” than stocks, took the higher yields offered by the Puerto Rican bonds even though the credit quality was lower.

Since that time, Puerto Rico has defaulted and will likely continue to restructure its payments. This has caused the price of some bonds to fall from par, or face value, of $10,000, to less than $7,000 (a 30% decline). Bonds with longer maturities have seen their prices fall even further.

The lesson for investors is that there really is still no such thing as a free lunch. Investments that offer or advertise higher returns invariably involve higher risk, whether they are stocks or bonds.

As an investor, you need to know what purpose you have for the bonds in your portfolio. If it is stability and the preservation of assets, then shorter term, higher quality bonds, CDs and cash are for you. If you are willing to accept more risk, longer-term, lower quality bonds may be attractive, but our view is as risk increases, a diversified stock portfolio may be the better investment for this portion of your portfolio.

PLEASE NOTE LIMITATIONS: Please see important disclosure information and the limitations of any ranking/recognitions, at www.fostergrp.com/disclosures. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov

 

 

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