This past December, stock prices fell -14%, bottoming out on 12/24/18 with a one-day loss of -2.7%. Watching your investments decline close to 15% in 16 days is scary, disconcerting and discouraging. With an aging bull market and increasing volatility, why stay invested?

In order to add value by market timing (owning more stocks in good times and selling stocks when the outlook is gloomy), one needs to anticipate market’s ups and downs. Every year, well respected market professionals try to forecast the annual return for the S&P 500 index. Below, we’ve compared the expert’s average annual return expectation versus the actual market returns over time.

As the chart demonstrates, analysts’ expected returns (blue bars) are a poor predictor of actual returns (orange bars). Expectations tend to group around long-term average and fail to predict market dips. In many years, expectations were wildly wrong.

Why can’t investors predict when the market is going to fall? Because market returns are driven by humans behavior which is inherently unpredictable. Predicting market returns is a fool’s errand.

Investors’ behavior during the Great Recession

Since 1990, the S&P 500 index has returned an average of 9.3% per year. Unfortunately, most investors did not achieve these results. According to studies , the main culprit for underperformance is investor behavior, primarily moving in herds and a fear of losses.

The Great Recession of 2008 is a great example of extreme disruption in markets and of widespread fear and anxiety. Recall how bad it was: bond markets collapsed, many brokerage firms went bankrupt, mortgage markets stopped trading and the U.S. Government had to step in to support markets and financial institutions on a scale not seen since 1930’s. Stock prices fell -37% in 2008 and another -24% through 3/9/09! Many investors, driven by a fear of greater losses, simply sold stocks to protect capital and, at the time, this felt reasonable. Unfortunately, this selling begat more selling which exacerbated and extended the downturn.

Investors often fail to achieve average market returns because they typically sell stocks near the bottom of market downturns in an attempt to avoid further losses. Unfortunately, this selling stocks during times of panic, turns a temporary loss into a permanent one. After hitting bottom on 3/9/2009, stocks rallied 66% as investors worst fears failed to materialize, and closed the year up +26%.

The panic around the Great Recession demonstrates investors’ tendency to act irrationally and overact to news. While predicting economic variables like inflation, GDP growth and earnings growth is difficult enough, anticipating investor response is pure speculation. To accurately and consistently predict future market returns forecasters need to accurately and consistently predict investors’ emotional and sometimes irrational responses to unknowable future news and events.

Daily returns matter

Adding to the unpredictability of stock markets is the speed at which prices fluctuate and adjust to new information. In periods of high volatility, daily price changes are sizable and can dramatically alter investor returns over time. The below chart demonstrates that over the last 15 years, if an investor missed the best 5 days of returns their returns were lower by almost 40%!

Attempting to time the market is made even more difficult by close proximity of the best and worst days in the market. Often trading around those days can be nearly impossible. (See prior Perspective: Predicting the stock market is a bad idea) The sharp bounce off the recent lows of late December through the end of January (+12.1% from 12/24) seems to reinforce this idea.

Time cures volatility

History has shown that for investors who remain invested over a market cycle, volatility is smoothed over time. In fact, the longer one remains invested the lower the likelihood of principal loss.

For investors with a one year horizon, returns can vary greatly from -43.3% to +53.6%. However, for investors with a 10-year horizon, the range of annualized returns shrinks to -3.4% to +19.5%, closer to the nearly three decade average of 9.3%. Staying invested for the long term is the best way to survive market dislocations similar to the Great Recession or the volatility seen this past December.

Asset allocation smoothes the ride

Another weapon investors can use against market volatility is diversification. During periods when stock markets fall, safer assets like quality bonds tend to outperform. (See perspective: Quality Bonds: an Underappreciated Role in Portfolios) The fourth quarter of 2018 is a great example of the benefits of diversification. During this period, the S&P 500 Index fell -13.5% and U.S. bonds rose 1.64%. While quality bonds do not boast high yields and high returns, they do tend to rise when investors panic and offer solid diversification benefits to portfolios.

For investors who are concerned with portfolio volatility, a diversified portfolio reduces overall risk and helps smooth markets ups and downs. In the following chart, we compare annualized returns (blue bar) and risk (orange bar) for selected investments back to 2004. The red diamond plots the risk-adjusted return, where a higher number indicates greater returns for each unit of risk. The portfolio on the far left is an “Asset Allocation” portfolio comprised of 25% bonds and 75% U.S. and international stocks. This portfolio has returns similar to those of other asset classes (in blue), but the risk is much lower as measured by the orange bar. Similarly, the red diamond which measures the return per risk, indicates that the “Asset Allocation” portfolio generates higher risk-adjusted returns through diversification than any of the other assets.

The well-known pitfalls of market timing show the importance of building diversified portfolios that help clients remain invested and confident throughout market downturns. Thoughtful financial planning incorporates future volatility and the potential for market weakness and can help support investors through more turbulent periods within investment markets. We understand that market volatility is unsettling and can make clients nervous, but we want to avoid emotional reactionary errors that turn a temporary loss into a permanent one. In market downturns, it is important to focus on the long term and those parts of the portfolio that are providing diversification. This focus is critical for clients to achieve their financial goals and investment success.

Note: All charts are sourced from Bloomberg

Note regarding last chart: “Asset Allocation” is comprised of 25% Barclays U.S. Bond Aggregate Index, 50% S&P 500 Index, 15% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 2.5% Dow Jones U.S. Select REIT Index and 2.5% Alerian MLP Index

In 1934 Congress passed the Reciprocal Tariff Act which essentially ceded to the President authority to negotiate tariffs with other countries. This bill was passed as the U.S. was exiting the Great Depression and Congress looked to reverse the disastrous Smoot-Hawley Tariff bill of 1930. (Further background on the Smoot-Hawley bill can be found in an earlier write-up here.) When drafting the Smoot-Hawley Tariff bill, the scope and size of the bill increased dramatically as many Congressmen added provisions to protect businesses in their home states. By passing the Reciprocal Tariff Act of 1934, Congress essentially acknowledged they were not capable of containing special interests and empowered the President with authority over tariffs.
President Trump has wielded these trade powers in a new and unpredictable manner. Investors are concerned that a trade war could bring higher inflation and a global economic slowdown. The trade issues began in March when President Trump announced tariffs on steel and aluminum imports with some countries like Mexico and Canada being exempted. The tariffs affected approximately $40 billion in imported goods. The Federal Reserve of Dallas estimates these tariffs could lower U.S. GDP by an inconsequential 0.24% as steel and aluminum imports account for a relatively small piece of the U.S. economy. Continue reading →

On March 1st, 2018 President Trump announced his intention to impose significant tariffs on steel and aluminum imports. The announcement sent stock and bond prices falling, stoking fears of higher prices and slower economic growth. Protecting domestic industries like steel and aluminum may have raw appeal, but tariffs are flawed in theory and have a history of hurting economic growth. History shows a link between tariffs and populism which last flourished in the 1930’s. President Trump’s proposed tariffs threaten the post WWII global trade order and stock and bond markets are now paying attention.
Tariffs are bad policy

Basic economics instructs that tariffs benefit a select few producers and harm consumers through higher prices as they reduce competition and allow less efficient producers to continue to operate. In 1776, Adam Smith wrote of comparative advantage stating that countries should focus on their low cost production and trade for goods where their costs of production are relatively high. In general, society benefits from trade as wealth rises everywhere.

Tariffs have a consistent history of reducing economic activity and hurting growth[note]https://www.cato.org/publications/commentary/truth-about-trade-history[/note]. The clearest example is the infamous Smoot Hawley Tariff Act of 1930, which essentially doubled tariffs on over 20,000 imported goods to an average rate over 50%. While this was one of many policy errors that contributed to the depth and length of the Great Depression, there is general agreement that these tariffs made matters worse. The effect of these tariffs on global trade are clear – from 1929 to 1933 world exports collapsed by roughly 55%.

Interestingly, there are many similarities between the 1930’s and today. Populist politicians flourished during both periods due to voter anger at 1) wealth and opportunity gaps, 2) perceived cultural threats, 3) established elites, and 4) claims of the government not working[note]https://www.bridgewater.com/resources/bwam032217.pdf[/note]. Both periods have similar economic overtones – low interest rates, low economic growth, stagnant wage increases and high debt burdens. In 1930, over 1,000 economists sent President Hoover a petition expressing their opposition to the Smoot Hawley bill, asking for his veto. President Hoover disregarded the petition due to voter anger at established elites. In a similar fashion, President Trump has ignored the advice of many of his advisors with these tariffs.

Politically, tariffs are easy to implement and hard to remove. One example is the Chicken Tax levied by France and Germany in the early 1960’s[note]https://www.npr.org/sections/money/2017/01/25/511663527/episode-632-the-chicken-tax[/note]. Success of U.S. chicken exports to Europe caused outcries from European farmers who lobbied politicians to tax chicken imports at 25%. The U.S. retaliated by taxing pickup trucks and commercial vans at 25%. Both sides of this tax remain in place today. In the market for sedans, foreign competition has improved car quality and choice for consumers, with even U.S. auto producers compelled to build better cars to compete. Consumers benefit from imports through improved quality and lowered prices for sedans, while competition and improvements for trucks and vans has lagged.

Anticipated effects of taxing steel and aluminum imports

Higher prices. For certain we can expect these tariffs to result in higher prices. Steel and aluminum are key inputs for production for companies in the U.S. Higher raw material prices will put U.S. producers at a competitive disadvantage against foreign producers. In recent stock market action U.S. car and plane manufacturers have been hit hard.

Job losses, not gains. The U.S. last imposed steel tariffs under President Bush in 2002. The project was abandoned after 20 months when a 2003 report estimated that the tariffs cost in excess of 200,000 jobs—more than the total number of people then employed in the entire steel industry at the time[note]https://www.theatlantic.com/politics/archive/2018/03/steel-tariffs-consequences/554690[/note]. Today, steel makers employ about 140,000 workers while industries that use steel as an input employ some 6.5 million Americans. Transportation industries like aircraft and autos account for about 40% of domestic steel consumption and will have to pay higher prices for steel. These tariffs will hurt U.S. competitiveness globally[note]https://www.wsj.com/articles/trumps-tariff-folly-1519950205?mod=searchresults&page=1&pos=2[/note].

As with the coal industry, automation, not falling production, has been a big part of the secular decline in workers employed. The Wall Street Journal recently highlighted a Voestalpine AG steel plant in Austria that employs 14 people today to produce 500,000 tons of steel a year. That output would have required 1,000 employees in 1960.

Retaliation. Expect the EU and other countries not exempted from the tariff to implement their own tariffs on U.S. goods. Likely candidates include agriculture, cars, motorcycles, airplanes and even Jack Daniels. Foreign politicians will try to hurt the U.S. in very specific ways to invoke the strongest political response. Think chickens = pick-up trucks.

Missed target? By far our largest trade deficit is with China which totaled $375.2 billion last year. President Trump’s steel and aluminum tariffs will not affect China’s trade surplus with the U.S. Canada is hit hardest by these tariffs as they are the largest exporter to the U.S. for both aluminum (56% of U.S. imports) and steel (16% of U.S. imports).

Security threat? President Trump justified the tariffs by claiming our national security was at risk. This broad rationale applies to all countries who export steel and aluminum to the U.S. Prior administrations used tariffs for anti-dumping protection to single out one country who was selling in the U.S. at a price below their cost of production. The ‘national security’ clause is a rarely used nuclear option which sidesteps World Trade Organization rules. The claim is a bit thin as the U.S. imports only 30% of total steel used and all steel used by armed services is produced domestically. By claiming this option the U.S., as the world’s largest economy, has opened the door for other countries to follow. If countries side step existing trading laws and norms, the post-world war II trading order will be in jeopardy.

Markets reacting to political risks

The tariff announcement seemed rushed as evidenced by the disagreement within President Trump’s administration and key committee heads in Congress who were unaware of the details. Speaker Paul Ryan has urged President Trump to reconsider and provide exemptions for certain countries. Until this tariff announcement, President Trump’s actions have been mostly pro-business and pro-growth which has allowed the market to shrug off many of his volatile statements and provocative tweets. Perhaps markets start to pay more attention to his tweets and comments.

Unfair trade?

President Trump evaluates trade relations based on size of current account deficit. Trade deficits do not necessarily make a country poorer as it ignores the effects of the offsetting capital account[note]http://carnegieendowment.org/chinafinancialmarkets/67867[/note]. Dollars used to buy foreign goods (less the value of our exports) flow back into the U.S. as investment. Since the U.S. trade deficit of the past 10 years has averaged $560 billion per year, there has been a lot of foreign capital flowing into the U.S. Foreign governments own a whopping $6.3 trillion of U.S. Government debt which is 33% of the total government debt. The U.S. benefits through lower interest rates. However, capital flowing into U.S. can be excessive, increase asset prices and in some cases cause asset bubbles. Foreign capital definitely helped fuel the housing bubble from 2004 to 2007[note]https://ftalphaville.ft.com/2017/10/02/2194387/guest-post-the-real-cause-of-the-americas-housing-bubble-was-foreign-money/[/note]. In theory trade deficits will weaken a country’s currency and the trade imbalance will self-adjust, because imports get more expensive and exports get cheaper as the dollar falls. Instead surplus countries have used their dollars from trade to buy U.S. assets averting currency markets, which explains why the U.S. has run a large persistent deficit since 1991. While President Trump’s view of deficits is overly simplistic, there is room to improve trade relations. Instead of harmful tariffs, finding a way to balance capital accounts would lead to more free currency markets and balanced trade.

There are other ways trade can be ‘unfair’. Foreign government subsidies, unconstrained ability to pollute, and cruel labor practices can give foreign companies a big cost advantage over U.S. companies. Socially conscious firms like Whole Foods promote ‘fair trade’ goods for their like-minded consumers. Mandating a level playing field for benefits and working conditions globally would help U.S. workers and improve U.S. relative competitiveness. Admittedly, these changes would be difficult to implement, but Trump’s anti-trade message has resonated with many voters.

Portfolio

During periods of uncertainty, portfolio diversification is paramount. We continue to be well positioned in high quality and short duration fixed income investments. We expect the trend towards higher inflation will benefit our alternative investments. Higher energy prices are a tailwind for MLPs and real estate managers tend to be good at raising rents to keep pace with inflation. For individual stocks, we continue to focus on companies with strong return on invested capital. While we cannot predict new tariffs, we believe our quality portfolio will weather the ups and downs of the market.

On March 2nd, President Trump tweeted “Trade wars are good and easy to win”. We believe neither to be true.

Stock markets around the globe have sold off over the past few trading days, giving back most of their gains for 2018. Notably, the S&P 500 was down 4.1% yesterday and 6.1% over the past two days, a level of volatility not seen since 2011. This sharp downturn has increased fears of a looming bear market. While we cannot predict where the market goes in the coming days and weeks, today’s market has key fundamental strengths most bear markets lack.
Economic Indicators are positive
The main differentiator between a stock market correction and a prolonged bear market is that bear markets are normally associated with a recession. During a recession, consumption, the main driver of the U.S. economy, falls for an extended period as unemployment rises. Stock markets don’t react well to recessions because earnings across sectors can decrease meaningfully. The fortuitous cycle that helps stocks during periods of earnings increases, improved outlooks and higher valuations reverses as earnings fall, outlooks dim and stock values plunge. Recessions are painful to stock investors.
Unemployment today stands at 4.1%, the lowest level in 17 years! In January, the U.S. economy continued its steady improvements, adding another 200,000 jobs, which marked the 88th consecutive month with U.S. job growth, the longest stretch since 1939. The U.S. economy is unlikely to fall into recession with such strong job growth. Continue reading →

We hope that your 2018 is off to a great start! We wanted to share the exciting news of our upcoming move. Our continued growth has created the need for more space and the opportunity to redesign a new office to allow us to better serve our clients!
As of February 26th, Crestwood Advisors will be located at:

One Liberty Square
Suite 500
Boston, MA 02109

We look forward to giving you a tour of our new space at your next visit. Parking arrangements at nearby P.O. Square Garage will remain the most convenient option when visiting. Please update your records, and as always, feel free to reach out to us with any questions.

Throughout financial history, every bull market seems to be characterized by some new investment product or vehicle that captures investors’ fancy. Like housing bonds in the early 2000’s, mutual funds in the 1980’s, and junk bonds in the 1970’s, liquid alternative assets appear to be that vehicle of the current bull market.
Prior to 2008, alternative investments were primarily available to only endowments and institutional investors. However, in recent years, investment companies created mutual funds with the promise of bringing similar strategies to all investors. These funds have seen tremendous growth and broad acceptance as many investors and advisors have allocated to these liquid alternatives in an attempt to build more diversified, sophisticated and endowment-like portfolios. Unfortunately, performance of liquid alternatives funds over the last five years has broadly disappointed investors. Continue reading →

September is historically the worst calendar month of the year for stock market returns. Since 1950, the average September return for the S&P 500 index is -0.7%.  Additionally, negative news which could affect stocks appear to be piling up including the impacts of Hurricanes Harvey and Irma, North Korea nuclear tests, the now extended deadline for debt limit talks and the continued Washington gridlock.  The strong stock market optimism from the beginning of this year seems to have faded and, with stock market valuations above historical averages, the fear is “what goes up must come down”.

We don’t dismiss any of these risks but, as investors, we understand that predicting near-term movement of markets is impossible. Most bear markets are accompanied by a recession and, importantly, current indicators of the economy show we are still in a modest and steady expansion.  The stock market’s performance this year has been driven more by strong earnings and economic strength than the promise of stimulus from President Trump’s agenda.  This year has been a good reminder that politics makes for good headlines and feverish emotions, but policy change in Washington moves slowly.  Additionally, while President Trump’s executive changes have been grabbing headlines most will have little to no immediate economic impact. Continue reading →

Whether it is retirement planning, funding future education for children or grandchildren, or the possibility of helping a family member financially down the road, most people have at least one question mark in their minds in regard to their financial goals.
We believe there can be great benefits in developing a formal financial plan. In fact, just the exercise of identifying personal goals can lead to greater peace of mind. Creating a plan for the future and a framework for measuring success that will continue to be relevant as personal circumstances evolve can increase the probability of achieving those goals. After all, if you cannot name the ambition, how will you know if you have succeeded or, more importantly, if you have drifted from the intended path? Defining an individual’s objectives, along with the perceived challenges in getting there, will flesh out the issues and will help separate the ‘wants’ from the ‘must haves’.

Continue reading →