A quarterly review by Crestwood Advisors designed to keep you informed of the latest economic and market changes.
- Importance of Time and Diversification
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
- Trade War – a Game of Chicken
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. (more…)
- Trumps Tariffs
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.
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.
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.
- Volatility is Back!
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. (more…)
- Crestwood on the MOVE!
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
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.
- Crestwood Advisors adds new partner
We are pleased to announce the addition of Alyson L. Nickse, CFP®, CDFA®as a Partner at Crestwood Advisors. Alyson joined Crestwood Advisors in September 2012 as a Wealth Manager and has over 15 years experience in wealth management. Her focus on building integrated, holistic wealth plans that help our clients achieve their investment, philanthropic, estate & tax planning goals benefits both Crestwood and our clients as we continue to grow. Alyson graduated with a BA from Colby College and has earned her CFP® and CDFA® designations and is a founding member of the Crestwood Women & Wealth Collaborative.
We remain committed to devoting and retaining the resources necessary to deliver the wealth management results that our clients expect from us. We continue to experience significant growth in client assets under management and we are confident that this is due to the strength of our entire team’s focus on delivering strong investment and wealth management solutions to our clients and our commitment to open, honest and ongoing dialogue with our clients.
We are happy to welcome Alyson as a Partner at Crestwood Advisors and delighted to share the news with you.As always, please contact us if you have any questions.
- A discussion of “Liquid Alternative” Investments
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. (more…)
- “Wake Me Up When September Ends” – Green Day
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. (more…)
- Predicting the stock market is a bad idea
With the benefit of hindsight, few tasks look easier than pointing out a market peak. Looking at a price chart of the stocks market, it is easy to point to the top and say, “Here is where to sell stocks.” Unfortunately, there are few indicators that help anticipate market tops. While market valuation is useful over 10-year periods, it is a poor indicator over a 1-year period. At Crestwood, we believe that trying to beat the market by attempting to anticipate the stock market’s ups and downs is a fool’s errand due to the sporadic nature of returns, importance of tax-deferred compounding and irrational behavior of investors.
Every day matters
Over the past seven calendar years, if you missed the best 5 days in the stock market your return drops significantly, falling from 132.7% to 87.6%! The below chart shows the outsized effect of missing days in the market can have on long-term returns: (more…)
- Financial Planning: Creating a Dialogue to Help Achieve Your Goals
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’.
- Sequester – what’s next?
Heading into the end of 2012 headlines about the pending “Fiscal Cliff”, an uncomfortable combination of spending cuts (sequestration) and tax increases due to kick in on January 1st, dominated the news. Ultimately, Congress made a deal on tax rates but decided to kick the can down the road again on sequestration to buy some time to negotiate before spending cuts were imposed. Two months later the new deadline of March 1st is upon us and still nothing has been decided. Once the sequestration cuts go into effect the impact for this year will total to be worth about $50bn, the equivalent to about 0.5% of GDP over that period.
The cuts are to be split between the Department of Defense and discretionary spending areas like education, food inspection and federal courts. The cuts were designed this way to entice both sides of the aisle to work towards a compromise. Clearly, that has not worked so far leaving the very real possibility of these budget cutting measures being enacted. If the sequester becomes a reality many government workers are likely to see reduced hours in an effort to avoid the need to lay people off. All in, as many as 1.8 million government employees could find themselves losing full time status. That would be the equivalent of cutting about 400,000 jobs from the economy.
These cuts will trickle down to the state level as well. Here in Massachusetts as many as 350 teacher and aide jobs may be lost due to decreased federal government funding. In addition to this, programs concerning clean air and water standards, child care programs for disadvantaged families and nutrition assistance for seniors are also liable to be greatly impacted. While the actual outcome of the sequester is unknown at this point, we do know that the cuts would cause most government agencies and programs to significantly alter their operations going forward. (more…)
- Crestwood Advisors LLC expands its research capabilities
FOR IMMEDIATE RELEASE
Crestwood Advisors LLC is pleased to announce that Nick Gaskell has been hired to the position of Research Associate.
“Nick brings significant asset allocation experience and will be a welcomed addition to the research effort”, said Robert Ix, CFA, Managing Partner. “We are fortunate to have Nick on the team and excited to continue to invest in our research capabilities”.
Prior to joining Crestwood Advisors, Nick was an Investment Analyst at John Hancock Financial Services in Boston where he was responsible for oversight, due diligence, and manager selection for multi-asset portfolios. Previously, Nick was an Investment Associate at Kraemation Investment Advisors in Wellesley, MA. Nick earned his undergraduate degree at Suffolk University and, in June, sat for the level III CFA exam.
Crestwood Advisors LLC, based in Boston, Massachusetts, is a boutique investment and wealth management firm serving high-net-worth individuals and families. For additional information, please contact John W. Morris, Managing Partner at 617.523.8880 or visit our web site at www.crestwoodadvisors.com.
- A Gift that Keeps on Giving
Was it really only a few short months ago that we were worrying about the fiscal cliff and sequestration? It seems that, while we as a nation continue to find ourselves settling into the “new normal”, the more things change the more they stay the same.
Today the average savings of a 50 year old is only $43,797 and 80% of people ages 30-54 do not believe they will have enough money put away for retirement (http://www.statisticbrain.com/retirement-statistics/). These unfortunate statistics illustrate how a majority of Americans are unprepared for retirement. An early start to savings in a retirement account is not only an important leg-up to beginning to build financial security, but also a valuable learning opportunity. Unfortunately, teenagers with part-time jobs and even young adults in their 20’s & 30’s are often hard-pressed to commit to saving towards their retirement goals due to cash-flow issues. The good news is that, as long as they have earned income, you can gift to Roth IRAs on their behalf; a gift that will continue giving.
In 2013, the amount of money you can directly give another person without incurring a gift tax is $14,000. These annual gifts are a tool for parents and grandparents who want to transfer wealth to younger generations of their family as tax efficiently as possible, and are most often donated to the beneficiary’s taxable accounts. When the gift is used to fund Roth IRAs, any growth in the account, as well as withdrawals, are sheltered from income tax as long as the IRS guidelines are followed. For younger beneficiaries, this is a good way to start saving for retirement since they have so many years ahead of them for their money to grow.
The primary limitation for this strategy is that the child or grandchild owning the Roth IRA (or if married their spouse) must have some earned income (W-2, Schedule C, etc.). The Roth owner must also have total income under certain thresholds in order for a contribution to be made directly to a Roth IRA account (it should be noted that there are some loopholes for contributions to Roth IRAs for households that earn in excess of the AGI limits). In 2013, the limitations are as follows:
Assuming IRS guidelines are followed, withdrawals from the account in retirement are 100% tax-free. While there is no crystal ball telling us what the federal tax system may look like next year, let alone decades from today, it is hard to imagine an environment when tax-free income would lose its appeal. (more…)
- Crestwood Perspectives: Trump’s Impact on Investment Markets
Yesterday’s unexpected election result causes investors to wonder what can be expected over the next few years from a Trump presidency and a divided country. This election has been highly emotional and personal, leaving many of us bleary-eyed and uncertain about the future. The high level of emotion in this election is reflected in global stock markets, which initially sold off on Wednesday following Trump’s victory only to recover strongly as the day progressed. At Crestwood we know that emotions and investing don’t mix well. We try to look past the rhetoric to analyze potential long term outcomes of the election.
Markets don’t like uncertainty and global stock markets initially sold off in reaction to Trump’s surprise victory. Adding to investors’ unease has been Trump’s avalanche of eye-popping rhetoric throughout the campaign. Trump wants to fire Janet Yellen, Chair of the Board of Governors of the Federal Reserve, tear up the North American Free Trade Agreement (NAFTA) and even suggested renegotiating the U.S. debt obligations. These comments are a small sample of his suggested changes that concern investors. With all of these comments long on rhetoric and short on details we are left speculating, for the moment, on how a Trump presidency will affect the markets.Early indications are that President Trump will leave most of the rhetoric and tweets behind, and focus on his priorities. It is important to remember that changes take time, and Washington is a system of checks and balances that prevents one individual from rearranging policy overnight.
Economic Policy priorities
Trump wants to stimulate economic growth and employment via:
- Corporate tax reforms: reduce the corporate tax rate to a flat 15%, and reduce the tax on repatriating profits earned overseas.
- Individual tax reforms: reduce seven tax brackets to three, treat carried interest as income, repeal 3.8% Obamacare surtax on “net investment income”, repeal the AMT tax and repeal most of the estate tax.
- Spending reforms: Increase government spending on infrastructure and defense
Depending on what Congress approves, these priorities would most likely add to economic growth. Also it is reasonable to expect that these changes would expand the annual budget deficit to 6%-7% of GDP from 3.0% today.Economically, the most impactful change could be on trade as Trump wants to renegotiate NAFTA and has even suggested a 45% tariff on Chinese goods. During this election, both parties attacked free trade as many U.S. voters believe that it has made their lives worse. By restricting trade, Trump hopes to keep jobs in the U.S. and improve wages.There are, of course, risks to these types of protectionist policies; tariffs could spark a trade war and increase the odds of a global recession. While improved salaries are good for individuals, wage growth increases the potential for higher inflation and interest rates. As president, Trump will have broad powers to amend trade deals without congressional oversight. We discussed in a recent Perspectives article our concern that many benefits of trade to the U.S. economy are underappreciated. This post is available to review again here.
In summary, we continuously monitor political changes that can affect investors and markets and yesterday’s election results were certainly a big one. Our initial review shows that Trump’s policies could increase wages and economic growth perhaps in a meaningful way. On the downside, we are on alert for higher inflation, higher budget deficits and/or global trade disruptions. Uncertainty drives market volatility and we expect that volatility will recede with added clarity regarding Trump’s cabinet choices and details on his policy initiatives.Yesterday’s trading action bringing stocks meaningfully higher and bond prices slightly lower yet again highlights the unpredictability of near-term market movements. As always, we build portfolios with long term goals in mind. Focusing on long term objectives helps avoid and minimize the emotional aspects of investing and risks of buying high and selling low. Hopefully, we can continue to add value by sticking to our strategy through multiple market cycles and keeping our eyes open for investment opportunities when they arise.
- Recent press release regarding Crestwood Advisors and Focus Financial Partners
Please click here to read the latest news regarding Crestwood Advisors and Focus Financial Partners.
- Implications of Populism
Why the anger? It’s the economy
One of the many notable characteristics of this unconventional presidential race is the broad-base populist uprising from both the left and right. Across the U.S., pockets of workers are fed up with dead-end jobs and stagnant wages. This anti-trade theme has resonated across both parties and will likely force changes in government policy, no matter who wins the election.
The primary cause of frustration is that workers across the U.S., especially those younger and less skilled, have faced falling standards of living since the Great Recession. A McKinsey report[ref] Poorer than their parents? A new perspective on income inequality
By Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap, McKinsey Global Institute, July 2016 [/ref] estimates that 81% of the U.S. population experienced flat or falling incomes from 2005 to 2014. The report shows similar results internationally with over 65% of households in 25 developed economies facing flat or decreased real income during the same time period. This equates to over 540 million people worldwide whose quality of life has not improved, many of whom are voicing their anger in elections. As we see in the U.S., these concerns are being integrated into both parties’ platforms. One only needs to look at Britain’s surprise Brexit vote to understand that these ‘new’ political forces should not be taken lightly. (more…)
- Matt Morse appears on NECN to discuss CVS and Target
Matt Morse appearance on NECN regarding CVS and Target – 06.16.15
- Investing Through Recessions
The U.S. economy has now grown for 69 straight months, making this the sixth-longest period of economic expansion since the 1850s. The stock market has climbed apace—albeit with plenty of volatility along the way.
Still, the law of gravity hasn’t been repealed. Economic growth and contraction have always alternated, and at some point we’ll experience a recession. That, of course, will impact stocks.
Recessions’ Toll on Stocks
Recessions are defined as periods in which Gross Domestic Product—a measure of trade and industrial activity—shrinks for two successive quarters. Slowing economic activity typically coincides with lower corporate sales, earnings and profit margins, higher unemployment, as well as higher levels of bankruptcy. Typically, equity indexes will fall in advance of and during a recession. Often a bear market, a period when stock prices drop by at least 20%, and a recession, will overlap one another. (more…)
- Investing Through Recessions
The U.S. economy has now grown for 69 straight months, making this the sixth-longest period of economic expansion since the 1850s. The stock market has climbed apace—albeit with plenty of volatility along the way.
Still, the law of gravity hasn’t been repealed. Economic growth and contraction have always alternated, and at some point we’ll experience a recession. That, of course, will impact stocks.
Recessions’ Toll on Stocks
Recessions are defined as periods in which Gross Domestic Product—a measure of trade and industrial activity—shrinks for two successive quarters. Slowing economic activity typically coincides with lower corporate sales, earnings and profit margins, higher unemployment, as well as higher levels of bankruptcy. Typically, equity indexes will fall in advance of and during a recession. Often a bear market, a period when stock prices drop by at least 20%, and a recession, will overlap one another.
U.S. Stock Market Returns and U.S. Economic Recessions Since 1926
Since 1926, stocks have fallen an average of 26.5% from the top to the bottom of the market around recessionary periods. For example, during the latest recession, from April 2008 to June 2009, stocks plunged more than 46% from peak to trough. But importantly stocks do recover: Since 1980, U.S. stocks have returned an average of 93.1% in the five years after a recession while bonds have averaged returns of 46.6%.
The Difficulty of Predicting Recessions
“The only function of economic forecasting is to make astrology look respectable.” –John Kenneth Galbraith, economist.
In April 2008, the consensus among economists was that none of 77 major economies would fall into recession in 2009. In reality, 49 of them did just that. As one researcher noted: “The failure to predict recessions is virtually unblemished.”
The fact is that it’s difficult, even for those who have devoted their lives to the study of economics, to accurately forecast recessions. This means that it’s also extremely difficult to predict the market declines that typically accompany, and often precede, recessions. For investors, the ability to anticipate a recession and “time the market” is equally as difficult. The best strategy is one that focuses on long-term investment goals.
At Crestwood, we seek to mitigate the impact of recessions on our clients’ ability to achieve their long term goals in three main ways.
1. Developing the Correct Investment Strategy
The Crestwood team works with each client to gather information about their goals, wealth, ability and willingness to take risk, time horizon and income needs. The information helps us to determine an appropriate investment strategy for each client. In addition, the suitability of this strategy and any changes in client’s goals are frequently discussed to ensure portfolios are structured appropriately.
2. Employing Intelligent Diversification
Crestwood’s approach to diversification incorporates the performance of various asset types during periods of recession and stock-market declines. Many investments provide diversification during normal times, but not all of them provide it when stocks fall—which, of course, is likely during a recession. For example, an asset class that performs well during recessions are high quality bonds, which have appreciated an average of 15.1% during recessions since 1988. Including asset classes which can preserve value and appreciate during various market conditions allows us to build portfolios that will be more durable during recessions.
3. Focusing on Quality and Price
During recessions, low-quality, high-priced investments tend to experience the sharpest declines. Crestwood equities have a history of competitive relative performance during market downturns, and a key reason is our preference for buying quality investments at reasonable valuations. This preference is expressed throughout our portfolios. We implement our investment philosophy by investing in companies and funds that reflect this approach.
The Importance of Staying the Course
Individual investors face temptation on a daily basis. One need only turn to the financial media to hear about a hot opportunity possibly being missed today, or the grave danger lurking. At Crestwood, we continually discuss the importance of remaining focused on long-term goals.
During the late stages of any economic expansion, temptation rears its head in the form of high recent stock returns. It’s important to remember that stock returns, along with high valuations, often look strongest just before a recession—but that recessions generally spell the end of bull markets.
This is when many investors, chasing returns, make the classic mistake of buying stocks near their highest price. Too often, those same investors end up selling stocks near their lows.
The prudent approach for balancing risk and reward through changing economic and market environments is to develop, and stick with, a well-diversified portfolio. Impulsively increasing your stock allocation and assuming greater equity risk is likely ill-timed, as much of the gains may have been already realized.
To illustrate why, consider a portfolio with a 75% allocation to the S&P 500 index and a 25% allocation to the Barclay’s Aggregate Bond index, which features a cross-section of different bond types. Such a diversified portfolio has a risk level that is 24% lower than the S&P 500 index alone.
The chart above shows historical performance of a diversified portfolio versus a U.S. equity stock-only portfolio (100% S&P 500 index) for five years just before the top of the stock market during a U.S. recession and just after the top of the stock market for recessions dating back to 1976. As you can see, an all-stock portfolio appears to be preferable right before a recession, based on trailing five-year returns.
But stocks underperform significantly during a recession. In the five years following a recession, a portfolio of 75% stocks and 25% bonds outperforms a 100% U.S. stock portfolio. Although a more aggressive, U.S. equity only portfolio may outperform a diversified portfolio prior to recessions, the diversified portfolio’s steadier overall performance through market cycles typically makes it an appropriate strategy for investors who want to mitigate stock market downside typical of recessions.
The takeaway is clear: Rather than chasing returns and increasing allocations to stocks at the top of the market, set a diversified strategy for the long term, and stick to it.
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- Quality Bonds: an Underappreciated Role in Portfolios
Stock markets across the globe fell sharply during the first few weeks of 2016. After years of strong stock market performance, downturns like these remind investors of the importance of diversification and disciplined portfolio construction. Even though interest rates remain near historic lows, bonds remain an important part of this diversification as adding them to portfolios lowers volatility (i.e. risk). Historically, high quality bonds, that is those with lesser credit risk, proved an important source of diversification during periods of equity market stress, offering lower correlation while their lower quality brethren tend to have returns more highly correlated to stock market returns. Lower quality bonds imply greater credit risk, which is the risk of not getting paid because the issuer goes bankrupt.
Whenever the outlook for the stock market is threatened, investors will sell risky assets to buy safe investments. This ‘flight to quality’ behavior is a well-known herding reaction to bad news. Historically, owning high quality bonds provides a diversification boost during periods when portfolios need it most. At Crestwood, we include high quality bonds in portfolios to provide a ballast against equity risk which helps to offset periods of stock market stress.
Despite these attractive qualities, concerns over lower expected returns and potential interest rate increases have reduced the appeal for quality bonds. Unfortunately, the near historically low current yields for bonds is suggestive of low future returns (see Perspectives 5/1/15). In addition, the Federal Reserve is on a path to reduce their aggressively stimulative policy of near-zero interest rates. In December 2015, they increased the federal funds rate for the first time since 2006. When interest rates rise, bond prices fall, because most bonds have fixed interest payments and higher rates make these fixed interest payments less valuable. So, not only are lower returns expected, but depending on the pace of future increases in interest rates, it is possible that returns for some bonds could be negative. (more…)