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February 2019 Newsletter

When it comes to the stock market, “the rearview mirror is always clearer than the windshield.”

                                                                                                            -Warren Buffet

It was only six weeks ago when it seemed global stock markets were in free fall. Between September 21st (2018) and December 24th, the S&P 500 declined by 19.8%, the 11th worst drawdown since 1955. It was the second worst month of December in history; the worst since 1931.  In fact, for the full year, all but one major asset class finished with losses; the first time since 1972 that at least one group did not gain at least 5%. (The US Aggregate Bond Index was the exception, posting only a negligible gain.)

Fast forward to now and the mood of the market has quickly changed….and seemingly almost on a dime.   For one, the Fed has done its best to calm markets about its intentions to raise interest rates.  Through numerous statements and public appearances, the Fed has not only talked down the prospects for future hikes, but also has outlined their preference to hold off on reducing their balance sheet, a.k.a., “Quantitative Tightening.”  In walking back their previous comments, the Fed has basically taken the risk of higher rates off the table for the foreseeable future and investors have applauded.

In summary, there has been a significant change in the Fed’s message in a matter of weeks. And that’s probably the biggest reason the stock market has had a remarkable start to 2019.   In early December the Federal Reserve raised interest rates by .25%, spoke about their expectations to raise rates twice more in 2019 AND foresaw no reason to alter their balance sheet runoff. Needless to say the markets did not agree one bit and stocks plummeted.

But then in January, Powell abruptly changed course; just last week, he emphasized that, in fact, there is NO need to raise rates at this time, while continuously underscoring the Fed’s need to be “patient” and “flexible” in future rate decisions.  And what about the balance sheet runoff?  Powell late last year referred to the runoff as having such little effect on the markets that it would be like “watching paint dry.” Well, given the market’s poor reaction, all of a sudden this plan may be halted or adjusted, too.

So, did Powell succumb to outside political and social pressure, or are there actually real economic forces that have deteriorated, allowing the Fed to hold off on rate increases?   And if there is hidden economic weakness, then are the markets missing it? We will find out in the coming months.

International Stocks vs US Stocks

Over the past 70 years the US stock market has been a darling, outperforming foreign stocks on average by 1% per year. $10k invested in US stocks in 1950 turned into $14 million vs. only $8 million in foreign stocks. Want to know how much of that outperformance has come since 2009? All of it. (Meb Faber, 2019)

Simply put, US stocks and foreign stocks have taken turns outperforming each other for decades; however, over just the last nine years, US stocks have not only outperformed, but “dramatically” outpaced foreign equities leading to a huge divergence in performance.

$14million vs. $8 million? Wow…that is a remarkable statistic. As Faber goes on to outline, the US stock market currently trades at one of the widest valuation spreads in history compared to foreign markets (according to the cyclically adjusted price-to-earnings ratio—i.e., CAPE ratio). Today, the CAPE ratio for the US is 29; for foreign stocks it is 16.  US stocks are now almost double the price of foreign stocks, while the long-term average for both (since 1980) has been 22.

Most investors today, probably because of psychological “Recency Bias,” are further convinced that the US deserves to trade at a premium. But history says otherwise. Notwithstanding the debate about the validity of the CAPE ratio, which many market pundits now dismiss, any way you slice it, international stocks are meaningfully cheaper than US stocks.  As such, it is prudent for investors to be diversified and include foreign holdings in their portfolios. As history tells us, one of these years, international stocks will likely outperform US stocks again, we just do not know exactly when.

Active/Passive Investing Debate

One of the latest statistics in the active vs. passive debate is that in the 15 years ending in 2018, only 55% of actively-managed bond funds and 51% of actively-managed stock funds are still around.  Stunning! Think about this:  If you are an active fund investor, you possibly face a better than 1 in 2 chance that your fund may not be operating in 15 years! Forget the chances of it outperforming (which, statistically, are remote!), you only have a 50% chance that your fund will still even exist!

Unfortunately, this message is still lost on the majority of investors. Just recently, we were asked to offer an opinion on a portfolio worth several million dollars held at a full-service brokerage firm. The customer is paying sizable advisory fees--relative to the size of the portfolio, and has holdings that are a “scattered” combination of 15 actively-managed mutual funds that for the most part could be replaced with passive funds that cost roughly a third less AND have better performance.   

Retiring Into a Bear Market

At the end of December, the Wall Street Journal had a good article addressing the question of what people should do who face retiring during or into a declining stock market.  The author stresses a point that we have written about many times previously:  You should take steps to control what you can control and certainly not allow what you cannot control to overwhelm you.  

For example, here are a number of points that should be considered:

*Setting a budget;

* Reducing debt;

*Timing Social Security;

*Establishing a “pension” from your investments;

*Manage Taxes;

*Planning for long-term care;

*Planning for tax efficient withdrawals from investments

*Cash flow Planning-where will your income come from?

*Portfolio diversification

Of course, there will always be a sense of trepidation in leaving the workforce and no longer receiving a regular paycheck.  And this anxiety may only be amplified when the market is falling and you are relying largely on your investments for income; however, there is never a time where anyone can predict what will happen in the short-term, and further, there is a strong probability that what is happening “NOW” will change in the future.   This is the “recency bias” that we all fall prey to from time to time.  The truth is bull markets don’t last forever, nor do bear markets.    

The last few months in the markets are classic examples of the dangers of market timing and poor investor behavior. Many investors panicked and sold stocks last year and now face the decision of what to do now….making short-term emotional decisions can be quite disruptive to a solid long-term investment plan.

All the best,