What do you get when you throw together a few tweets, a potential change to Fed policy, a partial government shutdown, a wall (or no wall?), a Democratic-controlled House, and an Apple profit warning? You guessed it…market volatility.
After years of market complacency, the current mix finally shook some nerves. When nerves get rattled, the temptation to alter decisions based on emotions increases. Before they do, let’s consider the impact of recent market movements.
Why aren’t they calling?
You would think clients would be calling...worried about the markets, but they’re not. Some clients offered apologies for “bothering me” for money movement or year-end questions because they realized “I must be busy with phone calls because of the market.” I wasn’t. I thought about the comment and saw an article on a financial planning blog that also stated they weren’t getting calls. Why aren’t we getting calls about the markets? The answer is simple. We don’t base your plan on short-term market movements. The lack of calls likely means we are doing a good job of educating and sharing. When I received a request for the suggestion box, I realized we should review recent market volatility.
For the suggestion box
I sent out a post on Christmas playing on the theme of how Ebenezer Scrooge might have benefited from a discussion with a financial planner. One client wrote back… “What would really be appreciated right now given the volatility of the market is an email with your thoughts about the current situation - - versus a philosophical blog.”
When I read the response, a few thoughts came to mind. First, if one person says it, others may be thinking it. Second, when I started writing posts, the one thing I absolutely didn’t want to do was write another summary of what the market did last week. Third, for at least this person, our message wasn’t clear.
What took so long?
My first response to the increased volatility was… “what took so long?” The numbers didn’t support the emotional market movement. We’ve been surprised there wasn’t volatility sooner. Our message has been consistent, and I thought clear. Like many looking at numbers rather than emotion, we felt the market is and has been overvalued. The tailwinds that drove the market (US stocks) higher were becoming headwinds. We expected the shift to happen sooner.
We believe all asset prices (real estate, commodities, stocks, and bonds) are based on valuations in the long run. This doesn’t mean pricing is not impacted (and exaggerated) by emotions in the short-term. We’ve questioned whether stocks could maintain their near historic high valuations.
When considering valuations, we frequently share Schiller PE ratios (see link below). We hadn’t witnessed valuations at this level since the late 1990s. The comparative time frame is interesting because in the late ’90s there was this thing called the internet. You may have heard of it. The internet changed our lives in many ways. Consider a world without instant access to just about anything you want (some can’t). Improved productivity should (and did) change companies. But even in that environment, companies couldn’t hold the elevated valuations in the long run. What was so special in the current environment that warranted the second highest reading in history?
Rather than a new technology driving valuation higher, we have a new (perhaps continued) Fed policy driving risk lower and the cost of borrowing lower. Low rates incentivized investors and money managers to accept more risk than they may have in “normal” times. We know risk and costs matter.
Cost of borrowing matters
Interest rates represent the cost of risk when lending. In normal times, the lender is compensated for accepting risk via an interest payment and the borrower accepts a cost for borrowing. Artificially low rates meant borrowers (in this case companies and governments) paid little to nothing to borrow. Should borrowing be risk-free?
Low (zero) interest rates resulted in corporate actions like stock buybacks. From a government standpoint (the ones creating low rates), the goal was the growth of the economy, not stock buybacks. Companies are not the only entities borrowing with a focus on short-term results.
The 800-pound gorilla in the political arena is (or should be) the national debt. Like valuations, there are theories (I call them stories) about why the 22 trillion-dollar debt doesn’t matter (technically it is 21.9 trillion as I write this, but it won’t be long at this pace). Debt matters for households, companies, and yes…governments.
Debt allows us to trade today’s pleasure for tomorrow. We accept some today (and enjoy it) and pay back a portion over some period. Of course, this means we limit what we do in the future by the payment. If we don’t, we get into a vicious cycle.
The continuation of a higher lifestyle is tempting but can also be debilitating. For many, the threshold of debt acceptance is not realized until it is too late. As if by surprise, the costs of previous debt overwhelm today. Every household has a level of debt they can manage. Companies and governments also have a threshold. Markets penalize (or should) companies who expand beyond a manageable level. But what about governments and especially the U.S. debt level? What level becomes unmanageable? More importantly, what does the penalty look like and when does it happen?
I am not anti-debt. Rather, I am a proponent of using debt wisely. Accepting debt should come with a plan of how it will be repaid and a conversation (realization) of what will be sacrificed in the future. In most cases, we expect income to rise and/or the real cost of debt to fall (assume inflation) in the long-term. A smart conversation considers the long-term impact of income and debt, both current and future.
When the U.S. (and the world) fell into the Great Recession few debated the need for Fed action. The Fed held a long-held belief that lowering interest rates would boost the economy’s growth. When rates are low, consumers should spend more as the cost of debt is lower. In other words, they can enjoy the benefits of accepting debt today without a significant future cost. In the extreme, with zero interest rates, you aren’t paying anything, you are simply shifting your time frame.
A few believed the Fed should have let markets self-adjust and risk a “hard landing.” In other words, let the markets fix themselves. This may have created a more significant fall, but the theory is it would have created a quicker return. The Fed likely made the right choice as we entered the Great Recession. But we aren’t in that place anymore and haven’t been for a while.
The Fed is supposed to be politically neutral. In theory, market returns should not dictate actions, at least not directly; the underlying cause might be a reason to act. Based on speeches and minute notes, the Fed’s decisions were at least partially influenced by market conditions. The market believed Bernanke and then Yellen would use the Fed to support markets. They termed this process the “Bernanke (and then Yellen) put.” The new Chair has not followed suit, much to the dismay of President Trump.
There are extreme times and circumstances in which we might need to accept a higher level of debt than we would ordinarily desire. The Great Recession was arguably such a time for the Fed and other foreign central banks. But once the emergency has passed, there must be a new plan.
Interestingly, based on a recent conversation about debt, a client sent me an article from an economist that stated the fear of national debt is overblown. I think his point is interesting and will address it in a future post. But for now, I believe there is a time and place for debt (when struggling) and a time and place for saving (when in the growth phase).
Time to save…not spend
One of the tailwinds behind markets in 2017 and early 2018 was the passing of new tax legislation. The theory is that with a lower tax bill, companies would increase spending (wages and purchases) which would “trickle down” into the economy. After a few headline bonuses, most of the corporate tax savings appears to be inward driven (stock buybacks, etc.). Some passed through and we enjoy an economy with low unemployment. We are finally starting to see some wage growth. But what about tax receipts?
When we were considering debt earlier, the threshold was dictated by the balance of income and debt. The greater the income, the greater the ability to accept some debt (it is all relative). Consider the government…their income is tax receipts. How did the new tax legislation affect government income?
Per the US Treasury department, individual income taxes climbed 6% in the fiscal year 2018 (compared to 2017). Individual income tax collections for fiscal year (end September) totaled $1.7 trillion (up $14 billion form 2017). This is explained by the increase in employment and higher wages. But corporate income taxes fell by 31%. The combination created an increase of total federal revenue of .5%.
If the government maintained its income and individuals had more income (on which they paid more tax), the plan should be a success. The problem is the government spent $127 billion more in fiscal 2018. The net result…deficits increased by $113 billion. In other words, the government took on more debt. If we are truly in a period of growth and prosperity, governments should be looking to lower debt not increase it because we know there will be slower times in the future. When that happens, the debt burden will be increasingly painful.
So, what are our thoughts on volatility?
We expect volatility to continue and likely increase. We expect the Fed to slow and maybe stop their rate increase path. The reason behind the change in the path will dictate whether this is good or bad news for markets. We’ve witnessed the benefits of lower rates so if we’ve reached a “neutral” rate, that will likely be beneficial. If the Fed has changed the path because the economy is stalling, the result may not be welcomed.
At some point, politicians need to address spending. We know how overextended balance sheets affect families and companies. We have never been in this position before and we are not alone. Other governments have similar balance sheets, in many cases worse.
We have only addressed the decisions with a direct financial impact so far. As we consider uncertainty, we should include health care costs, tariff impact, immigration debates and political bitterness. Each of these has a cost and add to the uncertainty of markets.
We have recommended accepting a slightly more conservative portfolio allocation. This decision has become more uncomfortable as bonds suffered in 2018. But a loss of less than 3% will pale in comparison if we can’t find solutions to the topics discussed above.
So…our view on volatility…we expect it. We have expected it. We wondered how a world filled with so much uncertainty could have a market with so little volatility. Market losses are part of investing for the long run. We believe chasing returns is a fool’s errand. Instead, we focus on your long-term plan. We believe a path that projects success of funding your plan is the goal. We are taking a more conservative position today with a plan of how to add market risk when valuations improve.
I hope that helps clarify our position on volatility. If you have questions, please let me know.
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