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The market fools experts yet again (an interest rate story)

In the last year, interest rates have fallen dramatically. At the end of the 3rd quarter in 2018, the yield on a 10-year note from the U.S. Government was 3.05% and today it stands at 1.68%. This decline in interest rates is unusual, but not unprecedented. Given the vast resources of the world’s largest money managers, banks, insurance companies, and universities, surely someone saw this coming.

By and large no one did, and, unless we see a rise in yields in the fourth quarter, no one will be very close. The data above comes from the Wall Street Journal Economic Forecasting Survey. Each month, the WSJ surveys over 50 economists on a wide variety of things, one of which is what they expect the U.S. 10-year Treasury bond will be yielding at a future date. The chart shows what each economist predicted, versus what actually happened.

The difficulty in forecasting rates is well shown by looking at yields at the end of June. Nine months prior, the world’s leading economists’ predictions ranged from 2.75% to 3.94% with an average of 3.40% and a standard deviation of 0.28%. The actual yield on June 30th was 2.00% or 5 standard deviations below expectations. A 5 standard deviation variance should happen 1 out of every 3.5 million times, or effectively never, when events are normally distributed. This reinforces what we already knew:  markets aren’t normal, and people can’t predict them.

As we’ve seen here with interest rates, it is very difficult to time markets, getting in or out at the right time to take advantage of the market’s next move. Smart and highly compensated people who work on large teams with unrivaled access to data spend all day trying to forecast the market. And still, they are wrong as often as they are right.

The best-case scenario for average investors trying to time the market is that it will insert an element of chance into their financial lives. For those willing to accept a materially less comfortable retirement for the chance at having a relatively lavish retirement, market timing may make sense. But that is not most people, and the universe of investors who try to time the market on average underperform for the following reasons:

  1. Excessive Costs: Market timing requires buying and selling positions which comes at a cost. Every time you transact a security you cross a bid/ask spread and some securities come with a fee to trade. While small individually, when done repeatedly these little costs add up. Some use options to time the market. Options are a terrible investment over the long run. Options trading is like playing in the poker room at a casino. With every bet you make, there is someone else on the other side. The only one sure to profit is the house.
  2. Holding Cash: Most who try to beat the market end up holding an unnecessarily large amount of cash for extended periods of time. As cash is a poor long-term investment, this generally reduces returns.
  3. Poor Decisions: Theoretically, every future movement in the market is random, securities are efficiently priced, and investors should not be able to pick winners or losers. Still, there is data that shows the average investor who trades frequently has an uncanny knack of buying high and selling low. The psychology of investing is difficult for anyone to master and frequently instincts work against investors.

The markets future movements are unknown, even to “experts.” Timing the market or picking stocks will usually hurt your wallet, not to mention the mental stress that comes with it. Having a long-term strategy and sticking with it is the best way to build wealth in the long run and to position yourself for an enjoyable retirement.

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Market commentary – october 2019

Stock Markets

It was generally an off quarter for stocks, except for Real Estate Investment Trusts (REITs). The year-to-date numbers look good. Recent periods show variability among individual markets as well as within various time periods – REITs continue to do well, no doubt reflecting declining interest rates. One theme running throughout the past ten years’ stock returns is the better-than-average numbers for domestic stocks versus international stocks.  While this behavior is clear by looking back, investment decisions are made by looking ahead.  Markets have no memory so we can’t bank on superior results from domestic markets continuing.

Another theme in these ten-year numbers is that the domestic large-cap market (S&P 500) returns consistently exceeded those of other benchmarks. Expected earnings and growth drive stock returns, and any surprises that alter these expectations produce volatility.  S&P 500 stocks are well-followed by analysts; there is no reason to think that they will consistently provide positive surprises.  So, what’s going on?  It may be simply that S&P 500 stocks are the default investment when investors desire more risk in the face of anemic returns in other markets.  These results are by and large unrelated to company earnings and investments opportunities – suggesting a “passive management bubble”.  If that explains some of what is happening, then the relative results in this market won’t go on forever.

We know that maintaining a globally diversified stock portfolio has the best chance for long-term success.  However, because domestic markets, especially the S&P 500, are so popular and familiar, it has been especially difficult for investors to maintain strategic commitments among several other markets this time around.

Bond Markets

A yield is what you earn by holding a bond to its maturity. Changes in yields drive returns – falling yields are positive; rising yields negative.  The longer a bond’s maturity, the greater the impact a given change will have on prices and returns. 

The Yield Curve is a picture of how these yields vary across several bond maturities.  Shown to the right are U.S. Treasury securities a year ago (September 2018), at the end of last quarter (June 2019) and today.  Not only can changes help us better understand bond returns, they can also be useful predictors of the direction of interest rates.  The sharp fall-off over the past year means positive bond returns, especially at the longer end – the long-term Treasury benchmark (7-10 yrs.) earned nearly 10% while the short-term benchmark (1-3 yrs. Treasury) earned only 3%. Bond returns were positive over the past quarter reflecting the downward shift in the Yield Curve.

Last year’s curve is typical; the more or less “flat” curve we see today is not.  However, it is consistent with expected lower rates in the future.  The story behind this prediction is that the Fed will continue to reduce rates to fight the upcoming economic decline. However, while there is some indication of a slowdown, neither the stock market, nor labor markets (where unemployment is at historical lows) seem to anticipate much of a slowdown.  The recent cut in interest rates is more in response to political pressure – at these levels the effect of any decrease will be mostly perception.

Recessions and the Tools to Respond

There is a lot of noise about a coming recession.  While the numbers still look reasonable, the tools to respond may not be as potent this time around. The hue and cry for the Fed to reduce interest rates notwithstanding, and with rates at historically low levels and massive Treasury securities on the Fed’s balance sheet, there is not much room for monetary policy to make a difference. As far as fiscal policy is concerned, the Government is already running substantial deficits due to the recent tax cut.  The positive impact may be behind us and with today’s political dysfunction, the opportunity to do more with fiscal policy may not be available.   A lot of uncertainty – little wonder the stock market is volatile.  With the large tax cuts in place and an accommodative Fed, we have enjoyed a nice ten years that may be difficult to repeat.

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Recessions and investing

The word “recession” makes investors feel uneasy and with good reason; the correlation between a bear market and an economic recession is very high. For anyone with money in the stock market, especially those nearing retirement, this can be scary. The “r” word has been making headlines in recent months as investors worry about trade wars, the yield curve inverting, and drops in manufacturing activity. In this piece, we’ll unpack what a recession is, what it means for markets, and what can be done to protect a portfolio against one.

A recession is defined as a period of two consecutive quarters where economic activity declines on an inflation-adjusted basis. The main cause of this is economic activity decreasing; however high inflation and population growth can play a factor as well. For example, Japan has had three recessions in the last 10 years as their population has shrunk by 1.52%.

In the United States, economic activity is measured by the Bureau of Economic Analysis’ calculation of Gross Domestic Product (GDP). This measure takes three months to publish and is then revised each of the next two months before we are given a final reading. Because of the definition and the time it takes to report, we don’t know we’re in a recession until 9 months after it is upon us.

Regarding impact, we analyzed the six recessions we’ve seen over the last 50 years.

For example, in November 1973, a 16-month recession began in the United States which saw GDP shrink by 3.2%. The stock market peaked 11 months prior to the start of the recession (December 1972). It took 21 months to bottom out with a loss of 45.6%. During that time international stocks dropped 29% and five-year government bonds rose 4.5%. Fourteen months after the bottom, a balanced portfolio recovered all it had lost.

A recession’s impact on the market varies. Sometimes the impact is small (the drop we had in Q4 of last year was worse than the market’s reaction in three of the recessions) and other times it is very large. The thing that struck our team was how quickly a balanced portfolio recovers from a recession. A 60% stock portfolio that is diversified among international stocks, and is rebalanced quarterly, recovered on average 9 months after the market bottom. When you’re living through the drop, it can feel like a long time, but for investors whose money has a 30+ year investing horizon, it isn’t that long.

Another thing to remember is we don’t know when/if the next recession is coming. The Wall Street Journal Survey of Economists puts the odds of a recession in 2020 at less than 50%. Australia has gone 28 years since their last recession.

While there is no such thing as an average recession, let’s play one out. Say we begin a recession in January of 2020. We won’t know it’s a recession until next September. The market will have peaked this past July and will drop 31% before bottoming in October of 2020. A diversified 60/40 portfolio will decline 13.3% and recover those losses by July of 2021. Again, it’s not fun, but it’s not the end of the world.

And to reiterate, we don’t know when or if this will happen. We’d bet a lot of money a recession won’t start in January of 2020, not because we think we know what the economy will do, but because it’s a low probability event. In the 48 hours we took to research and write this piece, we’ve had a bit of good data and positive news from trade negotiations. The market is up 2.7% over that time and the headlines talking about a recession have vanished. That could easily change; the only point is that no one knows, and headlines are fickle and sensational.

If the fear of a recession is keeping you up at night, it’s a good idea to reach out to your advisor and discuss your asset allocation. A financial planning best practice is to periodically make sure you’re appropriately allocated for your long-term goals and individual risk tolerance. But alterations that are “short-term” by nature or “tactical” are usually mistakes. As Peter Lynch (one of the most successful investors of all time) once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Our job as your fee-only fiduciary advisor is to make sure you don’t prove Peter Lynch right.

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Life events to consider – buying a house

Whether it’s your first house, you are relocating to a new area, or you are upgrading to your “forever” home, buying a house is one of the most significant purchases you will make. Properly budgeting for the costs to buy, finance, and maintain the new home can help set you up for financial success and keep you from feeling “house poor.” While there are many considerations that go into finding the right house for you and your family, reviewing the points below will start you off on a solid foundation (pun intended!).

How much can you afford? – 3 primary rules of thumb include:

  • Maximum purchase price is 3x your gross household income.
  • Housing-related payments (mortgage, taxes, homeowner’s insurance) should be less than 28% of your monthly gross household income.
  • Total debt payments should be less than 36% of your monthly gross household income.

What type of mortgage to get and how much to put down:

  • The most common types of mortgages are conventional mortgages. Conventional mortgages have a fixed interest rate and vary in duration, with 15 or 30 years being the most common.
    • A 30-year mortgage will generally have the lowest monthly payment but a higher interest rate.
    • A 15-year mortgage is the opposite. Your interest rate (and therefore the overall cost of the mortgage) will be lower, but your monthly payments will be much higher.
  • Regardless of the term length, lenders typically require you to make a down payment of 10% to 20% of the purchase price. If you put less than 20% of the purchase price down, you will likely be required to pay Private Mortgage Insurance (PMI). This insurance protects the bank in case of a home mortgage default and is typically between 0.5% and 1% of the loan amount each year.

What are some of the other costs to consider?

  • Property taxes and homeowner’s insurance – Property taxes can add a significant amount of cost on a home. Taxes vary by state and by county; however, it is not unreasonable to assume that if you are targeting a $1M+ home, you should estimate paying $25K to $40K a year in property taxes. Property taxes may be included as a portion of your monthly mortgage payment, or you may need to pay them directly during the year. Don’t forget to take advantage of state programs, like New York’s STAR program, which can reduce your property tax burden. While not nearly as expensive, homeowner’s insurance goes up as the purchase value of the home increases. It may be advantageous to bundle your various insurance policies together through one carrier. Often insurance companies will provide discounts for having homeowner’s, car insurance, umbrella policy, etc. with them.
  • Closing costs – Most mortgages will have some form of closing costs associated with them. The fees cover the loan recording and processing, attorney costs, title insurance, appraisal and various other new mortgage requirements.   Expect closing costs to be approximately 2%-5% of the loan value.
  • Maintenance and upkeep expenses – Homes can be expensive to maintain. Routine repairs and improvements on an older home can be a few thousand dollars a year. Major repairs such as replacing the roof, or damage from a weather event, can cost tens of thousands of dollars and can be unexpected. Plan on budgeting about 1% of the home value for annual maintenance.

 How to title the property?

  • Tenants by the Entirety (TBE) – For married couples, this is typically the default titling option. Advantages of TBE include creditor protection in certain circumstances and probate avoidance when the first spouse passes away. Just like with owning property as joint tenants with rights of survivorship (JTWRS), the deceased tenant’s share passes to the surviving tenant via operation of law and not through the decedent’s Will or revocable trust.
  • Tenants in Common – In some instances, it will be advantageous to own the property jointly as tenants in common. The main difference between tenants in common and TBE or JTWRS is that each tenant can direct the passing of their interest through their Will or revocable trust. This is advantageous if real property is needed to fund a testamentary trust, such as a credit shelter trust.
  • In Trust – For those using a revocable trust (or trusts) as part of their estate plan, making sure to title the property in the name of the trust(s) is essential. Usually the attorney who drafts the trust will also draft a deed to transfer existing property into the trust(s). If a trust is already in place and you are purchasing new property, the new property should be purchased directly in the name of the trust(s).

So, whether you are purchasing a first home, a forever home, or perhaps a second (or third) property, there are a number of considerations (financial and otherwise) that should be reviewed beforehand. Proper planning will not only help you acquire the house of your dreams, but can also help make sure that dream does not end up in a financial nightmare down the road.

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