Will Rising Rates Cause Stocks to Crash?

SYNOPSIS

  • Several investors have voiced the concern that higher rates are the beginning of the end for this bull market.

  • A rising interest rate, on its own, is not enough to estimate the future direction of stock prices.

  • The decision to sell stocks simply because rates are rising could risk leaving an investor out of attractive returns for quite some time.

THE IMPACT OF RISING RATES

The U.S. has not experienced a rising interest rate regime for over a decade, and several investors have voiced the concern that higher rates signify the beginning of the end for this equity bull market.

Consumer and business spending fuel the majority of economic growth, and since most major purchases are done on credit, interest rates are vital to the health of the economy. For example, if the interest rate on a car loan doubled from 4% to 8%, then fewer consumers will buy cars because the interest payment would eat up more of their monthly income.

High interest rates have historically led to recessions for this very reason, and we all know what recessions do to the stock market, so let’s see if history can offer any insight into the impact of rising rates on the stock market. The chart below is a good starting point.

The horizontal axis is the 10-year Treasury yield, which represents long-term interest rates, and the vertical axis measures the relationship between the S&P 500 and interest rate movements.

A dot below the 0.0 level indicates a negative relationship between the S&P 500 and interest rate movements. Meaning, when interest rates have been at 10% and moved higher, the S&P 500 has gone down. This behavior confirms the notion that rising interest rates can hurt stocks.

At 10%, consumers are mostly likely not spending much already, and to move them even higher is going to choke off the economy that much more. Less spending equates to lower profits for companies and ultimately sends stock prices down.

A dot above the 0.0 level indicates a positive relationship between the S&P 500 and interest rate movements. Meaning, when interest rates are at 2% and move higher, the S&P 500 goes up. This behavior contradicts the notion that rising rates hurts stocks.

At 2%, consumers are still spending because rates this low tend to equate to early stages in an economic recovery. This point in the cycle is very good for stocks because the economy is growing faster but not overheating to where the Fed feels they need to intervene.

“...a rising interest rate, on its own, is not enough to estimate the future direction of stock prices.”

Therefore, the only conclusion that can be derived from historical data is that a rising interest rate, on its own, is not enough to estimate the future direction of stock prices. We must also consider the current interest rate level because this is a critical factor in determining the health of the economy.

WHEN TO WORRY

The orange-dotted line at 5% indicates the threshold where an interest rate hike has gone from helping stocks to hurting them. Currently, the 10-year Treasury yield is around 2.2%, so we are far away from this line in the sand.

Unfortunately, it’s not as easy as owning stocks until the 10-year Treasury yield hits 5% and then selling. This threshold is based on historical averages, and there was nothing average about the aftermath of the financial crisis.

The last time the Fed moved short-term interest rates this low was during the Great Depression, and repeating these extreme measures most likely shifted the goalpost to where a 5% threshold may no longer apply.

This uncharted territory forces investors to consider other factors before estimating when stocks may start to feel the pressure from rising interest rates. The most important of all is inflation because this has become the Fed’s main focal point now that unemployment has reached all-time lows.

Currently, the Fed’s favored measure of inflation is below their target, and this has historically been a very good time to own stocks. Until inflation creeps higher and stays there for more than a few months, the Fed has little incentive to push our economy to the point where future rate hikes become a headwind for stocks.

IMPLICATIONS FOR INVESTORS

I enjoy traveling to meet with investors, and as a result, I spend a lot of nights in hotels. One thing I have learned during my time on the road is that hot water in most hotels is very dangerous. I will never understand why property managers allow the temperature to get to the point where it can melt aluminum, but it’s nearly universal across the country.

Therefore, every time I shower in a hotel, I follow an iterative process to ensure I don’t end up in the hospital. I turn the hot water knob ever so slightly, checking the temperature along the way before I move it higher.

The Fed follows a similar process when raising interest rates. They know that if they ramp up interest rates too far too fast, the economy will get scolded. This is why they have only been raising by 0.25% each time since December 2015. They want to see how the economy reacts before continuing, but this is incredibly difficult to get right.

When I test the water temperature in my shower, I get near immediate feedback, so I know exactly when to stop. The U.S. economy is too large and has too many moving parts for anything to be immediate, so a change to interest rates, no matter how big or small, can take up to a year to feel the effects.

This lack of timely feedback is the precise reason why the Fed continually screws up and drives our economy into a recession. At some point down the road, this will happen again, and stocks will fall into a bear market. But it is highly unlikely that this will happen anytime soon.

The bottom line is that stocks have experienced tremendous gains in the early innings of rising interest rates, and the decision to sell stocks simply because rates are rising could risk leaving an investor out of attractive returns for quite some time.

 

Median Refi Loan Age Drops

Housing Market

As rates have gyrated over the past 1-3 years, mortgagees have ramped up refinancing more often.

A significant contributor to the financial crisis of 2008 was the onslaught of lower quality mortgages, or otherwise known as sub-prime loans, which were “packaged” and sold as complicated products deemed as high quality.

The dramatic drop in mortgage debt from its height in the second quarter of 2008, to its low in the 1st quarter of 2013, was a drop of over 10.5%. Data collected by the Fed since 1951 has never seen such an elimination of mortgage debt of this magnitude.

The growth of the mortgage market has been compromised ever since the financial debacle of 2008, when new lending regulations limited loans. Growth in mortgages actually didn’t start again until the second quarter of 2013.

Economists see an improving housing market as a result of an improving job environment and stronger household finances. Such dynamics lend themselves well to the overall health of the economy.


Source: Federal Reserve

 

Equity Overview

Global Equity Overview

The equity markets started to experience what stock analysts call a sector rotation, when one or several sectors fall out of favor leading to funds flowing to other sectors.  This past month technology stocks fell as markets perceived that the sector may have become overvalued.  As this occurred, banking and financial sector stocks rose, as favorable regulatory related news lifted the overall sector.

The S&P 500 index posted its strongest first half of the year since 2013.  The Dow Jones industrial average index rose 8% in the first half of 2017, its best performance since 2013, while the S&P 500 was up 8.2% the first half of 2017.  The NASDAQ’s strong performance for the first six months of 2017 was predominantly led by the technology sector, its best first half since 2009.

Global equity markets had the best first annual half since 2009.  Overall improving sentiment in the euro zone as well as increasing international growth prospects helped propel global markets the first half of 2017.


Sources: S&P, Reuters, Bloomberg, Dow Jones, Nasdaq

 

How's The Market Doing?

Global Financial Private Capital
Thought for the Week

SYNOPSIS

  • When asked how “the market” is doing, the question invariably refers to the performance of the S&P 500 index.

  • Diversification should occasionally disappoint investors because there will almost always be a few under performers at any given time.

  • While the S&P 500’s performance may make for good banter on television, it should never be used to gauge the success of a diversified portfolio over time.

THE MARKET

When asked how “the market” is doing, the question invariably refers to the performance of the S&P 500 index. Since its inception in 1957, it has slowly become the de facto barometer for the overall health of global financial markets.

The index is also one of the most commonly used benchmarks for investors to assess their individual performance. Beat the S&P 500 and not only is one expected to build mass amounts of wealth, but any fees paid to active managers become justified.

The challenge for investors is that the S&P 500 has surged over the last eight years, and many are frustrated to see their portfolios return only a portion of “the market’s” performance since the end of the financial crisis.

While it is understandable that investors want to achieve the highest returns possible, the S&P 500 is one of the worst possible benchmarks to use for a diversified portfolio for three reasons:

  1. Concentrated: The index only comprises 500 large stocks

    based in the U.S. It is also highly concentrated since it is weighed by market cap. For scale, just four technology stocks (Apple, Amazon, Google, and Microsoft) currently make up more than 10% of the index.

  2. Aggressive: A portfolio consisting of only equities is nowhere near representative for most investors, particularly retirees because they tend to hold a wide range of investments that are more conservative in nature.

  3. Too Small: The total amount of investable assets in the world is estimated to be around $300 trillion, but the total market cap of the S&P 500 is closer to $20 trillion. Hence, the index only represents less than 10% of assets invested globally.

Consider a scenario where a conservative investor’s portfolio consisted of 30% in stocks and 70% in bonds. Comparing this portfolio to only the S&P 500 would be inappropriate.

Furthermore, any investor with a portfolio designed to generate income could never benchmark themselves against an index that is currently yielding below 2% annually and consists of a large portion of non-dividend paying stocks.

Simply put, the S&P 500 is by no means an accurate representation of global financial markets, nor is it a benchmark that should ever be used on its own.

THE GOLDEN RULE

Diversification is this “Golden Rule” of investing, and investors are to maintain broad-based diversification at all times1. There is simply no exception, and those who choose to ignore are playing with fire. The chart below demonstrates the importance of diversification by depicting the relationship between diversification and risk.

 
Source: Modern Portfolio Theory and Investment Analysis, Ninth Edition

Source: Modern Portfolio Theory and Investment Analysis, Ninth Edition

 

The vertical axis measures portfolio variance, which is a fancy word for risk, and the horizontal axis counts the total number of securities in a portfolio. The relationship clearly shows that as the number of securities increases, the risk falls exponentially.

Unfortunately, it’s not as easy as buying 20 securities and calling it a day. A basket of only healthcare stocks will not diversify an investor all that much. Instead, investors must consider other geographies and asset classes and then monitor how the relationships between these assets change over time.

Another challenge is the emotional toll it creates. A properly diversified portfolio should occasionally disappoint investors because there will almost always be a few underperformers at any given time, but this is the whole point behind diversification.

If we knew up front which investments were going to be homeruns and which would be duds, investing would be as simple as buying the winners and avoiding the losers. Crystal balls are hard to come by in this business, so the next best approach is to manage risk rather than take too much of it.

To achieve this goal of risk mitigation, diversified portfolios often hold investments that are designed to underperform the S&P 500 in a rising market so that it can provide a cushion when our economy falls into a recession.

This yin to the yang produced by the S&P 500 can deliver a smoother ride by mitigating the impact of major drawdowns, like the one in 2008 that drove the index down over 50%. The last thing an investor would want to do is to sell these invaluable tools because they are not keeping up with “the market” when it is rising.

THE RIGHT BENCHMARK

If the S&P 500 is nowhere near an appropriate benchmark for investors, then the question becomes why it is so often regarded as such. I believe the answer is the media.

One of the most fundamental economic principles is that we are all self-interested. We operate our lives and base our decisions on what will best serve us and the people we love. Recognizing this principle is critical to understanding the motivations behind most decisions by not just people but also corporations.

Within this context, the media represents a group of for-profit institutions that are in business to make money. The bulk of their revenues come from advertising, so they are highly incentivized to attract as many eyeballs and website clicks as possible.

More viewers translates to more advertising dollars, so they need to keep their audience hooked so they don’t change the channel. The S&P 500 just so happens to be ideally suited to achieve the media’s goal for two reasons:

1. Unpredictable: The inability to predict what will drive the market on a daily or even monthly basis means that a never-ending supply of storylines is readily available.  Much like watching a great mystery, viewers never know what to expect next.

2. Highly Volatile: In the short-term, emotions drive stock prices, and few subjects make investors more emotional than their money.  The sharp ups and downs cause investors to become fixated on what is moving their nest egg.

If this over-emphasized index is not a good measure of performance for a properly diversified portfolio, then investors need a more appropriate benchmark.  The problem is that no universal solution exists because each investor is different.

A benchmark is unique to an individual and should be established in a way that is designed to guide an investor to achieving their long-term return objectives.  Fortunately, constructing a proper benchmark is a relatively straightforward task for a trained professional.

IMPLICATIONS FOR INVESTORS

Imagine the opportunity to play a round of golf at Augusta National.  For those who do not golf (like me), this is the site of The Masters golf tournament, and most avid golfers would give up their first born to play 18 holes on this legendary course.

Before arriving in Augusta, a golfer would prepare by filling a golf bag with an arsenal of different clubs that all serve a unique purpose.  For example, there is a high probability that any golfer, no matter how skilled, will end up in a sand trap at some point.  Hence, a sand wedge becomes a necessity.

There will also be a need to hit the ball short distances to the hole, so a putter is another vital club that must be in the bag.  Longer shots off the tee will require a driver, and so on.

The point here is that any serious golfer will bring every possible tool to make the experience of golfing at Augusta as enjoyable as possible (no golfer wants to end up in a sand trap, but they also don’t want to ruin their score by leaving their wedge behind either).

Planning for a round of golf is analogous to a long-term investment strategy, and the driver in our investment golf bag is the S&P 500. This “club” hits the ball the farthest and creates the most excitement (any golfer will admit that few things in this world feel more rewarding than hitting a monster drive down the fairway).

However, seasoned golfers also know what can happen if a swing is off by even a millimeter. The slightest mistake can send the ball towards the moon, and it could take several strokes just to get back on course.

The point is that it takes way more than just one club to get through a round of golf, and it most certainly takes more than one investment to help an investor achieve their long-term goals. We need investments that can help us grow our nest eggs over time, but just as important, we need others that can guide us through the sand traps that are pervasive through financial markets.

Furthermore, no golfer beats themselves up for their inability to hit their wedge as far as their driver because a wedge is not designed for long drives. Assessing the performance on the golf course involves comparing a wedge shot to other wedge shots, and a drive to other drives.

The bottom line is that despite the adrenaline rush that comes with a big drive down the fairway, the key to a good score is having a strong short game.

 

Recent Fed Rate Hikes In Question

Monetary Policy
July 2017

Over the past 27 years, the Federal Reserve has raised it key rate, the Federal Funds Rate, 35 times, each to slow down inflationary pressures and to curtail elevating price levels.  The Fed increased rates aggressively and consistently in 1994 to hold off a rapidly expanding economy, lifting rates six times for the year.  A decade later, the Fed raised 8 times in 2005 in order to temper a rapidly expanding housing market where easy mortgage lending had essentially gone out of control.  The Fed’s most recent rate increases this year, in March and June, are the first since December 2016.  The Fed also raised in December 2015.

 
 

The level of the Federal Funds rate is much lower now than it had been during previous increases, with the Fed Funds rate reaching a target of 1.00-1.25%. The Fed Fund target levels reached 4.25 in December 2005, with the target rate reaching 6% in February 1995 following six increases in 1994.

The item at question during these recent rate hikes is where inflation actually is today.  The Fed has an inflation target of 2%, meaning that it wants to see inflation growth at 2%, which translates into some economic growth.  The concern among analysts and economists is the fact that current inflation, as measured by the Consumer Price Index (CPI), is running closer to 1.8%, as reported by the Bureau of Labor Statistics (BLS). Some believe that if the Fed tightens too much too soon, then the rate increases could create recessionary pressures, opposite of the Fed’s intent.  The CPI during the Fed increases in 2005 was 3.4% and in 1994 was 2.6%.

Some economists and entities, such as the IMF, believe that deflation, not inflation may become an issue again.  Over the past twelve months, the core CPI index has actually fallen, from 1.9% to 1.7%, still below the Fed’s 2.0% inflation target.  Deflationary factors are becoming more apparent throughout the economy in sectors such as finance, education, health care, and now food services and groceries.

Sources: Federal Reserve, BLS, IMF

CD Rate History

Historical Note

Not since the days of inflation and high interest rates have Certificates of Deposits (CDs) been perceived as a viable source of income for retirees and conservative savings for working individuals.

 
 

For years, banks used CDs as primary marketing products to attract new customers and help build deposit bases. As rates fell substantially, CDs became less attractive, incentivizing banks to find other products to sell. The historically low rates of today have created CD yield wars with rates from .25% to 1.00%, rates not seen since 2002.

Contrary to what most people think, a CD isn’t as liquid as many believe. Banks restrict access to the funds until the maturity date of the investment and impose penalties for early withdrawals.

Data compiled by both the FDIC and the Federal Reserve over the decades has carefully tracked CD rates offered by banks nationwide. The average 3-month CD as of this past month has a rate of 0.91%, roughly 1/10th of a comparable 3-month CD in 1983.

The primary drawback of using CDs as an investment is that a fixed rate over a short period of time doesn’t produce the growth that stocks may produce over a long period of time. So when a 3-month CD paid 13.78% in 1979, the inflation rateof 13.3% that same year translated into earning a meager half percentage difference in real terms net of inflation. The challenge today, even with low inflation of below 2%, is that the average 3, 6, and 12-month CD rate is still below the current rate of inflation.

Source: Federal Reserve Bank of St. Louis

Americans Are Working More & Sleeping Less

Demographics
July 2017

The Department of Labor in June released a survey, called the American Time Use Survey, on how much time Americans spend working, sleeping, and a host of other activities. Nearly 10,500 people were surveyed by the Labor Department nationwide for this latest report.

The survey found that Americans spent just over 4.5 hours each weekday working in 2016, an increase of 8 minutes from the previous year. Meanwhile, the average amount spent sleeping fell by 5 minutes from the year before, to 8.5 hours per day.

The survey results may not necessarily be representative of everyone, but for a basic government report, it does give employers and economists a rough idea of how we spend our day.

Such data may reveal that too much leisure time could be indicative of high unemployment or even excess reserves for spending. While an increase in hours worked may be an indicator of an increasing demand for workers.


Source: Department of Labor; American Time Use Survey June 2017

Should Investors Fear A Weakening Dollar?

Global Financial Capital
Thought for the Week

SYNOPSIS

  • The U.S. dollar (USD) plays an integral role in global economic activity, so its value relative to other major currencies is watched very closely.

  • A weaker currency does not imply a weaker economy, and the two often march to the beat of their own drum.

  • The USD is the most widely accepted, trusted, and stable currency in the world, and the odds of this changing anytime soon is extremely low.

DOLLAR FEARS

The U.S. dollar (USD) plays an integral role in global economic activity, so its value relative to other major currencies is watched very closely. Over the last several months, the “greenback” has fallen, and given its importance, investors are now starting to ask if an extended period of weakness will adversely affect their nest eggs.

To make matters worse, anytime the dollar weakens by more than a few percentage points, the fearmongering ramps up around two frightening outcomes:

  1. Imminent Crash: A weaker currency will drive our economy into a deep depression.

  2. Reserve Status: China or some other contender will take over as the world’s reserve currency and cause the value of dollar- denominated assets to fall apart.

Don’t believe me? Conduct a Google search on the subject, and you will be inundated with tall tales of an impending dollar collapse. Some have even filmed videos that look like fake talk shows in the same manner used by TV infomercials in the 1990s (until the government banned many of them).

The world does not end all that often, so before we discuss the implications of the recent dollar weakness, let’s first deal with the doomsday rhetoric.

IMMINENT CRASH

Most Americans who have traveled overseas would agree that a stronger dollar makes for a more enjoyable vacation. For example, let’s assume that a hotel in Paris is charging €300/night. Currently, one euro can buy approximately $1.15, so the hotel would cost $345/night (300 x 1.15 = $345).

A year later, the dollar strengthens relative to the euro, to where €1 can only buy $1.05. The hotel then becomes cheaper at $315/night (300 x 1.05 = $315).  The stronger dollar makes an American more confident because his/her money can buy more stuff.

A weaker dollar does the exact opposite. If a dollar can buy fewer euros, then an American traveler will feel less confident because hotels and anything else priced in euros will be more expensive.

When it comes to investing, most forms of weakness tend to carry a negative connotation. Falling revenues, shrinking profit margins, and a softening market for goods and services usually leads to bad outcomes for investors.

However, currencies are very complex instruments that often test the limits of intuition. There are times when a weaker currency can help an economy, and governments will often intentionally drive the value of their currency lower for two reasons:

  1. Increased Demand for Exports: If the USD has weakened relative to the EUR, then €1 can now buy more dollars. U.S. products become less expensive for buyers paying in euros, and the U.S. would expect to see increased demand for their exports.

  2. Reduced Demand for Imports: If companies in the U.S. buy goods from Europe, these costs have now increased because $1 now buys fewer euros. Americans and U.S. companies may start buying less from Europe and shift to domestic producers.

Both advantages lead to stronger international competitiveness and economic growth, but that is not to say that a weaker currency is always a good outcome for an economy either. Rather, the point is that the strength of a currency, on its own, is not enough to inform us one way or another on the true health of the economy.

LOSING RESERVE STATUS

The International Monetary Fund (IMF) is an international organization created back in the 1940s to foster global monetary cooperation, secure financial stability, facilitate international trade, and assist in global economic growth.

The IMF executes its mandate through various services and levels of support for member nations. For example, the IMF is one of Greece’s largest creditors, and they have given the country several billions of dollars over the years to help get their economy back on track.

Another function of the IMF is to set recommended guidelines on the use of “reserve currencies” by central banks across the world. A reserve currency is one that is held by governments and institutions in very large quantities to facilitate international transactions. Since the 1940s, the most widely accepted reserve currency has been the U.S. dollar (USD).

They currently recognize five currencies in a basket that is weighted based on their prominence and availability – U.S. dollar, Euro, Chinese renminbi, Japanese yen, and British pound sterling.
Most central banks like the Fed and the European Central Bank hold several currencies, but the bulk of their assets are in some combination of these five.

A reserve currency must be both desirable and available, and here is where the doomsayers’ prediction fails to hold water. According to the IMF, more than 85% of foreign exchange trading involves the dollar, and nearly all commodities are priced in dollars.

For example, if a company in Malaysia wants to buy a barrel of oil from Saudi Arabia, that transaction will need dollars to complete. Rewriting these contracts and redirecting so much international trade would take time and equal trust in a replacement currency.

Regarding availability, the USD currently represents 64% of all known central bank foreign exchange reserves. The next closest is the euro at 19%, so there is nowhere near enough euro in circulation, let alone any other currency, to replace the total value of dollars held.

China is even lower. The renminbi accounts for around 5% of international trade and less than 3% of central bank reserves. Given China’s blatant manipulation and strict currency controls, it’s virtually

impossible to envision how they could gain any real traction, let alone supplant dollar anytime soon.

Simply put, it took the U.S. several decades to create the level of trust and availability needed to become the world’s reserve currency, and there is little chance this will change anytime soon.

IMPLICATIONS FOR INVESTORS

Now that the fearmongering has been put to rest, let’s address what has been driving the value of the dollar down this year.

The first culprit has been expectations from investors that the global economy is improving. Foreign investors desperate for returns had invested heavily in the U.S. since the end of the financial crisis, and it appears that many are now packing their bags and heading home.

As they sell their dollar-denominated investments, they must then convert those dollars into their home currency, and this increases the supply of dollars available on the open market. Rising supply leads to lower prices, so the value of the dollar falls.

The second is lower expectations around President Trump’s ability to push his economic agenda through Congress. His policies are expected to stimulate the economy, so if they were to go away, this could weaken the demand for dollars.

While both make for good banter amongst the pundits on television, they are far too myopic for long-term investors to lose sleep over for three reasons:

  1. The Trend: Trends matter far more than data points, and the trend for the past six years has been an indisputable bull market for the dollar, where it has strengthened nicely alongside our economic recovery.

  2. Home Bias: Portfolios tend to have a “home bias,” which means that the bulk of the investments are in the investor’s home currency. Since most U.S. investors’ expenses are paid in dollars, the need to manage foreign currency risk is lower.

  3. Natural Hedge: A properly diversified portfolio should create a natural hedge, where the impact of currencies diminishes over time. For example, if the euro strengthened versus the yen, a portfolio’s European allocation should offset a portion of its Japan exposure.

There is no question that currencies impact returns, but the degree of impact to U.S. investors only becomes problematic when a portfolio is imbalanced and/or improperly diversified. If this is the case, then an investor has much bigger problems than currency risk.

The bottom line is that the USD is the most widely accepted, trusted, and stable currency in the world. Traits like these take decades to reverse, so ignore the ups and downs that happen over the span of a few months because any impact to your portfolio will likely be minimal over the long run.

 

 

 

The Good News About Banks Passing A Stress Test

Banking Sector Focus
July 2017

Imposed stress tests by the Federal Reserve for the nation’s banks resulted in a favorable outcome. A total of 34 banking entities were subject to the Fed’s stress test, officially known as the Comprehensive Capital Analysis & Review (CCAR). The better than expected results will allow banks to increase their dividend payouts and execute share buybacks.

Data from the Fed’s test results revealed that the average common equity capital ratio for the 34 banks was 12.5% for the first quarter of 2017, versus 5.5% in a stress test imposed during the financial crisis in 2009. The results of the tests provided data that the 34 banks would be able to maintain enough capital in a recessionary scenario along with 10% unemployment, allowing them to provide sufficient lending to businesses and individuals during a significant economic downturn. Banks act as an essential lubricant for the financial structure of the country.

Dividend paying banks had been restrained from paying larger dividends due to heightened regulatory scrutiny enacted by regulations. Because of improving cash flows and amassed excess cash, analysts expect banking sector stocks to have dividend growth surpassing most other sectors once the regulations finally release their grip.

Additionally, the forecasted rising rate environment tends to allow banks to become more profitable, permitting broader lending to consumers and businesses throughout the economy.


Source: Federal Reserve; CCAR June 2017 Release 

Mortgage Refi Cash Outs On The Rise

Mortgage Market Review

Nearly half of mortgage borrowers in the first quarter of 2017 opted for a cash out option when refinancing. The amount of cash outs is at the highest since the 4th quarter of 2008, when the financial crisis was in motion.

Cash outs were tremendously popular during the housing boom when almost 90% of all refinancing included a cash out option. Cash outs as a percentage of total refis dropped considerably to 12% in 2012 following new rules and regulations.

Also fueling recent cash outs is the rise in housing values that allows homeowners to extract a portion of their equity as cash. Before new regulations, cash outs were available on higher percentages of home values, whereas rules today limit cash outs to much lower loan to value loans.


Sources: Federal Reserve, Federal Housing Finance Agency

Another Bear Market?

Global Financial Private Capital
Thought for the Week

SYNOPSIS

  • This week, oil fell into its sixth bear market in the last four years.

  • Oil has been a big story and market-mover since Saudi Arabia started a price war back in 2014.

  • Saudi Arabia will regret the day they started this price war.

BEAR MARKET

This week, oil fell into its sixth bear market in the last four years. A bear market is defined as a decline of 20% or more in price since a recent peak, and there are few things the financial media loves more than a bear market. Hence, this news made the front page and consumed hours of live coverage by the networks.

Oil has been a big story and market-mover since Saudi Arabia started a price war back in mid-2014. Back then, oil was trading in triple digits, and the Kingdom was concerned about losing market share to the energy revolution that was well underway in the U.S.

Their goal was simple - cut prices to attract more business and cause high-cost U.S. producers to go under. Saudi Arabia has one of the lowest production costs in the world, so they felt that they could withstand a prolonged period of low prices. Once the U.S. producers left the market, they would then raise prices to regain their old profits.

This is a classic competitive strategy ploy attempted in nearly every industry.  For example, imagine an established chain of ice cream stores that is large enough to buy supplies in bulk at a cheaper cost and pay lower rents because leases were signed several years ago.

Then one day, a small competitor opens down the street from one of its locations. The incumbent decides to kill off the competition by dropping its price for ice cream to a level that cannot be matched by smaller stores. Eventually, the challenger goes out of business, and the incumbent restores prices back to their original level. The problem for Saudi Arabia is that their master plan has not unfolded as they had hoped, but before we discuss the implications of this new bear market, it’s important to understand why this price war will end up being a mistake of epic proportions.

DARWINISM IN BUSINESS

Business is a lot like the wild, where only the strongest survive.  Prior to Saudi Arabia’s price war, oil producers were making a killing because nearly all known oil reserves were profitable with crude selling above $100/barrel.

An ample food supply attracts predators, and big profits do the same for capitalists.  New oil companies were being formed overnight, and they all were so anxious to grow as fast as possible that most threw financial discipline out the door.  As the price war began and times got tough, natural selection became the only force that could bring harmony back to the sector.

The strong were those with disciplined managers, diverse operations, and relatively sound financials. These companies represented the smarter and healthier gene pool in the wild. The weak were those who took on way too much debt, did not manage costs properly and had bad management teams. These companies represented an injured buffalo in an ecosystem that offers no protection from the imminent dangers that hunt them.

Ultimately, the weak cannot survive. The cruelty pervasive throughout financial markets does not allow them to remain in business.  Some filed for bankruptcy and others got acquired by the strong, but in any event, they had to go before order could be restored.  Simply put, the price war ultimately benefitted the U.S. energy sector because it thinned out the herd and forced survivors to become stronger.

HUGE MISTAKE

Fast forward to today, and Saudi Arabia is starting to realize that Darwinism and capitalism are inextricably linked, and there is no country in the world that thrives on capitalism more than the U.S.  Since the U.S. energy revolution began, the strong companies have been reinvesting billions back into their businesses to lower their cost of production.  Rigs are now run by computers, and costs have been cut to the point where they have not only learned how to survive with cheap oil but become profitable.

Data supports this conclusion. Drilling in the U.S. has been rising this year, and a company is not going to increase production if they cannot charge more for a product than it costs to produce it. But what is most compelling about this new bear market is the impact to the Organization of the Petroleum Exporting Countries (OPEC) cartel.  Almost a year ago, OPEC agreed to cut production to boost the price of oil higher.  Saudi Arabia and many other members’ economies are heavily reliant on oil revenues, and the pain experienced by the 70%+ drop in the price of oil became too much to bear.

The fact that oil is now moving opposite to the wishes of the cartel is an incredible sign that the cartel that has controlled the price of oil for decades appears to have finally lost their grip. This will be a very big deal for the rest of the world because now the market will decide the price rather than a small group of self-interested and complacent governments.

IMPLICATIONS FOR INVESTORS

Saudi Arabia could have avoided a lot of pain and misery if they had just spent a few hours reading through economic history to assess the success rate of price wars.  The short version is that they almost never work.  The irony behind their decision is that they have done nothing but better position our economy for the long run.  The absolute best possible outcome for the U.S. is an extended period of cheap energy. We pay less at the pump, and companies here pay less for their input costs.

If the bear market deepens further, we may see some equity market volatility, but it will not last. What will persist are the continued efforts of U.S. producers as they drive down their production costs further. The loser will be OPEC because cutting prices is easy, but raising them can be incredibly difficult. This is a lesson they are learning right now, and they will most likely pay the consequences that come from failing to diversify their economy away from oil.

The bottom line is that not all bear markets are bad, and we should be thanking Saudi Arabia for thinning out the herd rather than concerning ourselves over periodic equity market volatility.

 

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Sincerely,

China Buying U.S. Treasuries Again

Global Fixed Income

Currently valued at over $13 trillion, the U.S. Treasury Bond market continues to be the world’s largest and most liquid bond market, attracting capital from foreign central banks seeking safety and stability.

China-Tsy-Holdings.jpg

Federal Reserve data as of May17 shows that foreign central banks held nearly $3 trillion of the $13 trillion Treasury market, an increase of over $60 billion since the beginning of the year. Of the various foreign buyers, China’s central bank has increased its Treasury holdings the most by $29 billion to a total of $1.08 trillion. China is currently the second largest holder of Treasuries, with Japan the largest holder.

A reversal in the U.S. dollar has also helped propel buying by foreigners in order to help stabilize their local country currencies. U.S. Treasuries continue to offer higher yields than other developed country debt such as Japan or Germany, attracting yield seekers.

For the first time in almost 30 years, China’s government debt rating was lowered in May by one of the major credit reporting agencies, Moody’s. Such a move could diminish China’s ability to borrow funds from domestic and foreign investors.


Source: Federal Reserve Foreign Holdings Report, Moody’s

 

Words to Live By

Global Financial Private Capital
Thought for the Week

SYNOPSIS

  • The best part of being a professional investor is the opportunity to learn something new every day.
  • Investors are wrong far more times than they are right, so it’s important to view every hit or miss as a learning exercise.
  • Here are ten lesser-known quotes that have helped guide my investment philosophy and decision-making process over the years.

LEARNING FROM OTHERS

The best part of being a professional investor is the opportunity to learn something new every day. It may be cliché, but the brain truly is a muscle that must be used regularly or else it risks atrophy. Below are ten quotes from various individuals who have shaped the way I view not just investing but also other facets of my life where logic and reasoning are critical to success. Some of the names will be quickly recognized, but most will not.

“If you can’t explain it to a six-year-old, you don’t understand it yourself” - Albert Einstein

No matter how complicated and/or intimidating the world of finance and investing may seem, nearly every concept can be explained. Therefore, be extremely careful around any investor who tries to impress or confuse you with financial jargon. Best case scenario is they are showing off, but more likely than not, they have no idea what they are talking about.

“I would rather be rich than right” - Nelson Peltz

I attended an investment workshop a while back and was privileged to hear Nelson Peltz speak to our group about his investment in DuPont. Mr. Peltz is a legendary investor who takes a long-term view in his holdings and has been incredibly successful.

This quote was so powerful to me because it sums up what this business is all about. To be successful, we must recognize that we will be wrong far more times than right. Check egos and emotions at the door, view mistakes as learning exercises, and be happy when proven wrong because it most likely just saved you from losing a lot of money.

“There are three types of lies – lies, damned lies, and statistics” - Mark Twain

Although statistics are powerful tools to help us recognize relationships, they mean nothing until properly vetted to ensure authenticity. Investors often succumb to the dangers hidden within statistics because they carry very powerful psychological triggers. It’s human nature to want to believe statistics on face value, and often the work required to support or disprove a relationship is either daunting or deemed irrelevant given the observed strength in the relationship.

By far, the most egregious abuser of statistics is the media. Think about how many statistics are quoted during nightly news broadcasts on television. Then think about how few of these figures are broken down to show how the data was gathered and/or analyzed. When it comes to statistics, my rule is simple. I consider them to be guilty until proven innocent.

“Wall Street indexes predicted nine out of the last five recessions” - Paul Samuelson

This well-regarded economist could not have summed up the true predictive nature of the stock market any better. Admittedly, the stock market has fallen prior to every recession going back to 1900, but it has been wrong more times than right.

Equities are anticipatory but they do not track the economy in lock step and often leave us with erroneous predictions. Focus on the direction of the economy rather than daily moves in the stock market. Emotions rule the short-term, and analyzing/ predicting emotions is impossible.

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.” - Charlie Munger

Google “Charlie Munger quotes” and spend some time reading through the results. His ability to sum up situations in a matter of words, albeit in a very blunt manner, is truly entertaining but more important educational. Not too long ago, the challenge for individual investors was gaining access to information that would enable them to make informed decisions on how to invest their savings. Wall Street used to be the gatekeeper to the research that investors desperately needed, and they only sold to big institutions who paid several million dollars each year to obtain.

Fast forward the clock to today, and thanks to the advent of the internet and regulation, there is now so much content available to investors that the challenge has become knowing how to find the information that matters. But it is out there. I dedicate the first few hours of every morning to reading from a wide gamut of sources because there are so many smart people out there these days who write for free, and I always feel a little smarter come lunchtime when I read from these experts in their respective fields.

“Be very careful when demand creates supply” - I don’t remember

I heard this from one of my instructors during a training program at the first firm to hire me on Wall Street. This quote taught me that booms and busts will exist until the end of time, and the two drivers of any cycle are always supply and demand. For example, take a housing market that is so hot that prices are rising close to double-digits. The opportunity to profit attracts builders to this market to create a new supply of homes. The problem is that builders get too greedy and overbuild, resulting in a lot of unsold homes.

Builders need to reduce their excess inventory or else it creates a financial burden on their company. Therefore, one builder decides to cut its prices to lure demand, which subsequently causes the other builders to do the same until prices crash.

The lesson learned here is to always have an idea where we are in any cycle, whether it be housing, stocks, energy, etc. Once supply begins to rise as it meets the beckoning call of excess demand, it’s time to start planning an exit strategy.

“Something that everyone knows isn’t worth knowing” - Bernard Baruch

Financial markets are comprised of assets whose prices are also driven by supply and demand. Prices rise when demand increases, and demand is fueled by information and analysis used by investors. If thousands of professional investors are taking this information and using it to buy/sell stocks, then we must assume that all available information has already been incorporated into asset prices in one way or the other.

Hence, the next time you read the Wall Street Journal over morning coffee or thumb through a three-month-old copy of Fortune Magazine while waiting to get your hair cut, just remember that this information is already baked into stock prices. It’s ok to still read them, but they should not be used as the reason to purchase whatever stock is being discussed. For an investor to believe that they have an information “edge” versus the competition, it must truly be something that other investors cannot access or else it will have already been considered.

“Three simple rules will explain 99% of human behavior: (1) Most people don’t think, (2) Some people are just jerks, and (3) Everyone is selling something” - Brett Arends, Columnist for MarketWatch

Rarely do I come across something so simple yet so powerful (particularly the third point). Since fear mongers never manage any real amount of money, they have chosen to get rich by getting people to sign up for their newsletter, buy their book, and pay for whatever other garbage they are trying to sell to those who need real financial advice.

Recessions happen, stocks lose investors’ money, and economies collapse under too much debt. But they don’t happen that often, and those who make such predictions carry no weight with me unless they can show me a time in the past where they made a bullish call and was ultimately correct. Only then can I consider them to be impartial.

What makes matters worse is that eventually one of these clowns will get lucky. The market will drop for some reason, and they will take their requisite “victory lap” around the media circuit to tell you why their system worked once again (even if the market decline occurred for reasons exogenous to their thesis). As the saying goes, “A broken clock is right twice a day.”

The world does not end all that often, and those who preach it are predators that have only one objective in mind, and that is to grow the size of their wallet.

“The real value of historical record is as a gauge of risk, not return” - William Bernstein

Mr. Bernstein is without a doubt one of the best writers and financial minds of our time, and his seminal masterpiece, The Four Pillars of Investing, is a mandatory read for any aspiring investor. History may not repeat itself exactly, but often it gives us a pretty good idea of how bad it can get. Knowing how to spot bubbles and when asset prices detach from reality can save investors from life-altering mistakes.

In April 2000, right around the time the dot-com bubble burst, here are just a few of the companies that were trading at valuations that look like typos:

  • Terra Networks selling at 1,200 times sales
  • Akamai Technologies selling at 3,700 times sales
  • Telocity selling at 5,200 times sales

For scale, even the most egregiously expensive growth stock in today’s market sells for 20x or maybe 30x sales. A more realistic valuation for a growth company is closer to 3x-5x sales, and even this range could be debated amongst conservative investors. Oh, and none of these companies had any earnings.

We all know how this story ended, so the next time you look to history as a guide, focus more on what it can tell you about the risk rather than the return. As Sir John Templeton famously said, “The four most expensive words in the English language are, ‘This time it’s different’.”

“The stock market is a giant distraction to the business of investing” - John C. Bogle

I constantly get asked the same two questions by both the media looking for a story and day traders looking for an edge. The first is what I think is driving the market at any given moment, and the second is what I think the market is going to do over the next 6-12 months.

My answer is always the same to both, which is I have no clue, and if I did, I would not be answering questions from reporters. Instead, I would be shopping for an island because what’s the point of having a crystal ball if you can’t use it to make enough money to establish residency in your own utopian state?

Think about the stock market this way. If emotions dominate the short-term movements in stock prices, and emotions are viruses to investing, then trying to understand what is driving the stock market on a daily, weekly, or monthly basis only adds unnecessary risk. There is simply no upside because any decisions based off such analysis will result in being either lucky or wrong.

That being said, I still watch the market closely because stocks go on sale all the time, and I love a bargain. A stock will often fall for unknown reasons while the fundamentals stay intact. Emotions cannot be analyzed but fundamentals can, and when these opportunities present themselves, it’s fun to profit on the fear and panic of others.

The bottom line is that this business is about managing risk rather than taking risk, and spending time agonizing over why the market is doing whatever it is doing or where it is going adds zero value.

Sincerely,

 

Credit Scores On The Rise For Americans

Consumer Finance

Higher scores lead to more available credit as consumers tend to receive more financing offers and promotions. Eight years after the financial crisis, consumers that suffered bankruptcies and repossession are seeing their credit scores improve. Theoretically, as credit scores increase, consumer expenditures also increase, but some believe it might be different this time. More favorable and higher credit scores are usually held by older consumers, who actually spend less as they enter retirement and empty nester years.

 

The onslaught of lower rates for over eight years now has also buffered consumers with the help of lower interest payments and more going towards paying down principal balances.

Sources: Fair Issac, Experian, Equifax, TransUnion

The Evolution of Bitcoin

Market Facts

An emerging form of digital currency has received tremendous media coverage this past month, Bitcoin, which is essentially virtual money that is traded digitally by exchanges. Bitcoins can only be purchased and sold with legitimate currency, such as dollars or euros, making it available worldwide. The total estimated value of Bitcoins worldwide as of May 30, 2017, is over 36 billion dollars.

Bitcoins exist as software, not physical currency, and are not regulated by any country or banking authority. Even though U.S. Senate hearings disclosed that Bitcoin could be a means of exchange, it gave no assurance that it would actually become an accepted medium of exchange. Government regulations would need to be created and then enforced in order for Bitcoin to become accepted by other government entities. The currency can be traded without being tracked, thus raising the potential for illicit activity, such as involving weapons, drugs, and prostitution. Bitcoins are not illegal, but it is also not legally recognized by governments as a currency.

Since the beginning of 2017, the total market value of Bitcoins have risen over 20 billion dollars, more than doubling since January 1 2017.  

Some believe that the price appreciation of Bitcoin has been a result of speculation and hasn’t been used as a store of value or as a medium of exchange to any extent. Some compare Bitcoin to the tulip craze in Holland of 1637, when speculators pushed the price of tulip bulbs to incredible levels, followed then by a collapse in the tulip bulb market.

Bitcoin has surged on speculation that perhaps one day digital money will eventually become a legitimate global currency and even replacing currencies from certain countries.

Bitcoins are mined by powerful computers that calculate complex, mathematical functions. Total Bitcoin quantity is capped at 21 million and currently there are about 12 million that exist worldwide. Circulating physical coins only represent Bitcoin and are not a store of value as is legitimate currency.

The growing mobile payment industry could be a big benefactor to the acceptance of Bitcoin as new and creative applications are being devised to accept digital currency. Bitcoin transactions are very popular among mobile users, where rather than using a credit card or cash to make a purchase, all you’d need is your phone.

Bitcoins emerged in 2008 designed by a programmer or group of programmers under the name of Nakamoto, whose real identity remains unknown. New Bitcoins can only be created by solving complex math problems embedded in the currency keeping total growth limited.

In 2014, the value of Bitcoins fell by over fifty percent following remarks by China and Norway to not recognize the digital currency as legal tender. The government of Norway ruled that Bitcoin does not qualify as real currency but rather qualifies as an asset, producing taxable capital gains. Norway said that Bitcoins don’t fall under the normal definition of money or currency.

More and more nations have been taking an official stance as the popularity of Bitcoins has evolved. The European Banking Authority has warned about the risks of trading digital money and being subject to losses where consumers are not protected by any government entity or authority.

As digital currency evolves, some believe that it will eventually be accepted as a legitimate currency. But for the time being, others believe that its time hasn’t arrived yet. Various studies have recently emerged with different opinions, such as a Stern School of Business study conducted by David Yermack, which concluded that Bitcoin behaves more like a speculative investment than a currency and has no currency attributes at all.


Sources:          Bloomberg, Reuters

 

 

How to Help the Next Generation Plan for Retirement

Global Financial Private Capitol
Thought for the Week

SYNOPSIS

  • Retirement planning has become far more complicated for the younger generation relative to when current retirees first got started.

  • Here are some tips to start preparing today for markets tomorrow that will help them navigate the complexities that they will most likely face.

  • Disciplined investing can build a nice nest egg over time, but true financial freedom only comes when one accumulates money without fear of losing it.

OH, TO BE YOUNG AGAIN

Imagine starting over in your 20s, armed with what you know now. There would be no limit to what you could accomplish with decades of experience on your side.

Until scientists find a way to turn back the clock, the next best thing you can do is offer advice to the younger generation, particularly your grandchildren, so that they can avoid the pitfalls that only experience could help them navigate safely.

Many of the rules have not changed: don’t spend too much money, don’t take on too much debt, and always plan for a rainy day. Continue to reinforce these concepts in the same manner your parents and grandparents did for you.

But just as cars and computers have grown in intricacy over the years, so has the process of planning for retirement. Low interest rates, the impending extinction of pension funds, and increasingly complex financial markets require a far more sophisticated plan going forward.

You can help your grandchildren navigate these complexities by instilling upon them the importance of not just saving, but also investing by following these ten simple rules:

  1. Invest in Equities: Recent grads should be 100% invested in stocks for three reasons. First, equities have delivered an average annual return of 10%, which is the largest of any major asset class. Second, this cohort has a long time horizon, so if the market were to experience another dramatic selloff, they would have the time to build back any paper losses. Third, the effects of compounding will amplify returns over time.

  2. Buy Index Funds: Active management of a stock portfolio requires skill, education, and experience. Younger investors have none of these, and those who try will be doing nothing more than speculating. Only buy low-cost index funds that track major indexes.

    ... true financial freedom only comes when one accumulates money without fear of losing it.

  3. Never Buy Company Stock: Tell them to avoid the temptation to invest in their employer’s stock. They may think that being an employee gives them an “edge,” but it doesn’t and never will unless their title begins with a “C” (CEO, CFO, etc.).

  4. Contribute Monthly: Tell them to maximize 401(k) contributions to the point where an employer will match. Think of this as “free money” deposited automatically with every paycheck. Long-term investors ignore entry prices and never try to time buying. They invest monthly, no matter what the short-term trend in the equity market may indicate.

  5. Buy into Panic: If the stock market sells off by 8% over any given month, take whatever excess cash and buy the dip. Only use excess cash, which is cash above and beyond what is needed to pay bills. Make this a rule and systematic. No matter what, keep to this strategy. If there is no excess cash then wait for the next dip.

  6. Establish a Roth IRA: Taxes are only going one direction, so recent grads should set up Roth IRAs before their incomes exceed the legal limit for these highly advantageous retirement accounts. Paying the tax now while their tax brackets are lower and before the politicians raise them higher will ensure that they get to keep more of their hard-earned investment.

  7. Learn How Money Works: Our educational system is utterly useless when it comes to preparing kids for one of the most important subjects, which is how money works. Buy them books, pay for personal finance classes, have them sit with your financial adviser, and tell them to always keep three to four months of living expenses in cash (mandatory) because bad things will happen.

  8. Download these Apps: Smartphone apps can help the younger generation start saving today. Mint by Intuit will help manage finances. Acorn will round up all credit card purchases and invests the change in low-cost funds. Have them download both.

  9. 401(k) Loans: In the pantheon of major financial mistakes, taking out a loan against a 401(k) balance reigns supreme. The temptation to tap this account over time should be squashed immediately if it ever surfaces. Barring a major emergency, there is zero upside.

IMPLICATIONS FOR INVESTORS

Markets evolve over time, and what worked for you will not be enough for your grandchildren. Hence, build upon what was taught to you with these additional strategies, and the younger generation will be better off when it comes time for them to retire.

Lastly, pay close attention to the 7th point above because education cannot be stressed enough. I have lost count to the number of extremely wealthy individuals I have met in my career who live in fear every day of losing what they worked so hard to accumulate. Disciplined investing can build a nice nest egg, but true financial freedom only comes when one accumulates money without fear of losing it.

The bottom line is that the days of easy retirement planning are over and won’t be returning for a very long time, but you can help kids get on the right track by following these guidelines.

Sincerely,

Mike Sorrentino, CFA
Chief Strategist,
Global Financial Private Capital mikeonmarkets.com

The French Vote & Consequences For the Euro & EU

The French Vote & Consequences For the Euro & EU
International Update
May 2017

A similar sentiment that encouraged British voters to exit the European Union (EU) is now influencing French voters to possibly do the same. A leading candidate, Marine Le Pen, is an advocate of France exiting the EU.

A growing concern in Europe is that a domino effect may take hold as the sentiment to exit the EU spreads to other countries. Upcoming elections in Lithuania, Austria, Netherlands, and Germany may yield additional candidates that also favor an EU exit. Of the 28 EU member countries, France currently has the third largest economy after Germany and the UK, which voted to leave the EU in 2016.

The challenge ever since the euro was introduced to the financial markets in 1999 has been how best to synergize the various cultures and languages entangled throughout the EU. In addition to cultural and social diversity, the EU imposes certain rules and laws on EU member countries and their citizens. The regulations have been considered intrusive and overbearing by several EU members.

A current objectionable mandate by the EU on its members has been the acceptance of immigrants. For years, EU members have honored an open door policy to immigrants fleeing political persecution in their home countries, such as Syria, Afghanistan, and Albania.

With the onslaught of recent terrorist activity and attacks by identified immigrants throughout Europe, a growing anti-immigration sentiment has taken root. Among the countries with considerable inflow of immigrants has been France, whose recent terrorist attacks has influenced French voters to insist on new immigration policies.


Sources: Eurostat, Bloomberg, Reuters

 

Where Trump Tax Cuts Will Help The Most

Fiscal Policy

President Trump’s proposal to cut the corporate tax rate from 35% to 15% could benefit various industries and sectors throughout the country.  U.S. based businesses with a domestic focus would benefit the most including retailers, telecom companies, regional banks, restaurants and health insurers.  Domestic based companies have about a 35% tax because they lack lower overseas operations taxation.  Standard & Poor’s estimates that highly taxed companies could see a 30% increase in after-tax earnings if the top corporate tax rate falls to 15%.

Not only may corporations attain higher profits, but consumers may also enjoy lower prices should some of that profitability be passed on to consumers.

The proposals also include a one-time amnesty rate of 10% for U.S. companies that have an estimated $2 trillion in profits trapped outside the United States.  U.S. companies have been discouraged from bringing these profits back to the U.S. because of the current 35% tax rate. Proceeds from the repatriation of $2 trillion into the economy could result in job creation, manufacturing, and increased dividend payouts for shareholders.

Pass-through businesses stand to see a generous tax reduction under the proposals.  Sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are considered pass-through businesses.

The proposal has become extremely popular with these entities because they currently employ more than 50 percent of the private sector work force and account for roughly a third of all private sector payroll.


Sources: The Tax Foundation, IRS

 

A Bitter Rivalry

Global Financial Capital
Though for the Week

SYNOPSIS

  • Yale University’s endowment returns have crushed the competition over the last 25 years.
  • Alternative investments are those that are not considered to be traditional investments such as stocks, bonds, and cash.
  • Yale can attribute its stellar performance to its large allocation to alternative investments.

BRAGGING RIGHTS

The Ivy League comprises some of the most prestigious educational institutions in the world. Names like Harvard, Princeton, and Yale conjure up images of future world leaders studying relentlessly to achieve perfect marks.  This is a group of high achievers who are unfamiliar with the concept of “second place,” and they fiercely compete  to be the best at everything.  To this cohort, it’s either the  gold medal or nothing at all, and this even extends to  the performance of their school’s endowment fund.

An endowment is critical to the financial stability of a university because the returns fill the gap between revenue (tuition, etc.) and spending (salaries, etc.).  The more money the endowment generates each year, the more a school can pay to attract better professors, build state-of-the-art facilities, and support research endeavors.

Therefore, endowments are closely followed, but no two schools receive more attention than Harvard and Yale.  This bitter rivalry is the investment equivalent of Ohio State and Michigan, Yankees and Redsox, or even Jimmy Connors and John McEnroe.

The table below compares the average annualized returns of Harvard, Yale, and other endowments to all active balanced mutual funds and an indexed 60% stock/40% bond portfolio. The returns clearly show that Yale’s bragging rights over Harvard have been in full effect for decades. When compared to the rest of the competition, it’s not even close. Yale’s returns are so far above all others that it begs the question of how they have been able to do it. 

AN ALTERNATIVE APPROACH

Any real estate agent will say that the three most important rules of real estate are (1) location, (2) location, and (3) location, because the neighborhood determines most the value of a home. Buy a bad house in a great neighborhood, and you should still do ok.

Similarly, the three most important rules in investment management are (1) asset allocation, (2) asset allocation, and (3) asset allocation. Picking the right allocation explains 93% of long-term returns1, and Yale has done a phenomenal job finding the best neighborhoods.

The chart shows the neighborhoods that Yale’s endowment fund selected last year.  

Source: Yale Daily News

Source: Yale Daily News

Two striking conclusions are evident:

  1. Few Stocks & Bonds:  Yale’s allocation to traditional asset classes is tiny. Only 18% is invested in stocks (4% domestic and 14% foreign) and 8% in bonds and cash.
  2. Lots of Others:  Asset classes not classified as either a stock or bond (red-dotted box) comprises 74% of the asset allocation.

Those other asset classes are commonly referred to as “alternative investments” because they are not considered to be equity or fixed income investments. Without question, these are the drivers of Yale’s massive outperformance.

Screen Shot 2017-05-22 at 3.33.47 PM.png

Now that drivers of Yale’s returns have been identified, let’s go under the hood to see why these asset classes have done so well. The chart below lists three different portfolios based on risk tolerance and compares the risk/return characteristics of each over the last 25 years.  

The conservative portfolio consists of 30% stocks and 70% bonds, the moderate is a 50/50 split between the two, and the aggressive is 70% stocks and 30% bonds. As expected, the conservative portfolio has less risk than the aggressive one but also lower returns over time.

However, when each of these portfolios is adjusted to hold a 50% allocation to alternative investments, all three portfolios benefitted from higher returns and less risk (indicated by the three red arrows).

The reason why we see higher returns comes from the sophistication represented by these alternative strategies. These managers tend to fish in different ponds than traditional stock and bond managers, and their expertise often leads to (1) larger returns over time and (2) a smoother ride for investors.

Risk is lower because these asset classes are often less affected from what tends to drive stock prices down. This increased diversification creates tremendous benefits for those investors who prefer a smoother ride over time.

Simply put, Yale’s large allocation to alternative investments is the reason why their returns have far surpassed its competition and the traditional 60/40 portfolio.

IMPLICATIONS FOR INVESTORS

Access to alternative investments has historically been restricted to institutions and ultra-high net worth investors. Fortunately, these barriers have started to fall, and individuals are now able to invest in these assets just as pension funds and endowments have for decades.

The big hurdle that remains for most individuals to invest in alternatives is perception. Thanks to
the financial media, these investments carry a negative connotation as being riskier than traditional investments in stocks and bonds.

Arguably the most egregious of misconceptions is the hedge fund industry. These investment firms employ complex investment strategies to profit across the entire business cycle or mitigate specific risks. They are run by some of the best and brightest investment managers on the planet, and the table below shows that the industry returns far surpassed the S&P 500 from 1998 – 2012, with around half the annual volatility.

Screen Shot 2017-05-22 at 3.28.37 PM.png

The Sharpe ratio in the far-right column is a measure of efficiency. It divides the excess return above risk-free investments by the annual volatility to measure how much return a manager is generating per unit of risk. A higher Sharpe ratio indicates a more efficient manager, and this hedge fund index delivered 3.6 times more efficient returns than the S&P 500 over this period.

However, since the financial crisis, the media has attacked the hedge fund industry over perceived lackluster returns, fee structures, and large bonuses paid to a select group of high-profile managers. It is as if we cannot go a week without hearing about how some hedge fund has closed or a pension fund fired another manager. The onslaught by the financial media has been relentless.

These stories do nothing but harm individual investors because they paint a picture of hedge funds being the Wild West of the investment world. Nothing could be further from the truth for three reasons:

1. Smoother Ride: Hedge funds aim to deliver more efficient returns, and in doing so tend to give investors a smoother ride over time. Less volatility leads to fewer sleepless nights.

2. Talent: Hedge funds often pay better than traditional asset managers because the strategies are more sophisticated and require the best talent. The intellectual brainpower in many of these firms rival NASA far more than the gunslingers at the O.K. Corral.

3. The Name: Hedge funds get their name because their goal almost always involves hedging some form of risk. Large institutions are not run by incompetent managers, and they would never pay the fees charged by hedge funds unless they were doing their job.

The chart below quantifies the importance of these characteristics by comparing the recovery rate needed to break even for a well-regarded hedge fund index during the financial crisis to the S&P 500.

Since the hedge fund index fell significantly less during the financial crisis, the amount needed to recover was a fraction what the S&P 500 needed to return to get back to even.

Add it all up and individual investors can learn a lot from watching what Yale and other top performing institutions are doing with their money. The level of responsibility that these endowments carry is tremendous, and the notion that some of the most experienced investors overseeing hundreds of billions in assets would gamble away the financial future of the universities they represent is hard to envision.

The bottom line is that Yale University has generated stellar returns over time because those who manage their endowment chose to fish in a different pond than most others, and it is time for investors of all risk tolerances to consider dipping their toes in this water.