Have we entered a Deflationary Spiral?

As of January 12, 2015, the S&P 500 Index is down over 3% YTD and it is the worst start to the year for the S&P 500 Index since 2009. The major news that came from overseas was the Euro zone slipped into deflation as prices in the euro zone fell 0.2% percent year-over-year in December. The plunge in energy prices is causing concerns that we might be entering a deflationary spiral. Investors are clearly unnerved by the precipitous drop in energy prices and other commodities which have historically been a reliable leading indicator of future economic growth. These indicators could be foretelling a period of slower global growth. We believe that energy prices may need to stabilize before markets become less volatile and begin to move much higher. We believe that if energy prices fall even more from these levels, corporates profits could be negatively impacted. The Federal Reserves ‘beige book’ reported this week that oil prices are causing a slowdown in areas of the country sensitive to oil prices.

As energy companies cut back on production we will sadly see layoffs as well as huge cuts in capital expenditures. Schlumberger, which is of the largest oil services company said that it will be firing 9,000 workers due to the plunging oil prices. We believe that this is just the beginning of massive layoffs in energy companies if energy prices do not rise. We believe that many energy companies will also start to announce one-time charges related to the fall in prices. On the other hand, well-run energy companies should be in a better position to gain market share and pick up assets on the cheap.

Why have markets suddenly become so volatile?

Global markets are clearly out of sync and market turbulence is now flashing in red, “fasten seatbelts”. Volatility has returned with a vengeance. The  investopedia definition of a volatile market is, “an unpredictable and vigorous changes in the prices of stocks.” Our definition of volatile markets is quite different. We believe that markets become volatile when the equilibrium of the stock market gets thrown out of balance as investors become uncertain of the future. Analysts fear that consumers will hold off on purchases if they believe prices will continue to fall. Interest rates around the globe have fallen to nearly zero in many overseas countries. For example, in Germany, the 5-year bond rate actually turned negative. Deflation is the real fear. Would you place your money in the bank if they paid you less than what you put in? Your reaction would be to find the bank that would pay you the most for your money and had the best reputation for security. For an overseas investor that bank is called the US Treasury. These foreign investors who buy US Treasuries first need to sell their home currency to convert into US dollars. Hence, the result is the US dollar is now stronger than the Euro when it was first launched back on Jan 4th 1999 at 1.1789. The Euro has continued to weaken and US Treasury rates have dropped. A weak Euro is not welcome news to a US multinational company that relies on a large proportion of its sales from outside the U.S.. We believe that earnings estimates may fall for many of these multinational US companies. However, many of these same companies may see a boost in profit margins due to the lower cost of energy. We believe this quandary is confusing many investors who are trying to determine the net effects of these changes on future cash flows. This uncertainty will be a major reason why stocks may remain volatile in the near term.

Why did we anticipate a drop in energy stocks last month?

We believed the cash flows for many energy companies tied to the energy markets would drop substantially. In our last few investment updates back in November and December of last year, we warned our clients to beware the “Black Swan” in oil. We recognized major downside risks within certain industries that rely on high oil prices. We cited our favorite quote from Warren Buffett, “Risk comes from not knowing what you’re doing.” Our article a few weeks ago warned about the falling future earnings estimates of energy companies and that these companies represented a classic “value trap”. In the last week, many of these companies have fallen over 8%. Sentiment has suddenly turned extreme as investors are now focused on the short-term and they now could be missing compelling future buying opportunities. We stand ready to buy the panic. We will carefully be watching the cash flows of these companies. We believe that the managements of these companies may not be too forthcoming on their future plans but accurately reported cash flow statements may tell the true story.  There is a high stakes game of poker occurring at the boards of many energy companies. Do you cut production or do you hold out and wait for your competitor to cut production. Drillers are hardwired to believe that energy prices will always go higher. Our belief is that future cash flows will be what ultimately drive these stock prices higher or lower.

Not Planning to Retire Soon – Hope for Less Rosier Headlines

The Dow Jones Industrial Average recently climbed to a record high of 18,000 for the first time on December 23rd.  Investors cheered this news and the media proclaimed that the bull market was heading even higher. There was no cheering from us at Constant Guidance Financial (CGF). We reflect back on Warren Buffett’s quote from his 1997 Berkshire Hathaway shareholder letter, “Disinvestors Lose as Market Falls—But Investors Gain.” Buffett’s point was that savers are able to deploy funds more advantageously at lower prices.  The stock market is the only market where people don’t like to buy “on sale”. If you are contributing to a 401(k) or other retirement vehicle and do not plan to retire in the near future, you should be hoping for less rosier headlines.

The Dow Jones Average is up nearly 175% since the low reached in November 2009. It is hard to believe that the index was at 6,547 such a short time ago.  While we prefer not to experience a significant market correction, we do prefer lower prices. We follow Buffett’s advice, “… smile when you read a headline that says, “Investors lose as market falls. Edit it in your mind to “Disinvestors lose as market falls — but investors gain.” As fundamental investors, we tell all of our clients who invest with as that we prefer lower markets. It is much easier to find better values when prices are lower.

In our view, there are not many bargains in equity markets these days. Investor confidence is at near all time highs, international investors are piling into the U.S. markets, companies are buying back record amounts of stock, and oil prices collapsed over 40%. Moreover, companies are flush with cash, jobs are plentiful, wages are on the rise, inflation is nonexistent, consumers are in a spending mood, and investors continue to buy every dip in the market. According to Barron’s Magazine, EVERY Wall Street strategist is bullish in 2015. They all expect to see a stronger U.S. economy next year.

At CGF, we do not make future market predictions because if we could accurately predict the market like the brokerage firms attempt, we would leverage our bet multiple times and plan to retire in 2016. We believe the best way to accumulate wealth over time is to find undervalued businesses and slowly compound returns over time.  We are constantly reevaluating our clients’ portfolios and looking for new investment opportunities. In the past, we were evaluating companies with earnings yield over 6%-8%. In this current market environment, the highest quality companies are now yielding between 4%-6%. Earnings yield is the quotient of earnings per share divided by the share price. We use earnings yield because we can compare the earnings of stocks to bonds. Earnings yield is the reciprocal of the P/E.  Today’s earnings yield is low relative to historic valuations; however, it is actually high when compared with bonds, CDs, and other assets. In this deflationary environment, many investors are satisfied with an average 4%-5% earnings yield versus an investment grade corporate bond with a 2% yield that has a 5-year duration. Earnings yield continues to favor equities. If interest rates begin to rise next year, then we would assume that equity markets would become more volatile. In the meantime, we will continue to hope for lower markets for our long-term clients and are willing to hold a small cash position for our clients nearing retirement as equity valuations remain slightly elevated.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Keeping Score: A Secret to Retiring Comfortably

Institutional Thinking for Individual Investors™

By Mitch Zides, CFA, CFP®, AIF®, NSSA® November 21, 2014

Over the course of my investment career, I have been fortunate enough to work alongside many of the smartest investors in the world. A few of these managers posted annual 20%+ returns over their entire careers and managed upwards of $30 billion. Intellectually, the best investors shared similar investment approaches and took long-term views. Textbooks have been written on unlocking the secrets of how these investors beat the market year-over-year.

The importance of keeping score

In this article, I would like to share with you important insights from the best investors that you can apply that will help make you more money and it has nothing do to with selecting investments.  What all the best investors have in common is that they keep score.  They all know exactly how their investment results materialized. These investors have set a bar and are trying to beat it on a daily basis. They understand the tremendous power of compounding and how exceeding this bar will make more money over time.

To illustrate the importance of benchmarking and compounding, the chart below shows the annual returns of a $100,000 investment over a 30-year period using incremental returns of 1%.

Growth-of-100000-150x150

Source: Constant Guidance Financial – This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

A 4% change in return from 6% to 10% can be the difference between you retiring comfortably or having to scale down your lifestyle in retirement. However, many of us are playing this game without ever looking at the scoreboard. Most investors are typically too busy to calculate these numbers or don’t know how to make sense of these numbers.

Selecting a Proper Benchmark

If you currently work with a broker, they might be calculating these numbers, but from my experience this is not the case. I have evaluated the investment statements from hundreds of these brokers and I have only seen a few who have set a benchmark for the portfolio that they manage. Each year you should receive a report card of your performance to evaluate whether your portfolio has generated the highest possible returns to meet your goals.  Brokers tend to focus on relationship building rather than investing because they just don’t know how or don’t have the tools to create a proper allocation1.  The advisors that I have seen that excel in creating portfolios tend to come from an investment background and recognize the importance of portfolio management. Others are not educated in asset allocation or do not have the knowledge to properly evaluate a portfolio.

As the chart above showed, each 1% increase of early return can be the difference in over $100,000 over the course of your life. The next step that you should take would be to a select the proper benchmark that will allow you to evaluate what went wrong or how you can improve the risk/return profile of your asset allocation. By no means should you ever fire an advisor who has underperformed the benchmark over a short time period.  Markets go in and out of favor and you really need to evaluate someone over a full market cycle. On the other hand, if your broker can’t produce these numbers or can’t thoroughly articulate their investment philosophy you might start thinking about making a change.

Learning from the Best

One of the most popular investment letters that comes out each year is Warren Buffett’s yearly letter to shareholders – http://www.berkshirehathaway.com/letters/letters.html. Each of his letters begins with a table that shows how he increased book-value per share versus the S&P 5002. With this statistic it is easy to see how much value he created during that year. At the other end of the spectrum, is an investor like Jim Cramer who on average recommends 5-10 new investments a night which total hundreds over the course of a year which make it virtually impossible to determine his investment results.

If you work with an advisor, you should ask them to determine your average yearly return and how that performance stacks up against a benchmark.  It is also important for them to select the correct benchmark. Similar to your fingerprint, everyone has a different risk profile and attitude towards their money. If your advisor can’t come up with these numbers, I would recommend working with someone who can calculate the risk/return versus a benchmark that is most suitable to you.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.