Inflation Targeting and Politics

The Federal Reserve voted this week to raise interest rates by 0.25%, which was the second increase this year. Federal Chair Janet Yellen said that their decision to raise rates was a reflection of the progress that the economy has made.  Her two main points for raising rates were the 4.3% jobless rate at a 15-year low, and wage growth remaining weak. In her prepared remarks after the decision, Yellen stressed that there is an emerging debate over raising global inflation targets, which is now one of the Fed’s most important questions facing monetary policy.  Since early 2012, the inflation rate has been running below the Fed’s 2% target. In April, the inflation rate dropped to 1.7%.

There are many economists who believe that U.S growth is weak and that inflation should be increased to spur higher growth. I disagree with these shortsighted economists. I’m not sure how the economy can be weak if almost all the major stock indices are up over 15% in the past year. Moreover, there are now bidding wars breaking out in the real estate market. House prices are actually higher than they were before the entire economy system almost failed and needed a government bailout. The major differences between 2008 and now are that banks are well capitalized and borrowers are more creditworthy. The stock market has risen as corporate profit margins have increased. It’s been a very good investing environment and I don’t want any changes to inflation targets.

In addition, I know that all of my clients in retirement need lower inflation because of their fixed incomes. If the Federal Reserve does change their target to say 3%, the result will be that millions of retirees suddenly will be in a budget shortfall. Yellen believes that interest rates have been stuck at historically low levels and unless something changes around inflation targeting, growth will remain weak. She said that changing this inflation target “is one of our most critical decisions.” This is unwelcome news that the Federal Reserve does not believe that higher inflation is a major risk to investors.

When I create a retirement plan and change my inflation assumptions from 2% to 4%, the probability of a successful retirement drops substantially. It’s the real return that matters the most for investors. I prefer a lower inflation rate and a chance to make a higher return investing in stocks, bonds, and preferreds. I hope that the Federal Reserve can remain independent from Washington, keep to their senses, and continue to target an inflation rate of 2%. Regardless of your political affiliation, we don’t want any elected government officials playing politics with inflation targets in order to increase economic growth. The economy is running well and it will be best not to trigger higher inflation.

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Beware the Market Hypothetical

Professionals and individuals alike make major financial decisions based solely on past investment returns. This is a huge mistake. Given that the average 5-year return of the S&P 500 now stands at 15%, these hypothetical returns show unrealistic promises of high returns.

Most financial advisors use market hypotheticals in their presentations to make the case that their investment model is superior.  They hope that the unsuspecting investor will ignore the warning “past performance is not an indicator of future outcomes” in fine print and will chose the investment or financial advisor that shows the greatest return potential.

Throughout my career, I’ve seen the worst investment mistakes made when people chase past performance. Here are five helpful tips on how to avoid this mistake:

Gimmick – There is a very large presentation book filled with charts and graphs that show hypothetical performance and no actual performance.

Tip – Make your decision based more on the investment philosophy and experience of the advisor or firm who will be managing the money. Is the investment process repeatable? What are the qualifications of the advisor?  

Gimmick– A mutual fund fact sheet is shown with very high returns.

Tip – Ask the advisor for the worst 1, 3, and 5 year returns for that same investment. 

Gimmick – A model portfolio based on risk and no actual returns is presented.

Tip  – Request to see actual returns of clients. If real returns are not available, ask to see a client reference list.   

Gimmick – A proprietary mutual fund is selected by the financial advisor. This is an investment managed by the company that you are meeting with.

Tip – In 99.9% of the cases, this mutual fund has much higher expenses and has likely underperformed its benchmark. Ask to see if there is an exchange-traded fund equivalent with lower fees and higher returns.

Gimmick – An annuity is recommended by showing you hypothetical returns with income expectations for life.

Tip – Request to see what the total expense will be for that annuity over a 5 and 10 year period. Determine when the original investment principal is exhausted. 

At this point in the market cycle, investors need to be very cautious on selecting their investments based on past returns. I have seen more and more hypothetical investments from other financial advisors that will not be repeated. It is very easy to construct models that are backward-looking and misleading. My recommendation is to tear them up and recycle the paper.

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5 Ways to De-Risk a Portfolio

Christine Benz is Morningstar’s Director of Personal Finance. She writes a weekly column called, “Improving Your Finances”, on I consider Christine’s advice the best and most reliable that you can find online. She writes on timely topics that are relevant to her followers.

This week she discussed 4 Ways to De-Risk a Portfolio in Retirement. As always, I was in complete agreement with her advice. In fact, many of the investments that she recommended, I already own for most of my clients in or near retirement. Her four ways to de-risk a portfolio are higher dividends, diversification, timely rebalancing, and investing in high quality stocks.

Many smart investors have already taken Christine’s advice and are de-risking their portfolios. They are rotating out of the U.S., buying high quality companies with no debt and strong cash flows, favoring dividend paying companies, and diversifying into bonds. The investors who don’t heed this advice are going to experience the most financial pain when the correction does hit.

Bloomberg’s chart of the week showed the companies with the highest debt are vastly underperforming the market.  If you remove the “FANG” stocks (Facebook, Amazon, Netflix, Google), the companies with the highest debt trail the market this year by 14%! This same market action occurred during the lead up to the Great Recession in 2008. The market is also becoming very narrow, and if you remove the FANG stocks, the S&P 500 year-to-date return drops from 9% to 4%.

This week, Seth Klarman, who I believe is the 2nd greatest living investor behind Buffett, couldn’t have written a better statement that summarizes the current risk level of the market:

“When share prices are low, as they were in the fall of 2008 into early 2009, actual risk is usually quite muted while perception of risk is very high. By contrast, when securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

There is more truth in these two sentences than anything I’ve read in a very long time. In the last 10 years, Seth has grown his hedge fund from a few billion to over $30 billion. He also wrote an investment book years ago that now sells for over $900 on Amazon. He is one of the few investors that bet against the housing market and he correctly anticipated the subsequent crash.

He considers cash a major part of his asset allocation. I’m sure that he would add cash as the 5th way to de-risk a portfolio. He keeps liquidity high and understands the potential downside of his investments. When the correction strikes, the most leveraged companies typically fall the fastest. Warren Buffett’s summed up excessive risk taking best with this famous quote, “Only when the tide goes out do you discover who’s been swimming naked.” The companies with the most debt or the investors who purchase illiquid investments are usually the ones caught swimming naked.

I’ll continue to help my clients stay invested in the market, while, at the same time, de-risking their portfolios, and keeping my clothes on!

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Digital Currency Mania

In February 2017, one Bitcoin was worth around $1,000, and this week it touched a high of $2,800! The 52-week low for a Bitcoin is $447. This Memorial Day, at the cookout, I’m sure there will be many conversations around politics, technology stocks, sky high house prices, and Bitcoin.

In full disclosure, I have owned Bitcoin and set-up a Coinbase account years ago. I even looked into mining for new Bitcoin. At this point, I’ve probably lost you. What is mining? What is a Bitcoin? What is Coinbase?

Bitcoin is a digital currency. It was created on a network of computers called a blockchain. Rather than getting into the technical language on how a blockchain is created and why Bitcoin exists, I’m going to touch on what I believe is most important to your cookout conversation. If you want all the specifics on Bitcoin, you can click here.

As early as 2011, you could connect your desktop computer into this Bitcoin network. The founders of Bitcoin were not in it for the money. For those people who mined for new Bitcoin, it was a hobby that they did for fun. If one of these computers plugged into the network, helped to make a transaction between a buyer and seller, a Bitcoin would be rewarded into a Bitcoin wallet. In the early days, Bitcoin miners would lose money on each transaction because it cost more money to power your computer than what a Bitcoin was worth. As more computers joined the network, it became harder for a desktop computer to win new Bitcoin. The higher powered computers were rewarded more and more Bitcoins. As Bitcoin increased in value, the energy costs became a small fraction of the potential profit. It became so profitable that entire data centers were built to mine for new Bitcoin. These computers cost upwards of $10,000. The technology was moving so fast that a $10,000 computer would be worthless in only a matter of a few weeks time, as faster computers came to market. If you couldn’t afford a Bitcoin miner, you could buy fractional ownership of one online. Investors began to see the value in building the computers and not in the Bitcoin. If they could get enough fractional ownership, they would make money regardless of the price of Bitcoin.

New exchanges and digital currencies were created overnight. There are now hundreds of digital currencies all competing to become the next lottery ticket. Coinbase is the exchange where you can buy and sell Bitcoin. Many of the exchanges were shutdown because of fraud and only a few major ones survived. The speculation on these exchanges is 100x higher than at a Foxwoods roulette table. There is a dark side to Bitcoin exchanges and your money is never 100% safe.

These virtual currencies are used to launder money, finance terrorism, and other illegal activities. It would disgust you that there are many criminals and mafia members that have made millions on Bitcoin. This was one of the major reasons why I stopped trading Bitcoin.

Bitcoin has yet to be recognized as a major currency, but most major retailers recognize Bitcoin as a legal form of payment. The reason for the huge move in Bitcoin over the past month is pure speculation that more buyers are about to enter the market. If an exchange-traded Bitcoin fund is approved, it will add to the mania. I believe that this frenzy reached its apex as speculators around the world were joining in on this newly created bubble. These Bitcoin traders that are late to the party will lose the most money. The early buyers of Bitcoin are not selling, which makes this bubble so interesting to me. They believe that a Bitcoin is worth over $10,000 and not $2,800. While I don’t believe that Bitcoin is worthless, it is showing signs of a classic market bubble.

Happy Memorial Day, as we remember with pride those friends and family members who served and died for our freedom.

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Amazon’s Lesson

In 1993, Warren Buffett used $433 million in Berkshire Hathaway stock to purchase Dexter Shoe. In his 2007 letter to shareholders, Buffett explained that this poor decision was magnified because he used the company stock to make the purchase. Warren wrote, “To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future — you can bet on that.”

It’s easy to reflect on all the “what if” investments that each of us have missed. Economist Larry Summers summed it up best with this quote, “Most investors want to do today what they should have done yesterday.”

It is always clear to look back at the “misses”. This week marks the 20th Anniversary of Amazon going public. A $1,000 investment on the day of May 15th 1997 would be worth around $638,000 today. A few weeks ago, Buffett was asked on CNBC why he didn’t buy Amazon shares, and his answer was simple, “Stupidity”.  Amazon’s amazing success has disrupted the business model of the entire retail industry. First, it was the bookstores, and then they bankrupted countless other competitors. This earnings season especially the market has been punishing many retail companies that are showing signs of slowing revenue. It is not uncommon to see companies lose over 15% of their value overnight.

Numerous investment lessons can be learned from studying Amazon’s phenomenal success. There is one in particular that I believe is critical to investment success.

A company that continuously grows revenue is much more valuable than a company that is generating profits but has no revenue growth. There are many retail companies that pay above average dividends; however, these stocks have been decimated because of lost revenues to Amazon. On the contrary, Amazon pays no dividend and has never shown any real profits. They reinvest all of their profits back into the business to generate even higher revenues.

There are many investments that appeared cheap on valuation, have substantial cash flows, strong balance sheets, and great dividends. In spite of these justifications to purchase these stocks, I would consider them value traps. With no revenue growth, falling profits will not be far behind. I consider avoiding these types of investments much more important than making decisions based on the daily political games being played out in Washington. I remain much more focused on which investments offer the best future revenue growth.

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Active vs. Passive Management

According to FactSet, the start of 2017 has been the best year for earnings growth rate since the end of 2011.  To date, the number of companies beating their sales and earnings estimates is above the 5-year average. As long as earnings growth rates remain in double-digits, markets should continue to climb.

The major trend emerging this year is that money is flowing into overseas markets. With political uncertainty playing out in Washington, investors are reallocating into Europe and Emerging markets. This week, Jeffrey Gundlach, who is Chief Executive Officer and Chief Investment Officer of DoubleLine Capital, took this trade one step further. He recommended to short the U.S. stock market and buy Emerging Markets. This is called a pair trade. As long as Emerging Markets outperform the U.S stock market, he will make money. He is not extremely bearish on the U.S markets. Rather, he favors Emerging Markets much more than the S&P 500.

Last year, Gundlach surprised markets when he predicted that Donald Trump would win the U.S. presidency. He was also correct with in is prediction when he called the bottom in interest rates. This new forecast is that too many investors are piling into passively managed funds. He believes that these investors are blindly making investments that they don’t fully understand. This also has been a very concerning trend for me.

There has been a backlash against active managers over the past 12 months. Ned Davis, who founded an investment research group that is now one of the largest independent institutional investment research providers in the market, recently wrote, “Don’t worry about fundamentals, or values; don’t worry about market timing; just buy the market and hold! Even if there is a small correction, the market has always come back! Sounds ‘bubbly’ to me.”

I strongly believe in both an active and passive approach to selecting investments for my clients. There are some investments where an active manager can add value and are worth paying a higher expense. For instance, I would never invest in an High Yield exchange-traded fund. I am very comfortable paying for an analyst to review the credit risk of the company and that company’s ability to pay. It is important to understand bond covenants and actual recovery rates if that company does get into financial difficulty. If you invest in the High Yield ETF, you are investing in a basket of companies that have the most debt and you have no idea if management has the willingness or even the ability to pay you. While this is an extreme example, it can be applied to other sectors of the market.

I believe that this trend towards passive investing will continue and even accelerate in the next few years. There was a technology bubble, a housing bubble, and at some point we are going to have to navigate through the coming passive ETF bubble.

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Why markets are trading at such high valuations

Jeremy Grantham, who is the co-founder and chief investment strategist of (GMO), a Boston-based asset management firm, released his quarterly letter. Jeremy built his reputation on predicting major market bubbles.  He called the housing bubble and warned about technology valuations in 1999.

I thought this recent quarterly letter was well written. He uses historical facts to make a case that while markets are overvalued, they are not in a bubble. According to GMO, the average P/E ratio over the last 20 years is 23.36. Over a 20 year period prior to 1997, the P/E ratio averaged around 14. He provides a few very good explanations as to why markets are trading at such high valuations.

U.S. profits are much higher than they were 20 years ago. The average U.S. profit margin is now 7% and 20 years ago it was 5%. He presents four arguments why profit margins should remain elevated.

Globalization –  “Increased globalization has no doubt increased the value of brands, and the U.S. has much more than its fair share of both the old established brands such as Coca-Cola and the J&J variety as well as the new ones like Apple, Amazon, and Facebook.”

Increasing corporate power – “Steadily increasing corporate power over the last 40 years has been, I think it’s fair to say, the defining feature of the US government and politics in general.”

Monopoly power – “The general pattern described so far is entirely compatible with increased monopoly power for US corporations. Put it this way, if they had materially more monopoly power, we would expect to see exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations.”

Low interest rates – “The single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now, and leverage was 25% lower.”

Going forward, he believes that the biggest risk to markets is rising interest rates. However, interest rates are unlikely to move that much higher given that much of the world is grounded below 0%.

This investment environment has resulted in many low risk investors buying more stocks. Back on August 5th, I wrote how the game rules were changing. The old rule of thumb of investing for retirement savers was to invest less in equities as they aged. This rule was very successful before we entered this period of globalization, increased corporate power, monopoly power, and low interest rates. As Jeremy wrote in his quarterly letter, “a regular bear market of 15% to 20% can always occur for any one of many reasons”, but this current trend could go on longer than people expect.

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The Economy vs. Stocks

There have been louder warnings by market pundits of a possible global financial crisis. Up to this point, these doomdayers have had a terrible record on predicting when the next market calamity will unfold. Each market dip has been short-lived with markets eventually making a speedy recovery. This week markets cheered the news that the pollsters finally got it right in the French election. The populist backlash in Europe has subsided for the moment.

With this hurdle cleared, the market turned its attention on whether President Trump can pass sweeping tax reform. The major provision in this plan is that the U.S. economy will need to grow by 3-4% or the tax cuts will add to the deficit. Given that the Q1 2017 GDP increased only at a 0.7% annual rate, higher economic growth is likely to be short-lived.

Over the last year, the S&P 500 index is up 17.78%, while GDP growth has stalled around 2.5%. This divergence can only be explained one way. Stock valuations have climbed in value much faster than earnings. Artificially low interest rates have helped to boost equity returns. Moreover, low rates have caused a buying frenzy in the housing market and bidding wars are common, especially at the lower price points. I believe that housing supply will remain limited.

The number of licensed realtors hit a nine-year high in 2016. Just this week, I received five mailings from real estate agents who were prospecting for new business. House prices in many of the major U.S. cities are now higher than they were before the Great Recession.  Along with the rise in housing, the Nasdaq reached a record level to 6,032. In March 2000, the Nasdaq passed the 5,000 mark before losing 80% of its value after the bubble burst. As Mark Twain wrote, “History doesn’t repeat itself, but it often rhymes”. Housing and the Nasdaq are once again beginning to show signs of excess speculation.

I believe that the market is in the late stage of the economic cycle. This part of the cycle can be very lucrative and can go on longer than investors realize. The pro-business environment should continue, even though recent government statistics have shown little GDP growth.  The biggest risk remains that the economy might overheat.  The investment theme that I have written about often is also starting to look a bit stretched.

It’s that Innovative companies will drive growth regardless of government policies or government statistics. There are many large companies that have cornered parts of the market that I would now view as monopolist. A few of these companies reported earnings this week and these results exceeded expectations.

Most of the management teams on these conference calls have sounded up-beat. All in all, the stock market might be ahead of itself, but higher expected earnings growth is not that far behind.

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Why the Dow Jones is a flawed index

Ever since the U.S. presidential election there has been a large divergence in returns between the S&P 500 and Dow Jones Industrial Average (DJIA). Year-to-date, the DJIA is up 4.60% and the S&P 500 is up 5.41%. The financial media and nightly news have always placed more of an emphasis on reporting the daily moves of the DJIA. As large milestones such as Dow 20,000 are crossed, there is always a discussion around key market levels. This is meaningless information for long-term investors.

In my 15 year career working at large financial institutions, I never had one client track their return against the DJIA index. The reason is that large institutions understand that the construction of this index is flawed. The DJIA is a price-weighted average of 30 large-cap U.S. companies. These companies tend to be the oldest and most popular businesses and represent a very good barometer of the overall health of the economy. The flaw of the DJIA index is that the large priced stocks have a much larger influence on the return.

For example, Goldman Sachs, is one of the highest-priced stocks, trading around $217. This one company accounts for around 9% of the total index. On the flip side, General Electric, is one of the lowest priced stocks, trading at around $30. The weighing of GE is equal to approximately only 1% for the DJIA. A move in Goldman Sachs has 9X the influence on the change of the price compared to General Electric.

This week a few of the larger priced DJIA stocks missed earnings – IBM, JNJ, Travelers, and Goldman Sachs saw a significant drop in price. The combined total drop in price was around $22 for these companies.  This change in price is equivalent to GE nearly going out of business this week!

A better proxy for market returns is the Standard & Poor’s 500 (S&P 500). This index is a market value-weighted index of 500 stocks. The components of these companies are by the actual size of the company in the market. The S&P 500 also attempts to mirror the diversity of the largest companies. As companies grow is size, they will become a larger component of the S&P 500 index.

The high returns over the last few years of the S&P 500 index has helped to propel the popularity of investing in the exchange-traded S&P 500 index (SPY). Most active mutual fund managers have not kept pace with returns against this index. However, there are more active managers that have done a better job at managing risk to this benchmark. It’s the risk-adjusted return that should matter most to investors. The risk of the S&P 500 is largely misunderstood by the public. There is now a much higher weighting of technology companies in the S&P 500. In 2009, technology companies only represented a 15% weighting in the index compared to approximately 21% in 2017.

This larger weighting is a major reason why I believe that the volatility for the S&P 500 will be higher in the future. Over the next month, I expect market moves to increase as major technology companies such as Apple, Amazon, Facebook, Microsoft, and Google report earnings. Positive earnings reports and future revenue guidance from these companies is much more important than the political games being played out in Washington.

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I recently finished a book titled Zero to One, which was written by Peter Thiel. Peter is an entrepreneur and investor, who started PayPal in 1998. After he took the company public, he made the first outside investment in Facebook, and since that time has been an investor in hundreds of startups. The book stems from a course on startups that he taught at Stanford in 2012.

He wrote that successful people find value in unexpected places and they do this by thinking about business first from principles instead of formulas. The same could be said of all successful investors. Making investments based on formulas or technical analysis does not lead to successful investment outcomes over fundamental analysis.

This week Bill Gross wrote (and underlined) in his April Investment Outlook that “equity markets are priced for too much hope, high yield bond markets for too much growth, and all asset prices elevated to artificial levels that only a model driven, historically biased investor would believe could lead to returns resembling the past six years, or the decades predating Lehman. High rates of growth, and the productivity that drives it, are likely distant memories from a bygone era.”

Bill also wrote that “Northwestern’s Robert Gordon has long argued that lower productivity may now be a function of having picked all of the “low hanging fruit” such as electrification and other gains from 20th century technology.”

Bill has one of the greatest bond investment track-records, but I know that Peter would not agree with much of this statement. Peter wrote in his book that new technology tends to come from new ventures – startups. These startups build a different plan for the future.  They are both imagining and creating the new technologies, while questioning received ideas and rethinking business from scratch. Peter believes in the power of planning and he writes that long-term planning is often undervalued by our indefinite short-term world. In July 2006, Yahoo! offered to buy Facebook for $1 billion. Mark Zuckerberg scoffed at the idea. The rest is history.

I believe that this way of thinking can be applied to many of the companies that have been the big winners in our economy. Eight of the top 10 companies in the S&P 500 companies are continuously innovating. Of these top companies – Apple, Google, Microsoft, Amazon, Berkshire Hathaway, J&J, and Facebook – all share the similar characteristic of being a monopolistic power. Peter defines a “monopoly” as a kind of company that’s so good at what it does, that no other firm can offer a close substitute. He believes that the reality is that there is an enormous difference between perfect competition and a monopoly. Either a business has it, or it doesn’t.

The cash flows for these monopolies require much less capital investment and more human capital. Outsized profits come from these monopolies, in turn, leads to higher stock appreciation. To paraphrase Peter, creative monopolies give customers more choices by adding entirely new categories of abundance; they are powerful engines for making it better. A company such as Apple only becomes a monopoly when people will pay even more money for a product. A search engine such as Google’s cannot be replicated. Hasbro is one of the most popular companies in our local area and they have been a very creative monopoly. I have a few clients who work there and you would be surprised that none of them think of their company as a toy company, rather it’s a technology company that specializes in entertainment.

Geopolitics and what happens in government is important, but not nearly as much as investing long-term in companies that are developing creative monopolies. There is a premium to own many of these types of businesses and this will likely remain the case even through these volatile markets.

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