Tuesday, January 27, 2015

Beware of Predictions and Remember the Boy/Girl Scout Motto

As I write this, the “massive” snow storm of “historic” proportions that was predicted to hit New York City and the Mid-Atlantic on January 26-27 turned out to be almost a non-event.  Meteorologists were actually apologizing for missing the forecast by such a large degree. (Boston and western Massachusetts is another matter.)

Sometimes we are surprised when something unexpected happens—like a 50% drop in the price of oil over 6 months.  Sometimes we are surprised when the expected does not happen—like rising interest rates or a huge blizzard. Sometimes, we don’t know what to expect because one group is predicting one thing, and another group is predicting another.

Today, we are seeing a pretty big (almost 2%) drop in domestic US markets. Mostly because those that claimed corporate earnings would NOT be hurt by a decline in oil prices and a rising dollar were wrong. Those that claim that markets cannot fall as long as interest rates stay low will probably also be proven wrong.

As an economist and investment manager, I am not in the business of making predictions but rather indentifying possibilities and assigning a range of probabilities to each.  The difference between assigning probabilities and making predictions is very subtle and often mis-understood.   But, that difference is essentially the difference between:   Making Predictions and Being Prepared.

Making predictions is a form of fortune telling and acting on those predictions by placing bets is gambling.   Identifying possibilities and assessing probabilities is the process of making Preparations.

Managing your investments with wisdom is best described by the Boy/Girl Scout Motto: Be Prepared.

I have long been warning that there are many different possible outcomes to the present economic trajectory, and there is little historic precedent from which to learn with one notable exception:

Markets go up and down in cycles.  There are short term ups and downs, but generally there are longer term 6-10 year cycles.  We have had 6 years of upward trend which is now quite “long in the tooth”.  And, there are parts of the markets that appear a bit over-valued. The probability of a substantial market decline, particularly in US stocks and bonds is now a significant risk.  Such declines seldom send an advance warning—they just grind lower over time and then begin to recover over time. The complicated process often takes one to three years and each sector of the market may tend to take a different path.

Keep in mind that the probability of a temporary decline does NOT justify selling good investments, and jumping out of the market to avoid a decline. Then jumping back in later. That would require you to be a fortune teller to be successful.  It is a fool’s errand.

For the retired investor this means that a prudent course of action is to be sure that there are sufficient liquid assets available to cover living expenses so that longer term investment holdings would not need to be liquidated after a temporary decline in value. 
In closing, I like to compare risk management to the decisions of a ship Captain of a large passenger liner running the North Atlantic.  One knows that there are icebergs.  Is the proper course of action running full speed ahead in the dark?  Or, should caution be the order of the day?

The Captain of the Titanic would have been a hero if he had set the new speed record for the crossing.  I am sure that many would have criticized the more cautious Captains of other ships that ran slower that ill fated evening but for the Titanic’s tragic sinking.  There will be times that Being Prepared may not produce the best short term outcome.  But, it provides the best probability of actually arriving at your destination. (Keep that in mind when the S&P500 outperforms your portfolio for one year or your bond portfolio does better than your stocks.)

As investors, we should always remember that our time horizon is 5, 10 years or longer. Investing is not like planting tomatoes in your garden---it is more like planting fruit trees in an orchard or like planting and maintaining a vineyard.

Be Diversified, Be Patient and Be Prepared.
P.S.  Happy that we did not get much snow in Central PA and Northern MD last night. But, my 48" snowblower is at the ready for our rather long driveway and Carol and I are prepared for whatever snow is sent our way. 

Wednesday, January 14, 2015

Global Uncertainty

Here are some figures that shed some light on the current state of global uncertainty. As of January 14, 2015. See illustration graph below.

In a world with historically low interest rates, long term bonds can be very risky as they lose value if interest rates rise. But, for the past six months, interest rates have fallen.   The return from July to January for Long Term Bonds is around 16.5%!

In a world with historically low interest rates, short term bonds that are not very risky do not produce much return.  The return from July to January for Short Term Bonds is around 0.4%!

We get conflicting information about the US Economy, but many have believed that things are getting better because unemployment is falling and confidence is improving--except wages are not increasing and the labor force is shrinking because people are giving up looking for work. The return from July to January for the S&P500 US Domestic Market Index is 1.2%.

We hear that things are not so good in Europe and Asia as well as being not so good in Emerging Markets.  The return from July to January for the World (International) Stock Market excluding the US is a NEGATIVE -12.2%. (More than 10% declines are categorized as "corrections".)

If you combine the US Market and the World (International) Stock Market for a Global Combined Stock Market, the  return from July to January was a NEGATIVE -5.9%.

If you look at the important Global Oil/Energy sector, the return from July to January is a whopping NEGATIVE -28.9%. 

Last January in 2014, NOBODY predicted falling interest rates and such a dramatic drop in Oil prices. Very few, if any predicted a negative return for international stocks.

Conventional wisdom indicates that falling energy prices should be good for the world economy--but many fail to realize that a great deal of economic growth has been fueled by capital investment in energy exploration, production and delivery. With falling oil prices, that investment is grinding to a halt--putting severe pressure on economic growth. 

Conventional wisdom would indicate that housing should be booming with interest rates so low. But, many fail to realize that housing tends to fall in value when interest rates rise, so buyers are wary of losing their equity if prices fall after they buy. 

Conventional wisdom tells us that growth should be accelerating--that we should finally be recovering from 2009.  But, many fail to realize that all of the Central Banks around the world continue to tell us that the global economy is too weak to support "normal" interest rates. Perhaps, this is as good as it gets in this "cycle"--after all, we are now 6 years away from the "bottom". We may actually have peaked and are on our way to the next "bottom". Certainly oil and commodity prices are telling us that.

We are sailing in "uncharted waters" and nobody is completely sure of what the future holds. When sailing in "uncharted waters" it is rational to be cautious--with your spending and your investments. 

Remember that investing Principles are always more important than Predictions--stay focused on the long term with a conservative, well diversified, risk managed, portfolio. And, don't use past performance by itself as a reliable indicator of the future.