Will Investment Returns Be Below Historical Norms

The link and graphic is to Bloomberg and a McKinsey Study.

We will be hearing more of this pessimism over the near term. The negative thinking centers on assumptions that: 1) Corporate profits having peaked; 2) Global growth will slow; 3) Interest rates will continue to be low.

In addition to the short term fluctuations in market sentiment (fear vs greed) one must also consider that there are cycles in long term market sentiment.

In my humble opinion, it is unwise to accept the assumptions in this article as having a 100% probability. My assessment is that they have a more than 50% probability of being very wrong.

Perhaps the biggest factor will be the assumption regarding global growth. While the rate may temporarily slow as excess capacity is absorbed in the short term; over the long term, the substantially growing "middle class" in developing countries has not yet come even close to the consumption levels of the average American. Energy, Health Care and Communication have potential future growth rates substantially higher than we have ever seen in the past.

Be cautiously optimistic in the long term.

Long Term Investment Returns Troubling?

Is it a Bull, a Bear or a Bunny

The symbol of a bull supposedly indicates a rising market. The symbol of a bear indicating a falling market. The symbolism relates that a battling bull engages in conflict by raising his head and horns, while the bear uses his paws and claws to pull down.


People have attempted to predict future market returns by describing current conditions as a Bull Market (rising) or a Bear Market (falling).  A third condition is sometimes calls a "Consolidating" or "Flat" market. 

Keep in mind that assuming that current conditions will continue with "momentum" into the future is a dangerous form of cognitive bias.  It stems from the incorrect application of Newton's First Law of Motion: "Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it."

Markets are not objects. Markets are an indication of the consensus view of the likely future. And this consensus view is often strongly influenced by the very real human emotions of fear and greed.

Greed and a "fear of missing out on gains" tends to drive Bull Markets. Fear of loss tends to drive Bear Markets.  Uncertainty tends to create "Flat" Markets. A fourth type of markets could be dubbed a "Bunny Market".  A Bunny Market jumps up and down and is driven by EXTREME uncertainty. Over the longer term, the market does not rise or fall--it just fluctuates.

Arguably, we have been in a Bunny Market for at least two years. 

The EXTREME uncertainty stems, in great part from unprecedented Central Bank interference that continues all over the world. There is no historical indication of what happens when this interference ends and interest rates return to "normal".  In fact, many predict that the old normal is replaced by a new normal where interest rates and inflation will be forever low. 

What is known for sure is that if interest rates do return to the "old" normal, there will be a great deal of economic turmoil.  Governments will have to raise taxes. Durable goods like cars and homes that are often purchased with credit will become more expensive and sales volume will decline. Some businesses that rely on credit will go bankrupt or at the very least will become much less profitable. And, people who have purchased long term government bonds at low interest rates will witness a significant loss of principal. Yikes!

No wonder every word that comes out of the mouths of Central Bankers have an effect on markets.

In addition to the uncertainty about interest rates, there is the uncertainty about the growth of emerging markets--particularly China. And, then there is the issue of oil and gas prices that seem to be greatly influenced by government policy--in Iran, Saudi Arabia and Russia as well as in the USA. 

So, at no time in history, other than perhaps during the World Wars, has the global economy and markets been more reliant on government policies and politics.  

So, the best investment policy is probably (for most people) to limit your exposure to long term fixed income investments and concentrate on owning a very diversified portfolio of stocks in companies that are likely to maintain stability and profitability during times of rising interest rates and/or a slower rate of global economic growth. And, take advantage of the Bunny Market by avoiding the temptation of buying when prices are high---and by having the courage to buy when prices are low.  Be patient. Investing is about the long term.



Please be sure to read the below disclaimer--Your personal portfolio choices should only be made after a complete review and analysis of your risk tolerance and income requirements and only after a discussion with your personal financial advisor.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Storm Update

At the end of 2015, I predicted that 2016 would be the “Year of Opportunity” but warned about “Continued Uncertainty”. Then on January 7, I sent an email to clients:

“Markets are in decline for several reasons--most of which have to do with concerns that several prior assumptions appear to be, in fact, myths: 1) The China economy will continue to grow at 5-7% per year; 2) Interest rates will continue to be low forever; 3) The US has eliminated the risk of being attacked by an enemy using a nuclear weapon; and 4) The US Economy can have robust growth while the rest of the world suffers slow growth or recession. All of these prior assumptions were and are "myths"--they are wrong.

Bottom line--a lot of speculators have decided that many of their assumptions were too optimistic if not outright wrong and the market is "re-pricing". This is what I have expected for many months.

Put in perspective--this week is sort of a repeat of August...The DOW is still 800 points higher than the August 25, 2015 low. These "storms" tend to last for 14-20 days, so expect more volatility.

This is not 2008 "all over again". What is happening now is quite different and sort of "normal" for periods when markets correct after becoming too optimistic. Value of your portfolio is NOT determined by daily quotes by the "market". The daily quotes of the "market" are essentially a measure of the emotional and fickle sentiment of a lot of market participants--many of which are not really "investors" but rather speculators who are buying or selling on what they think will happen tomorrow.”

The ”storm” as I predicted, has continued. We are still within that 14-20 day period that storms usually take to wear themselves out. The market is “re-pricing” and is in the beginning stages of creating real long term investment opportunities.

The DOW has fallen a little over 500 points since my January 7 warning and it is STILL above the August 25, 2015 low of 15,666. It is highly probable that the storm will continue until the DOW has fallen below this 15,666 level.

In addition to fears regarding a recession in China and other emerging markets, as well as the probability of rising interest rates, there are three other factors influencing market activity.  First, speculators have finally accepted that there is a real possibility of a “non-establishment” candidate winning the US Presidency. (Trump, Cruz and Sanders scare Hedge Fund Managers and Big Banks because they promise “change”.)  Second, speculators have concluded that falling oil prices are now threatening the stability of large banks who have loaned money that fueled the recent expansion of oil  and commodity exploration and production. (Nothing makes speculators more nervous than bank writeoffs.) Third, the price of oil is now being heavily influenced by speculators who profit by betting on the future price of oil. Just as speculators drove the price above reason on the high side, they are now driving the price below reason on the low side—their activity puts oil companies and banks at risk—a sort of vicious cycle that is nearing it’s end.

To put a bit of perspective on this, even though the price of oil has dropped almost 30% since August 25, 2015, the price of Chevron (CVX) stock has risen 19%.

On Friday, 1/16/2016, there seemed to be a bit of panic in market action. As if “something changed”.  In fact, nothing “factual” has changed.  None of the issues are new. The only thing that has changed is temporarily the “fear of loss” has replaced the “fear of missing out”.

Readers of my postings will recall that I often point out that big market moves often occur on “options expiration” days.  In addition, most investors know that markets often fall on the day just before a long holiday weekend.   BOTH of these factors came into play on Friday.  Options expired and Martin Luther King Day (US markets are closed) is Monday.

Don’t fear market declines any more than you fear bad weather. Both unpleasant, but both are temporary.

2016, The Year of Opportunity-Less, but Continued Uncertainty

Last month I shared an article about:

Warren Buffett is having an unusually bad year

Link: http://www.cnbc.com/2015/11/18/warren-buffett-is-having-a-very-unusual-bad-year.html

As a follow up, Mr. Buffett did not recover much in December:

Link: http://www.cnbc.com/2015/12/30/warren-buffett-faces-worst-year-on-stock-market-since-2009.html

Some of the uncertainty I wrote about in November has been resolved:

OPEC decided to continue producing oil at record low prices, losing huge sums, hoping to “make it up on volume and market share”.  Oil continues to be supplied at a rate higher than demand—and storage facilities are nearly full.

The Fed did in fact finally raise interest rates.

We are not going to have a budget impasse with a government shutdown but we will continue to have record deficit spending at the Federal level.

The economy, judging by holiday retail sales, consumer confidence and unemployment seems to be growing, albeit slowly.

But, a lot of uncertainty remains:

How long will it take for the price of oil, and other commodities to recover to more normal levels?

How fast and how much will the Fed continue to raise interest rates?

How will the reality that a lot of voters are just not satisfied with the status quo play out?  Seems like both the Left and the Right are highly energized. Change IS coming, but what kind?

How fast will the global economy grow, if at all in 2016 and beyond?

How will rising global terrorism affect our lives and economic circumstances?

The reality of Warren Buffett’s performance as an investor in 2015 simply points out that nobody predicts the future with certainty.  And measuring your personal investment performance over a one-year period is foolish.  Investing is a long term multi-year process. The outcome in the short term is always uncertain.  History teaches that over the longer term, despite uncertainty of events, investment returns from owning parts of profitable businesses increases our real wealth and/or produces attractive income over time.

In the long run, as Warren Buffett has stated, and as common sense reinforces, investing is really about buying and owning stocks/bonds at attractive “undervalued” prices. Attractive “undervalued” prices meaning low enough that the likelihood they will decline in price is low—in other words a price with a “margin of safety”. Few investments met that criteria in 2015.  Many are likely to meet that criteria in 2016.  We are already seeing signs of opportunity in short term investment grade corporate debt, and some well capitalized integrated oil companies.

So as the New Year of 2016 is rung in, be optimistic that prolonged periods of uncertainty ultimately produce very attractive opportunities for those who choose to focus on their long term objectives.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

The Year of Uncertainty

A recent headline for an article at CNBC: 

Warren Buffett is having an unusually bad year 

Link: http://www.cnbc.com/2015/11/18/warren-buffett-is-having-a-very-unusual-bad-year.html

Excerpt: “Warren Buffett has seen shares of his Berkshire Hathaway fall more than 11 percent this year. Even worse, Berkshire shares have underperformed the S&P 500 by more than 10 percent.”

There is always uncertainty regarding the future economic outlook, but 2015 seems to have more than usual.

The U.S. Central Bank, the Federal Reserve, commonly referred to as the “Fed” continues the Zero Interest Rate Policy and markets gyrate as they try to predict the first Fed interest rate increase, and more importantly, the speed at which they continue to raise rates.  Interest rates have a powerful influence on economic activity and asset pricing. 

For a time in the past, it seemed that “energy” was in short supply and prices would rise. That changed dramatically this year as the price of energy (oil, gas and coal) dropped by 50%.  Not because of market conditions, but simply because of government actions. (A price war between government controlled oil companies—OPEC. Sort of the mirror image of the 1970’s.)

US politics continue to be a concern, although the recent change of leadership in the US House of Representatives seems to have postponed a standoff on the Budget—at least until the next President is elected. 

And, now the ugly face of radical Islamic terrorism has shown itself again. Who knows what the next government action will be in response?

Notice most of the uncertainty is about what governments (US and International) are doing or about to do.  Most economic activity over the long run can be predicted by a study of history and the use of intelligent logic. But, when you throw government actions into the equation, it becomes very unpredictable in the short run.

Back to Buffett. His mentor Benjamin Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”   In other words, in the short run, markets will fluctuate by the popular sentiment of traders buying and selling for short term profit, but in the long run, it will be corporate earnings that determine the value of investment portfolios.

Solid companies, that are well capitalized, well managed and who have leading market shares in their areas of operation will do well in the long run.  Holding ownership positions in these companies during periods of uncertainty, up years and down years is a sound strategy. Buying them when they are cheap is also a sound strategy.  Knowing when they are “cheap” can be a bit more of a challenge.

Hold on as we may see more certainty as important meetings of the Fed and OPEC are scheduled for December.

Fixation on the Fed

The U.S. Central Bank, the Federal Reserve, commonly referred to as the “Fed” announced on Thursday that their Zero Interest Rate Policy or ZIRP, would continue.  Essentially, short term interest rates would remain at near zero.  

ZIRP and the other stimulus program used by the Fed called Quantitative Easing or QE, were put into place to stimulate the U.S. Economy.  

There are two valid reasons why the Fed would start unwinding both of these programs. First, increasing interest rates would tend combat inflation. Second, increasing interest rates would indicate that the economy is healthy and capable of supporting “normal” interest rate levels.

At least according to economic statistics provided by the government, inflation is under control. (Many would argue that these statistics are misleading.) But, in any case, the Fed does not see a need to raise interest rates to combat inflation.

The most important message sent by the Fed’s failure to raise interest rates is that they believe the global economy is not healthy and not capable of supporting “normal” interest rates. Sort of like a doctor saying “The patient is not in intensive care, but is still not well enough to be discharged from the hospital.”

So, in one way, the Fed’s inaction is a good signal for stocks and bonds—inflation will be low. But, on the other hand, it is a bad signal---the global economy is sick.

Couple that with the fact that Friday, September 18 is options expiration day and you get a lot of volatility.

Expect that until the Fed finally sends a clear message that “inflation is under control” AND “the global economy is healthy” markets will fluctuate up and down based on sentiment regarding what the Fed is likely to do next. 

What you should also remember is that the Fed does not control long term interest rates. Those are controlled by bond market sentiment. At least for now, the bond market agrees with the Fed—inflation is low and the economy is weak—so long term interest rates are low---at least for now. History teaches that bond market sentiment can change rapidly.

The Dilemma Created when Short Term money is invested in Long Term Investments

Many years ago, Warren Buffett told a story about “Mr. Market” being this wild and crazy business partner who suffered from bi-polar disease. The story was originally told by Benjamin Graham. I shared it with clients most recently in 2011.

“Mr. Market, is an obliging fellow who suffers from a severe case of bi-polar disorder. He turns up every day at the share holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. Sometimes Mr. Market is wildly overly optimistic and is willing to pay a very high price. Other times, Mr. Market is in such a depressed state that he is convinced that the future is hopeless and that the value of your shares are ridiculously low. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. Market doesn't mind this, and will be back the following day to quote another price. As an investor, you need to be confident enough in the value of your investments to be able to take advantage of Mr. Market rather than being affected by his disease.”

Given the recent market downturn, I thought a slightly different take on the concept might be useful.

Let’s assume you have $250,000 cash. Not wanting to bury it in the backyard or hide it under your mattress, let’s assume you have two “rational” choices.  Option A: You could put the money into a bank account and earn 1% per year interest, guaranteed by the government. Option B: You could buy a 50% interest in an office building as a Limited Partner.  The General Partner of the office building agrees to pay you a portion of the rental profits, if any. The General Partner also agrees to buy you out at any time you ask him to, but he gets to set the price. He agrees to quote you a “buy out price” or BOP on a daily basis.

You choose Option B and give the General Partner your $250,000. For the first few months, the General Partner sets the daily BOP at $255,000 each day. After the first three months, he even sends you a “rental profits dividend” of $625.00. You are told that you can expect $625.00 every three months.  You feel like you made a really good investment.

After a year or so, the General Partner begins raising the BOP.  Rental profits are rising. He offers you a BOP of $300,000. You think about it and decide to keep the investment since it is “doing really well”.

Several months later, the BOP offered each day begins to slip. The BOP declines to $285,000. The economy is slowing and it appears that a lot of new construction has flooded the market with new office space. Then something really bad happens. The largest tenant does not renew their lease and the office building is suddenly only 50% occupied. The General Partner claims to be unable to find any new tenants and the BOP falls to $240,000. You are afraid that the BOP might fall even further.  To make matters worse, the “rental profits dividend” is cut to $200.00 every three months.

What to do?

The problem for most people who are presented with this dilemma is the “right” answer is unknowable because the future is uncertain. It also depends on the financial situation of the person as well as all the “other” investments, if any, that the person owns.

History teaches that over time, it is reasonably probable that new tenants will be found, causing the “rental profits dividend” and the BOP to recover and rise over time.  It would be reasonable to assume that over a 10-15 year period, the value of the property would rise at least by the amount of inflation, and that the “rental profits dividend” would likely be about the same as the interest that would have been earned if the $250,000 had been deposited in the bank. (In other words, it might be best to just “wait” and hold on.)

A large dilemma exists for those who needed that $625.00 “rental profits dividend” to cover their living expenses. (Only a portion of that income should have been “counted on”.) An even bigger dilemma exists for those who figured that whenever they needed money, they could accept the BOP, sell out and use the money to cover their living expenses.

In other words a big problem here is when people assume that income from their long term investments will provide steady and consistent income in the short term. And, a bigger problem here is when people assume that the value of their long term investments will be stable in the short term.

Long term investments tend to fluctuate significantly in value.  It is wise to assume that they could easily rise by 20% or fall by 20% in the short term. And if they fall by 20%, it could take considerable time for them to recover.

In our example, the other point to consider is that making a $250,000 investment in one office building creates a concentrated risk. The $250,000 would have been “safer” if it had been “diversified” into several investments in different locales and different industries.

History teaches that diversified long term investments tend to provide double the long term value of shorter, less “risky” investments. But, that assumes that you hold them for the long term. During that long term period, often, the value of, and income from, the long term investment will fall below the value  of, and income from,  the short term investment. (In other words, when interest rates are only 1%, one should not expect an 8% return from equity investments in the short term. And, often in low interest rate environments, normal market fluctuations from equity investments may actually result in negative short term returns.)

Your short term investments (deposits) should always be sufficient to meet your short term (3-5 year) needs. Your long term investments should be meant for the long term so that fluctuations in their short term daily BOP does not matter to you. If your financial plan calls for a need to liquidate some of your long term investments to cover living expense, you need to sell, “in advance” when markets are “high” or undertake a periodic “averaging cost” plan to sell  regularly over time to average out market fluctuations.

Remember the story of Mr. Market: “you need to be confident enough in the value of your (long term) investments to be able to take advantage of Mr. Market rather than being affected by his (bi-polar) disease.”

PS.  I am sure that many clients are surprised that I remain so calm during periods of market turmoil. They often ask “Aren’t you concerned when we are losing so much money?. Shouldn’t we be doing something?” My answer is always, “All of this up/down is pretty normal. The daily value of long term investments only matters on the day we intend to sell them or the day we intend to buy them. Since we don’t intend to sell them for a very long time, the emotional bi-polar actions of Mr. Market with falling prices on a daily basis really does not matter except when we are buying. And when we are buying, we like it when prices go down. Investors need to remain confident that the long term value of their highly diversified portfolio of high quality investments remains intact, despite daily market value fluctuations.”