July 12, 2013
By Steve Blumenthal
Stonewall Golf Club – hole 18
Stonewalled – What’s the average investor do?
We walked off the 18th green and Chuck, my good friend and long-time caddie, says, “Steve, can I ask you a question about my wife’s 401k? What should I do?” I sensed the elevated degree of trepidation in his voice. “We are getting older and I don’t think we have the time to recover from another 50% market decline.” As we walked passed the long stone wall, I thought of the manic-depressive behavior post the Bernanke’s May 22 tapering comments and couldn’t help but think that we all are being Stonewalled by the various global central banks and government leadership (a verb – delay or block – giving evasive replies, especially in politics).
For years I have been a member of the Stonewall Golf Club located in suburban Philadelphia. It is a course that was created in the early 1990’s on the Pew family’s dairy farm (Sunoco family). For me it is a beautiful piece of paradise and a great place to simply get away and clear my head.
Today I thought I’d take a look at the big picture, talk about the big risks I see and share some thoughts on navigating the period ahead. I hope you find the information helpful as you construct your investment portfolios; hopefully, with a forward view towards the period ahead.
Stocks are likely to deliver 5.69% over the next ten years while bonds just 2.64%.
Historically, stocks have gained closer to 9% per year and bonds 4.8%. There is a mismatch in client expectations and what is likely to play out if history is any guide. Following is a link to data from Research Affiliates 10-year Forward Expected Return. Updated analysis is mine. (Click here).
When I view the expected return from a risk perspective I get concerned. When your starting point is one of low dividend yields, low implied inflation and low interest rates, your forward return is logically low but your risk is actually much higher.
For example, here is the chart I have shown before in regards to interest rate risk. The problem is that the average investor doesn’t think he can lose money in bonds. The 10-year Treasury yield was at 1.63% at the beginning of May 2013. Note the 1% move to 2.63% and the corresponding loss in value of -8.62%.
Could it be different this time? I wouldn’t want to bet my baby boomer retirement money that this time is different. My retirement plan is based on x, not -30% of x. What if both stocks and bonds decline significantly just days or months or a few years prior to retirement? This is the dilemma that you, Chuck and I face today.
Risk is elevated because investors are not being paid enough for the risks we are taking. The Fed’s game plan of zero interest policy, QE and the trillion dollar bond purchase program is forcing investors into riskier assets (stocks and longer-term bonds) at exactly the wrong time. That investment statement might look rewarding in the short term but massive manipulation in anything rarely works over the long term. There are unintended and unknown consequences in the making.
As we print, China prints, the UK prints, the EU prints and now Japan has initiated the largest policy experiment the world has ever faced. The markets are driven by desperate global central bank policy and risk cranks higher. We face a number of important headwinds:
- Global debt to GDP is 360% and there is no real way out. Europe is in a deeper debt hole than the US and Japan is in crisis.
- Japan has launched the greatest policy experiment in the history of mankind. Their currency creation and bond buying plan is 3x compared to ours.
- They have been largely self funded, have one of the worst debt to GDP ratios in the world, are dependent on exports to drive hoped for growth and counting on a cheaper currency to attract European and US consumers. In English, if a country cuts its currency in half, our dollar buys twice as much. It is like a 50% off sale. But…
- How will other countries like Germany, Korea, Indonesia and China react? In a world trying to grow out of a debt crisis, we all want and need growth. The result will be trade and currency wars.
- Most of us just focus on what is happening in the US. Take a step back and realize that we are deeply interconnected with currencies, investments and global trade.
- Money will find its way to where it is treated best. Here I favor the dollar and think the Yen is in big trouble (perhaps a small allocation to short Yen as I first suggested last November).
- The Fed is buying nearly 70% of each newly issued government bond. Our federal government is running a projected deficit of nearly $700 billion (down from $1 trillion per year each of the last four years). Most of that unfunded spending is funded by newly created currency at the Fed, who then buys the newly issued government debt. A good gig if you can get it.
- Japan is buying every bond along the curve in each bond auction to make up for their 11% fiscal deficit and expect to do so over the next two years. Is there an end in sight?
- The goal is to stimulate growth; though increasing debt does not stimulate growth especially when the money is used to finance non-productive enterprise.
My message today is to remain focused on risk first and return second. There are periods of time when it pays to be more aggressive (typically when you are being paid appropriately) and certain periods of time when risk is elevated. Risk is elevated.
Chuck wants to know what to do. The forward expected return is low because dividend yields are low, inflation is low and interest rates are low. At the same time, valuations are relatively rich (as measured by Medium PE of 19.5 (as of 6-30-2013) vs. a historical average of 16.6). That means the S&P 500 index at 1680 vs. a Median Fair Value of 1371 (chart below) is approximately 18.4% overvalued today. Source: NDR.
So Chuck, here is what I think you should do. Shift your eye to focus on risk. De-risk as the year moves forward. I believe another major financial storm is on the horizon. Put options are a good source of inexpensive protection if you have stocks you want to hold for the long-term. Expand your portfolio to include Tactical investment strategies that are unconstrained to benchmarks (pure buy and hold) and offer the ability to make money in different market environments including up trending markets. Be patient today and look for a better entry when valuations are low, dividend yields are higher and interest rates are higher. That day will come. Until then get more absolute return focused and become more tactical in approach.
I go into more detail on how to manage risk in my weekly piece titled Trade Signals. In particular, take a look at the 13/34 week EMA chart and the Big Mo Chart. Click here.
I’m hoping for some time at Stonewall this weekend with my kids and avoiding the deep rough. Oh, sometimes I don’t find the peace I’m looking for.
If you have any questions or comments, please feel free to email info@cmgwealth.com or simply reply to this email. Wishing you the very best.
Have a great weekend,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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