The following is a letter to clients that readers may adapt for their own use.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
So, Clark, what the heck is going on!?
So far, October is living up to its reputation as a tough month for the stock market and as a scary time for youngsters and adults alike. The Ebola virus has found its way to the U.S., and terrorists are pressing toward Baghdad. There is significant civil unrest in Hong Kong, a Chinese economic slowdown, growing economic malaise in Europe, and the apparent Russian invasion of the Ukraine. What else could possibly go wrong? Oh, if you are in Texas, the price of oil is falling from over $100 a bbl toward less than $80 [Ouch!].
I know this is a very negative way to start off a client newsletter, but look at the recent headlines: "Wall Street Runs Scared;" "Dow Suffers Biggest Loss of 2014;" "Dow Erases Gains for the Year;" "Market Tumult Squeezes Big Banks;" "Oil, Europe, Ebola Spook the Markets;" "Risk of Deflation Feeds Global Fears." As one client joked, these global issues could lead one to "put a gun to one's head" (at least, I assume he was joking!).
I'd like to briefly address some of this hysteria. First, these are not harbingers of a long-term systemic downturn or a bear market. The markets will always react to new and uncertain situations with trepidation and fear, and speculators will always react quickly in the short term to try to get ahead of the dreaded stampede. Of course the gamble for them is that there is no stampede, but unfortunately they could instigate a bit of herd mentality if enough investors follow their lead.
Remember, like I always say, it's not the decision to get out that's difficult; it's the decision to get back in! Ask anyone who bailed out at the end of 2008 and the beginning of 2009 how well their gold, bonds, and money market funds have done these past 5 years versus the market. They're still waiting for a signal, a sign, an omen to get back in. Maybe this downturn is it. Who knows?
It is the goal of the news to sell advertising. More people read and watch scary news than happy news. Knowing that, the intelligent long-term investor takes every bit of frightening news with a grain of salt. The U.S. economy continues to muddle along. Yes, consumer spending was off in September, down -0.1%. But the expectation was only +0.1%. This difference is a rounding error. No smart economist or investor would panic over this, especially given that August "back-to-school" spending disappears in September. Knowing how economic statistics are estimated, I am serious when I say the numbers are essentially equivalent. The difference can easily be attributed to rounding and flaws in data collection.
The idea that lower oil prices are bad for the economy is a bit funny. True, they can be an indicator that demand is slowing, especially if supplies were steady or falling. But we know that supplies are growing dramatically. It was just a matter of time before the prices began to fall accordingly. Lower oil prices may be bad for the up-stream operations of oil companies, but they are pretty good for virtually everyone else.
The relatively small drop in demand that has occurred worldwide is as much driven by improved conservation and efficiencies than a drop in economic activity. Yes, China is in a bit of a slump, and has its hands full with a populous that wants more freedoms but this was inevitable. China will continue to face these challenges until it changes its ways. While this may create a drag on the world's economies from time to time, it will ultimately lead to a better world.
Inflation is only slightly behind the Fed's target of +2.0% a year, at +1.7% year-to-year as of August 31 (though I saw an article quote this as 1.5% in trying to make a case for deflation; the rate is 1.7%, both core and all items). Historically, the Fed's target ranged from +1.5% to 2.0%, so this is in line with hoped-for price-growth targets. Deflation, more than excess inflation, is a serious threat for any economy. That said, the fact that Europe’s more socialistic economies are struggling with the potential of deflation should neither surprise nor worry U.S. investors. Japan's bout with deflation over the past two decades has not sent our economy into a tailspin. I don't imagine Europe's will either. The strengthening dollar – resulting from a perceived greater comparative strength of the US economy, is actually a bigger global threat to US investors.
Ebola is admittedly a scary prospect if in fact it is not contained. Despite early failures in Dallas, however, there is every reason to believe that the CDC will keep an outbreak from having any severe impact. The number of deaths from MRSA and related staph infections contracted in hospitals is around 70,000 a year, and 40,000 died from last year's flu bug. It would require 157,000 reported cases of Ebola in the US annually to equal the mortality impact of the flu and staph infections assuming the current fatality rate of 70% is maintained. We live with these other statistics without overwhelming fear and panic and without serious consequences to the stock market. From a purely economic perspective, until the numbers contracting and dying from Ebola in the U.S. exceed the numbers for other diseases, Ebola should not have a material impact on the stock market. I do understand that this is a very clinical and unemotional view, but in the long run the market reflects that kind of view.
Stocks are bought and sold in an auction marketplace. One buyer or one seller can literally drive market prices to one extreme or the other if no one is ready to take the other side of the trade. If things become fearful and uncertain, 99% of investors might not buy, and 1% might decide to run for the doors and sell everything. In this case, prices can do nothing but drop like rocks until one or more of the 99% pick up some bargains, (i.e. sell their bonds, cash, or whatever else they own besides stocks) and increase their stock allocations.
Those who argue that the market is overpriced rely on Shiller's CAPE ratio, a statistic that continues to include the depressed earnings of 2008 and 2009. This Cyclically Adjusted Price-Earnings Ratio as of October 15 was almost 26. They compare this to the long-term historical average for the CAPE of 16 times earnings (since 1871; i.e. 143 years). The CAPE average for the past 30-year period, however, is 23.4 times. So in context of the past 30 years, even the CAPE – which includes 2008/09 earnings – is not that far above its average. Price to earnings using current year (reported) earnings were 18 times earnings, versus the long term average of 15.5. When using forecasted earnings, the current price is 14.5 times forecast earnings versus the average of 14; essentially equal to the average using forecasted earnings. For my money, this forecasted earnings ratio is the one that makes the most sense since I invest knowing my returns are based on what will happen, not what has happened.
Also, earnings "surprises" (actual earnings versus forecasts) are a fairly consistent 2-to-1 upside surprise versus downside surprise. In other words, actual earnings tend to be higher than the forecast about two-thirds of the time. Based on this week's earnings announcements forecast on Monday, twenty-four companies listed by the WSJ announced earnings this week. Of those 24, only 3 are expected to have earnings less than those for the same period last year. Only 12.5% of companies expected to announce a fall off in earnings over the third quarter 2013!
I realize I have barely touched on some of the fears and concerns of the day, so please reach out to me if you want to discuss further. The bottom line: I do not believe this is a time to make a decision to reduce equity strategies on our diversified portfolios. I similarly do not believe it is a good time to increase equity exposures for obvious reasons. Decisions to make changes to our strategic allocations should be based on facts and circumstances in your life situation that have little or nothing to do with this week's stock market or economic statistics.
Having said that, let's do a quick review of the past quarter's market results and call it a day.
During the third quarter, U.S. stock market results were as follows: the Dow ended up at +1.87% (+4.6 YTD), the NASDAQ +1.93% (+7.59 YTD), and the S&P 500 up +1.13% (+8.34 YTD). International stocks fared much worse at -5.88%, and emerging market equities were down -3.50%. October has taken a decided turn for the worse as all the market indices are lower as of the latest market close, Wednesday, October 15th, with year-to-date returns of -2.6%, +0.9% and +0.8% (these YTD returns exclude dividends).
Barclay's US Aggregate index rose 0.17%, their muni bond index rose 1.49%, and their Intermediate Government/Credit index was even at -0.03%. The long (30 year) Treasury rose 2.69%. Commodities and real estate both took big hits during the quarter. The Dow Jones U.S. Select REIT Total Return index was down -3.0% for the quarter but up 14.69% for the year-to-date period; and commodities were down about -12.0% for the quarter depending on the index. All commodities indices are negative for the year-to-date and for the past 12 months by varying degrees.
Please let me know if there is anything going on in your life that you'd like to discuss. Certainly anything that might affect the need to distribute cash for spending over the next year or two should be discussed and planned.
Clark M. Blackman II, MA, CFA, CPA*/PFS, CIMA, CFP, AIF is president and C.E.O. of Alpha Wealth Strategies, LLC, a Kingwood, Texas-based fee-only registered investment advisor.
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