Q4 performance not as good as it seems…

Successful investing involves remaining balanced when market forces tempt us to make major portfolio decisions at inopportune times. Q4 was an interesting transition period and I think investors need to understand the bigger picture to avoid making any reactionary decisions.

We’ve spoken at length about how the Dow hitting a meaningless 20,000 target should not change your approach. The Dow is a broken index with only 30 stocks without broad sector exposure.

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Let’s dive into the Q4 performance. The chart above shows Q4 performance for the major asset classes. As you can see, it’s not nearly as good as the media portrayed it to be. The S&P 500 was up close to 4%, but the bond market fell by an equal amount and international stocks were also negative, due to a rising US dollar.

It’s very possible that a globally diversified portfolio ended the 4th quarter negative.

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If we drill down to the sector performance for the US stock market, we can see that the relative strength came mostly due to Financials, Energy and Industrials. Of course these are the same sectors that have under-performed much of the last five years.  The consumer discretionary (Amazon’s), Technology, consumer defensive and health care sectors all under-performed on a relative basis.

I would venture to say that many investors had more exposure to the sectors that under-performed. So the temptation for investors is to now pile into the thing that has gone up the most. So go all in financials for 2017?

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But before you go there. Take a look at this annual sector performance chart. Can you see any discernible patterns here?  If anything you can see that oftentimes the best performing sector one year turns out to be the worst performing sector the next. So before you go making a major change because of one quarter’s data, remember that change isn’t likely to yield any significant positive outcome.

This all brings me to the main message. The markets can do crazy things in the short term. But the reason why we invest doesn’t change. We don’t invest for one quarter, or even one year, we invest for long term goals while maintaining a certain level of risk.

Unfortunately there is no strategy that works well in every market environment. A conservative allocation will do well in periods of volatility, and under-perform when the stock market is rising rapidly. An aggressive portfolio will work great when the market rises rapidly, but will be very painful during the inevitable downturns.

A balanced portfolio will mean that you’ll usually hate some part of your portfolio each year. But oftentimes that part of the portfolio that you hated last year, will be your best friend the next, as mean reversion runs its course.

Rather than trying to constantly predict what type of market environment we’ll experience each year. It’s best to accept that just like the seasons change, the markets seasons change too. Periods of declining markets give way to periods of rising markets, which give way to periods where the market moves up and down without making any direction (not always in that order).

Investors should be more concerned about what what typically works over time, rather than what is working right now. The truth is that long term investing should be rather boring.

Don’t be surprised if 2017 starts off slow…

No one knows what the market will do on any time frame. As the Dow nears the meaningless 20,000 target, investors will be tempted to overreact and chase the market.

We have to understand that a significant correction (10-20%) can happen at anytime, even with no rhyme or reason. Major market declines (30%+) almost always occur because of an economic recession, but that’s not a given either.

This means that investors should continue to “stay the course” with their investment plans and not react to these moves. The old adage goes “the public loves stocks when they are expensive, and hate stocks when they are cheap”. Do whatever it takes to not fall into this category!

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The S&P 500 has moved about 2% below it’s recent highs as we close out the year. There has been more optimism than at anytime during this 8 year bull market, and that could certainly carry over into 2017. But don’t be surprised to see a slow start to the year.

The S&P 500 has support around 2195, and 2165 would be a 5% correction (most frequent correction size of the bull market). These levels could come into play, if indeed the market decides to take a break to start 2017.

Also January has been a tough month in each of the last three years. SPY returns for January:

2014   -3.52%

2015   -2.96%

2016   -4.98%

No one knows if the pattern will continue or be broken. This is why it’s best to stay away from the prediction department. Especially with your portfolios!

“Animal spirits” shouldn’t have a place in your investments

For those who are contemplating making portfolio changes as a result of this recent rally, ask yourself if you panicked on election night (when the Dow was down 800 points)? Or earlier this year when the market got off to its worse start on record? Or last summer when the Dow opened down 1,000 points?

In other words, the people who now want to chase the market after recent gains, are the same who are first to panic when inevitable volatility hits. This is a result of recency bias, or the temptation to chase gains, even though it hurts much more to lose money than to lose out on making money.

First, let’s put this recent rally into perspective. A 1000 point rally sounds great, but it’s only about 5% when the Dow is at 19,000. It’s important to look at percentage moves, instead of how many points the Dow moves. At 20,000, the daily point swings in the Dow are going to be higher than usual.  Just like the 800 point drop in the Dow on election night sounded worse than it really was (4%), a 1000-1500 point increase sounds much better than it really is. Much of the gains have come from the underperforming sectors of the last few years (Financials, Industrials, and Basic Materials). And as long as we are on the topic, the Dow index itself is flawed and shouldn’t be looked at anyway.

It appears part of the rally is due to an increase in sentiment. Let’s not forget that sentiment was favorable when George Bush, Jr. took office. His MBA and understanding of business was supposed to be very supportive for stocks. The result was one of the worst 8 year periods for stocks in recent history. This isn’t a fair comparison because this time period includes 9/11, a catastrophe no one could ever have predicted, along with two economic recessions. But fast forward to 2008 and the consensus was that Barack Obama was going to be awful for the stock market. The result was one of the biggest bull markets on record.

This is not to draw any conclusions. I’m simply pointing out that sentiment doesn’t always equate to actual performance. Because of one month’s performance, conservative investors now want to become more aggressive. We know that stocks don’t go up forever, and they don’t go down forever either. We’ve been saying for years that things aren’t as bad as they are being described. And as the Dow inevitably trades above the 20,000 level, sentiment may eventually swing too far in the opposite direction.

The reality is that the market has more than tripled over the last seven years. Even though the market is likely to move higher, it’s hard to envision similar performance over the next seven years. In fact I think it’s safe to say it’s more likely we experience a bear market (recession) before the market triples again.

It’s usually best to maintain a balanced approach to investing. Not getting too carried away when things look bad (stocks go on sale) and when things look good (higher valuations, lower dividends, lower expected returns). Focus on those things that you can control, such as keeping costs low and maintaining an asset allocation strategy that suits your risk tolerance and time horizon. And don’t scrap a perfectly good aset allocation just because it underperformed for one month. Animal spirits have no place in your investment accounts!

Financial Markets update

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After a difficult day to close the week, I felt a summary post was necessary. Friday was extra difficult because interest rates rose along with declining stocks. So bonds failed to provide the diversification benefit that they have historically done over time. This is not unusual, after all anything can happen (and usually does) in the short term, especially given the fact we are probably in the mid to late cycle of this expansion.

The chart above shows the broad based declines for Friday. Stocks, both domestic and international, fell over 2% each while bonds declined over 1%. Gold “outperformed” by falling only .60%.

So what happened?

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Last week Manufacturing PMI came in well below expectations and below the 50 level, which indicates contraction.

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This week the Services PMI also came in well below expectations. The street was expecting 55.4 and we ended up getting 51.4. Still expanding, but disappointing.

On Thursday the European Central Bank failed to announce any new plans for additional stimulus. And Friday morning Boston Fed president Rosenberg made the case for increasing rates sooner rather than later.

In my opinion the combination of poor data and more hawkish central banks induced some profit taking. We were probably overdue for some sort of pullback seeing as the markets had essentially risen some 10% in a straight line after the “Brexit” selloff.

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The chart above shows the S&P 500 is only about 3% off it’s all time highs. So we must take Friday’s selling into context. There is some potential support between 2116 and 2110 which coincides with the “Brexit” gap and prior swing highs. The most common correction during these last 7 years has been of the 5% variety, which from current all time highs projects support around 2075. Either of these spots could work but it’s possible the market could head lower too.

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The key is too focus on the big picture. The above chart shows the cumulative advance -decline of the NY stock exchange. This chart has been on fire ever since the early year sell-off. This represents broad market participation on this advancement and not the picture of a market getting ready to roll over.

We couple this with earnings growth that is starting to come back and an economy that is growing well below it’s capacity but not signaling recession either. This suggests the likelihood of continued upside for equities whenever and wherever this correction concludes.  The Fed could probably derail this by raising rates at far faster pace than the street anticipates. However everything they have said so far suggests they don’t plan on recreating a 1932 style policy error.

The key thing for investors is to focus on re-balancing instead of predicting. We know we will have another bear market at some point in the future and that stocks are more risky the higher they go and less risky the lower they go. So there is nothing wrong with becoming a little more conservative as stocks go higher and a little more aggressive as stocks go lower. Instead of getting spooked and scared completely out of the market, take some profits and rebalance into some of the laggards (whether it be bonds, value stocks, etc) and vice versa when the market rallies.

There is nothing wrong with accepting that we can’t fully predict every up and down and plan accordingly. What is a problem is when we get scared and sell at lows and then reverse and buy when the market is high. Do whatever it takes to avoid this, whether it be to stop watching the business news, stop looking at the accounts for awhile, or finding a capable advisor to do this for you.

Why you should stay the course with your investment strategy…

The key to successful investing is understanding that there isn’t a perfect solution, there isn’t an investment strategy that doesn’t have drawbacks, and no strategy will be immune to periods of under-performance.

At first this statement may seem like an oxymoron. After all, I’m saying that the key to successful investing is understanding that there isn’t a perfect solution. But hear me out. Once you understand that there isn’t a perfect solution and that there’s no magic recipe for market beating results all of the time, it will free you from the bondage of chasing every tip, strategy, or hot stock that happens to be performing well in the near term.

The only way I know of to be successful at investing is to develop a strategy and stick with it through thick and thin. There is no one size fits all solution here either. What works for me is to create a diversified portfolio of holdings, dedicating portions to holdings that work in a variety of different market environments (treasuries for deflation, growth stocks for risk on, high quality dividend and value stocks for the dull periods, etc.). This way there’s no need to try to predict every short term macro outcome each year (which is impossible anyways). My stock picking strategy is basically growth at a reasonable price. But there are a plethora of different strategies to choose from. You just need to understand your goals, time horizon and risk tolerance. And if you can’t do it yourself, find a competent advisor that can do it for you.

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Let’s use the example of Warren Buffett since he’s the most famous investor of our time. Buffett’s Berkshire Hathaway is up over 1,000,000% from it’s beginning in 1964 to the 2015. Handily outperforming the S&P 500 (up 2,300%) over that same time frame. So by looking at this chart you’d assume that Buffett must beat the market all of the time right?

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Actually this isn’t true at all. Per Bloomberg, Berkshire beats the S&P 500 51% of the time on a monthly basis, 55% of the time on a quarterly basis, and 67% of the time on a yearly basis. So in the short term it’s basically a coin flip and even on a yearly basis Berkshire under-performs the S&P one third of the time. The aggregate difference is so staggering because Buffett isn’t focused on beating the market but instead he focuses on his strategy and sticks with it through thick and thin.

So if the greatest investor of our time, with unlimited capital, fails to beat the market on an annual basis 1/3rd of the time, why do we think we can possibly do better? The problem is in the way we assess performance, focusing far too much on the short term. This leads investors to constantly change their strategy in a frantic search to find the perfect solution, when none exists. This search generates transaction costs, tax liabilities (if applicable), buying stocks/asset classes at highs, while selling stocks/asset classes low. In totality it usually causes more harm than good and once we accept this fact, the sooner we can move onto healthier investing behaviors and benchmark time horizons.

Now obviously this isn’t a truly fair comparison. Buffett basically operates a hedge fund and his insurance department of the business offers almost unlimited cash flow to buy more and more stock as it goes down. A luxury unfortunately very few of us will ever have. But the premise remains the same. The increased focus on annual returns has done more harm than good in my opinion. Personally I think performance stats on anything shorter than 5 years shouldn’t hold much weight. A typical full market cycle usually occurs in five years or so and that is how you truly judge performance.

Who cares whether you made 5% or 8% one year if you had to take on too much risk to achieve it and lose 50% of your account value during the next inevitable bear market. Who cares if your high dividend stock is paying 5% dividends instead of the 1.5% a treasury bond pays when your a conservative investor. That 3.5% isn’t going to make a difference when the stock drops 10% in one day anyway (something a treasury bond wouldn’t do).

Assess your goals in comparison to your risk tolerance and time horizon and use a strategy that best fits your comfort level and don’t look back. Don’t be tempted to deviate to the newest investing fad that’s flying high. You’ll do fine without it.

There is always a trade off between risk and reward in every legitimate investment. After seven years of solid gains in stocks, I worry that investors may have developed amnesia about where we came from, while being sidetracked by performance chasing. Usually investors get sucked into this game at the most inopportune times.

Sources:

http://www.businessinsider.com/warren-buffett-berkshire-hathaway-vs-sp-500-2016-2

http://www.bloomberg.com/news/articles/2013-10-16/is-warren-buffett-approaching-an-all-time-losing-streak