What a Stock Market Rally Looks Like

Rally_View

The stock market has been on a tear since the election.  Initially, the stock rally was concentrated in a few industries where investors believed the new administration would assist their financial position (airlines, banks, etc…).  Recently, the rally has taken on a life of its own and is just going UP.  There are 21 stocks contained in Portfolio One, and today 20 of the 21 stocks went up (one foreign stock ADR went down slightly).  This sort of correlation amongst all the stocks is a sign of euphoria in the market.  I don’t have any particular insight into where stocks are moving next but this is an interesting sign for the market right now.

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On Investing

Investing has changed significantly during the 25 or so years that I have been following both the market and also the tools available for an investor to participate within the market.  The following trends are key:

  • The cost of trading and investing has declined significantly.  Trades used to cost more than $25 and now are essentially free in many cases.  Mutual funds used to have “loads” of 5% or more standard when you made an investment, meaning that $100 invested only went to work for you as $95.  These sorts of up-front costs have almost totally been eliminated
  • ETF’s have (mostly) replaced mutual funds.  ETF’s “trade like stocks”, meaning that you can buy and sell anytime (mutual funds traded once a day, after being priced with that days’ activity) and they don’t have income tax gains and losses unless you actually make a trade (mutual funds often had gains due to changes in the portfolio that you had to pay taxes on even if you were just holding the fund)
  • CD’s and Government Debt are all electronic.  You used to have to go to a bank for various governmental bond products or to buy a CD.  Now you not only can buy all of this online, you can choose from myriad banks instantly rather than settle for whatever your main bank (Chase, Wells Fargo, etc…) offers up to you
  • Interest Rates are Near Zero.  One of the key concepts in investing is “compound interest”, where interest is re-invested and even small, continuous investments held for a long time can end up amounting to large sums (in nominal terms, because inflation often eats away at “real” returns).  However, with interest rates basically near zero, you need to earn dividend income or take on more risk (i.e. “junk bonds”) in order to receive any sort of interest income.  There is no “safe” way to earn income any more
  • Currency Fluctuations Matter.  When the Euro initially came out it was $1.30 for each US dollar, and then it went to 70 cents per dollar, and now it is about $1.10 per dollar.  At one point the dollar fell 30-40% against many currencies world wide (when “commodity” currencies like the Canadian and Australian dollar were surging).   For many years currencies were relatively stable against one another but that era seems to be ending, and thus the change in relationship between the US dollar and their currency can be much greater than the return that is earned on the international investments
  • Active Trading Has Mostly Been Beaten By Passive Trading.  While there are many exceptions, initially the majority of investments were “active”, but over the years many of the “active” managers have substantially under-performed the market, wilst charging investors more in fees (it is cheaper to run a “passive” index).  As a result, there has been a massive shift away from active investors to passive investors like Vanguard
  • Correlation Among Stocks and Investment Classes Is Much Higher.  Correlation means that stocks or asset classes tend to “move up” together or “move down” together.  It is not unusual for me to look at a portfolio of 20 stocks and 19 or 20 of them have all gone up or down on a single day.  This is related to active managers being unable to “beat” the market (see above)
  • The “Risk Premium” for Lower Quality Debt is Small.  The amount of extra interest required for low quality borrowers over the US Treasury benchmark is very small.  Investors are taking on a lot of risk to just earn a few more percentage points of return.  If there is a downturn in the economy (such as what happened only recently in US oil companies), there are likely to be significant declines in junk bond values that wouldn’t justify the modest risk premium you receive for holding these types of assets
  • ETF’s Provide an Easy Way to Participate in Commodity Markets.  It was more difficult to buy and invest in commodities like gold and crude in the past, and it was often limited to relatively sophisticated investors or those willing to hold on to physical commodities like gold (which can be risky since they need to be stored and protected due to high value and inability to trace once stolen).  Today you can easily buy a liquid ETF to participate in the commodity markets for key areas like precious metals (gold and silver) and crude oil / natural gas
  • Fewer Companies are Going Public and the Market is Shrinking (in terms of issuers, not total value) – It is easy for start up companies to access private capital (venture funds) and they tend to “go IPO” at high values, making a further upside (after the initial IPO) more difficult.  The total market is shrinking in terms of listings due to M&A (companies buying other companies) faster than the new IPO’s and many companies are “buying back” shares which also reduces the total value of the public markets
  • Bonds have had a Gigantic Bull Market that is Nearing It’s End – Bond prices move inversely to yield; thus if you held on to a 5% low risk bond (which would have been available everywhere in the early 2000’s), that bond would currently be priced at much more than 100 cents on the dollar today.  Interest rates peaked around 20% near 1980 and now are not far from zero; in this sense bonds are part of an enormous “bubble market” that has not yet peaked.  But given how low rates are (they are even negative), it seems like this bull run is about to come to an end
  • Ensure That You Include Dividends and Total Return.  A common mistake is to look at performance just in terms of stock or asset prices, and avoid including the compounding impact of dividends received, especially since dividends often rise each year.  Dividend income can make up a significant portion (25% and up) of total return, so selecting assets that provide dividend income is critical.  Finally, dividends provide favorable tax rates when compared to interest income

What does all of this mean?  I would sum it up in two ways:

  1. It is easy for individual investors to set up a simple and low cost way to track the market – the “basic plan” that I set up as a simple example can be used by anyone and it does what it says.  Here is a second plan that also includes some hedging of the non-US investment
  2. You will need to save much more (or take on more risk) because interest rates are low – with near zero interest rates, you can’t make much money on low risk interest bearing products (like CD’s, savings accounts, and simple government debt).  If you are earning risk income, you likely are taking on substantial risk of default because there is no “free lunch”.  As a result, you need to put more cash into stocks in order to earn dividends or see real returns, but this also could lead to significant losses if there is a market crash like 2008-9.

I try to promote financial literacy and have helped many friends and some family members when they ask questions.  Ideally we would actually drive financial literacy through school and into the university.  Even those who have a degree in finance or accounting often lack practical advice on personal finance and don’t know how to approach these issues.

One key concept is “net worth”.  Net worth isn’t how much you earn in salary, it is what remains in savings after taxes (or through long term deferral of taxes).  The only “assets” that count are those that you can turn into cash if needed, and they are “net” of the debt (such as on your house).  Most people have a negative or near-zero net worth, which is also linked to the concept that they are essentially a couple of missed paychecks away from very bad outcomes such as having to take out a payday loan or borrow money from relatives.

Another key concept is trying to avoid excessive student debt.  Unlike all other forms of debt (loans on your house, your car, or credit card debt) your student debt cannot be discharged through bankruptcy.  You essentially have no options except to repay your loans, and if you miss payments or fall behind the fees and penalties will greatly increase your balance due.  Student financial literacy is critical because they are making decisions that will impact themselves and their families for the rest of their lives and they must be made thoughtfully and with the end in mind (if you are taking out all of this debt, you must be driven in your career to make money in order to pay it off and get on with building net worth).

Cross posted at Chicago Boyz

Diversification

One goal of a portfolio is for it to be “diversified”.  In layman’s terms that means that the stocks are from different industries, in different countries, or otherwise significantly different from one another.  The thinking is that trends that impact one stock, for better or worse, won’t hit all the stocks in your portfolio, so losses in a subset of your shares won’t have a significant impact on all of your other stocks.

 

diversification

Unfortunately, however, stocks often exhibit high “correlation” with one another, meaning that even though the stocks are from different countries and in different industries, they all move the same direction.  This is great when the trends are in your favor (a rising tide lifts all boats) but is hard to swallow when every single stock in your portfolio declines at the same time.  Today was a bad day for stocks but it was amazing that all 18 stocks in Portfolio one had declines and not a single one “bucked the trend”.  It is true that they all move to different degrees, with some just a “bit” in the red and some losing 2-3% on a single day.  In fact every stock except for one single Japanese stock across all 6 portfolios dropped today, which is almost perfect correlation (heading the wrong way, though).

According to news reports, Apple had a bad report, and there was some other economic news, and everything fell and kept falling.  We have bad days like this, and we also have good days when everything rises, too.

Ideally, however, if you have diversified stocks you hope to move up in a good way, with some rising a lot, some a little, and some falling.  But some days are just bad.

Difficult (short-term) Time for Stocks

The markets have been selling off lately. Since these portfolios are a mix of US and non-US companies there aren’t “simple” indexes that I can use to compare them. But in general, the US markets which by various measures had been up in the 10-20% range are mostly back down to where they were in the beginning of the year and European and Asian markets are about the same or mostly worse.

These portfolios are meant to be long equity-only vehicles for young individuals with a very long time horizon in front of them (50+ years). They are “part” of a total portfolio and meant for a specific purpose; no one should just put all their wealth into a long-only stock fund.

Thus based on these elements I am loathe to do specific buys and sells based on total market conditions, because you are often selling off one stock for another stock with similar characteristics. Our markets today have very high “correlation”, meaning that almost all of the stocks tend to go up or down on a single day, especially when big market events occur. Correlation has been increasing over the years, meaning that even if you have a diversified fund (a rule of thumb is that you have 10 or more instruments that aren’t similar to one another) that doesn’t necessarily “save” you if they all move together.

The nature of the stock markets have been changing in the eleven years since I started this effort with Portfolio One, right around 9/11. There are many trends, but here are the key ones in my opinion:

  • Rise in international markets – international markets have always been important, even to US-centric investors, but today they are even more critical.  A stock market is fundamentally about “growth”, and most of the real growth is occurring off US shores.  Thus to not invest internationally, even with all their structural differences from the US market and other risks, is to miss out on the future
  • Reduction in IPO’s – the number of companies listed on exchanges has fallen as the number of IPO’s hasn’t kept pace with companies being acquired either by other companies or “going private”.  Also the IPO’s are later (see FB) meaning that a lot of the “upside” is gone when they launch, or there often is no upside at all if they are being sold out of a private equity fund (they already captured that)
  • Focus on Dividends – some of the dividend focus is due to favorable tax treatment (the limits on double taxation of dividends) and their 15% rate rather than as ordinary income and some is due to the gradual dawning on more investors that a substantial part of the total return is due to dividends and not just share price appreciation (unrealized)
  • Increased government intervention – in order to understand markets today you need to anticipate government moves to a greater degree than in the past.  Our large banks might never have survived the 2008 crisis without government intervention, and today they exist.  Will the government let them survive the next crisis, or will equity holders be wiped out like their were for Fannie Mae and Freddie Mac or Lehman?  Now you need to anticipate government reaction
  • Increasing Currency gyrations – for many years we had currency stability but we may be entering an era of less stability, especially in the key currencies the dollar, Euro, pound, yuan, etc…  This has many effects on competitiveness and immediate valuations
  • Low interest rates – a low interest rate policy has many effects on the market.  It depresses interest earnings (which impacts some equities) but also makes equities more attractive relative to debt instruments, especially when the chance of default rises.
  • The rise of Chinese stocks – while the US market went (mostly) moribund a whole host of Chinese companies came onto US exchanges or were accessible to US investors.  A lot of the “froth” and potential “boiler room” activities went into those stocks instead of US stocks

Here at Trust Funds for Kids we try to look at the long time horizon and make decisions accordingly.  This doesn’t mean that short term gyrations aren’t painful, as well.

Stock Co-Variance

Stock market “co-variance” means in laymans’ terms that, when something happens, all the stocks in your portfolio move in the same direction. Regardless of an individual companies’ performance, financial position, or future prospects, every stock in the index moves up or down together. As you can see in the list above, the 20 or so stocks in this portfolio ALL went down today.

The types of events that used to move markets like this were due to wars, elections, or changes in policies such as interest rate meetings like the Fed. Now, however, it is often due to the inexorable series of financial crises that we have faced in the US and now in Europe with the Euro crisis. Today the German bond auction had difficulty, and this ricocheted across the ocean into our markets.

To be an investor today you need to keep one eye on the stocks that you select and another eye on the overall factors that are causing the market to rise or fall. Unfortunately, many of these items causing the market to rise or fall are caused by government policies and actions which are impossible to predict in the short run and impact the entire market.

It is frustrating…

Co-Variance

At various times they call markets a “stock pickers market” meaning that if you could pick a decent stock out you would make money by going against the herd. At other times the whole market just moves in unison, meaning that whatever you pick (as long as the industry isn’t going down the drain) it doesn’t matter that much.

Yesterday this was the status of the 15 stocks in portfolio one. EVERY ONE of the stocks went down, and they represent a reasonably broad spectrum of industries and countries (US and overseas). On a grand scheme this happened when the market cratered in 2007-8; everything went down the drain but if you bought low at the nadir and held on the way up you basically doubled your money.

Co-variance is definitely on the rise, and US and foreign markets are generally moving together. There are always exceptions but when you see every stock moving in unison that is pretty much the definition of co-variance.

Market Timing

In the past I, like many general investors, shied away from the concept of market timing. It was viewed as too difficult, and many investors left the markets when stocks went down and then missed the rally on the way up, essentially “buying high and selling low”. Instead, investors were advised to “stay the course” and keep investing, assuming that, over time, the rising markets would reward continuous faith with high returns.

An article in Sunday’s Chicago Tribune showed in a crystal clear fashion that, in fact, market timing is the ONLY issue for stocks, at least nowadays. This article shows stock performance for the top 50 stocks by market capitalization based in the Chicago region.

EVERY SINGLE STOCK is showing positive performance over the last 12 months! What are the odds of that, assuming that the stock market has its ebbs and flows? Very remote. The ONLY issue in the market over the last few years has been timing; everyone lost in late 2008 when the market cratered, and everyone who bought in at the trough made a lot of money. Likely to see this same article in late 2008 virtually 100% of the top 50 firms would be in negative territory over the prior year.

While I can’t say for certain what is driving stock performance UP (now) or DOWN (2008), I can say that virtually the entire market is extremely correlated with this phenomenon, as indicated by the top 50 stocks all being in positive territory.

Recent articles I have seen point to returns as being closely tied to the P/E level; when you buy into a “cheap” P/E market, you do well; when you buy into an “expensive” P/E market, you do poorly. While no one can say for certain what cheap or expensive really means, that broad theory is one that might be crucial to stock investing post 2000. In modern history (the last 30 years) there hasn’t been a long period where stocks traded in such a narrow range (around the Dow 10,000 level); but we need to decide how to weight the last few decades against the entire history of the stock market.

While I am not a professional stock adviser, the fact that 50 out of 50 of the top Chicago stocks (by market capitalization) are all up has to be a signal of some sort.

Cross posted at Chicago Boyz and LITGM