Temper Tantrums & Our Asset Allocations
Updated: Sep 6, 2018
Dear Colleagues and Friends,
In my December newsletter -What should you do? I promised to go into more detail about how we come up with our asset allocations. I intend to keep that promise and I will go over specific parts of our methodology in the second half of this newsletter. First, I’d like to provide some insight on the current state of the markets, both domestic and abroad, and go over some thoughts on how we are positioning our portfolios in today’s context.
Building on the momentum discussed in my October newsletter – Strong Dollar, the US dollar continues to strengthen in step with concerns about Europe, Russia, Asia and Latin America. In short, the rest of the world seems to be facing some serious problems. We have suddenly found ourselves in a predicament of very lax U.S. monetary policy (interest rates held low by the Federal Reserve) and a very strong dollar. In the long term, a strong dollar can be problematic. It makes our goods and services more expensive in comparison to the rest of the world and thus constricts earnings for US companies doing business abroad. However, a strong dollar also increases our purchasing power outside of the United States. Currently €1.00 purchases $1.10 (please see the below graph). If you were ever thinking of a trip to Europe, now is the time to go.
Graph USD/Euro (Bloomberg markets)
Most economists believe that the Fed will increase interest rates in June. It has been over 9 years since the Fed raised its Federal Funds Rate. In this time, the monetary base has ballooned from $812 billion to nearly $4 trillion. i With the recent unemployment rate dropping to 5.5%, ii it will be interesting to see how the Fed rationalizes maintaining historically low interest rates.
More pertinent to this newsletter, is the deep fear that the stock market won’t stand for a rate increase. The S&P 500 is up 2.38% year-to-date, and it’s been a volatile few months iii. The stock market loves low interest rates because it allows for increased speculation (you can borrow at a low rate and invest with the hopes of making more than what you are paying in interest). Any time there is even a hint that the Fed will raise rates, the stock market has what can only be described as a temper tantrum. So far these temper tantrums have worked, and the Fed has been extremely cautious. No one wants to be held responsible for throwing the markets and the economy back into the hole, least of all Janet Yellen, the head of the Federal Reserve.
We believe that regardless of the market’s temper tantrums, interest rates will be raised in June or September 2015 and the movement will be nominal. Anyone who remembers the 1970s and 1980s (if not, ask your parents and see the below graph) can tell you that even if rates rise 0.50% from current levels, the fact remains that interest rates will still be very low.
Federal Funds Rate Graph iv
It should be pointed out that higher rates might not necessarily be a bad thing. Raising rates may entice some of the enormous stockpiles of corporate and institutional cash sitting on the sidelines to get into the game, either through investment and/or hiring. Furthermore, the longer we keep such dramatic monetary easing policies in place, the greater the potential for a crisis based on leverage and speculation (sound familiar?).
The Fed announced that although it may increase rates at a later time, it will not do so today and it will continue to look for improving employment and inflation numbers before it starts to raise rates. In summary, no one is in a rush to raise rates and the tantrum was averted for the time being.
China is slowing down. GDP growth came in last year at 7.4% v, its lowest rate of expansion in 24 years. vi However, if you think about a $10 trillion dollar economy, you realize how much harder it has to be for China to keep up its rate of growth. For illustrative purposes, 7% of the Chinese economy is larger than the cumulative GDP of Sweden and Poland combined. vii
With global consumption slowing down, increased labor costs, total Chinese debt at 282% of GDP viii and a banking system that many believe is on the verge of a major catastrophe, much of the world’s attention is on China, and rightly so. Major problems in China have the potential of making 2008 look like child’s play.
Most economists believe that if/when there is a major banking or financial crisis in China, the Chinese government will put out whatever fire is raging with quantitative easing (i.e. throw money at the problem).
It is unclear as to whether China will be able to convert to a consumption-based economy or not, or whether it will be able to navigate the economic and banking hurdles ahead. However, what is clear is that very wealthy Chinese nationals are scrambling to get their money out and they are heading to Canada, the U.S. and Western Europe. ix
Of all of the potential systematic economic risks, we believe China poses the most dangerous threat.
The price of oil continues to drop and is currently in the low $40/barrel range, x the lowest it’s been since 2009. This is fantastic news for Americans who love cheaper gas at the pumps and is a direct result of increased domestic oil production. According the U.S. Oil Price Information Service, U.S. oil production should finish this year around 9.7 million barrels per day ( the previous record was set in 1970 at 9.6 million ). xi If prices in oil climb to $70+, production could climb to 10 or 12 million barrels per day. At the opposite end of this struggle, OPEC is showing no signs of letting up on production. The consumers win.
Price of Oil – WTI Crude xii
The drop in the price of oil is hitting Russia especially hard, where oil and gas make up approximately 70% of exports and account for 52% of federal budget revenue xiii. Western sanctions over the conflict in the Ukraine are further compounding Russia’s problems. The Ruble has lost over half of its value versus the Dollar since the end of last year, and Russia’s Central Bank recently stated that it expects the economy to contract as much as 4% this year.
No one seems to be crying for Putin, but the people of Russia, who are no strangers to turmoil, are in store for serious economic hardship. xiv
The rest of the world
Greece: The current Greek Finance Minster was filmed giving a speech where he suggested that the Greek people give the finger to the Germans (who continue to subsidize their bailout). xv
Germany: Germany’s GDP grew around 0.7% in Q4 2014 (about 1.6% for the year), which is driving expansion in the Euro area. xvi
Argentina: Argentina is facing inflation of 18% while their President is wrapped in scandal and continues to fight US investors holding Argentine debt. xvii
Brazil: Brazil is facing inflationary problems as well and is ensnared in a major scandal involving the state-run energy company, Petrobras. xviii
Vietnam: Vietnam is attracting manufacturing, investment and attention away from China. xix
Japan: Japan is facing ever-increasing pressure from its aging populations and the looming presence of China (a rivalry of long historical importance). Military and economic posturing is on the rise. Reports surface about constant engagement by military aircraft and vessels. xx
Please note that the following viewpoints are not a solicitation. You should think long and hard before making any investment decisions and should seek professional opinions when you believe it is prudent.
US equities: We’ve transitioned away from small cap stocks towards large cap stocks. If and when there is a correction in the stock market, we want to be aligned with businesses that we believe can weather storms.
Municipal bonds: Unless you are in your 80s, have more money that you know what to do with, and are happy making very little return, do not invest in municipals. In order to get any kind of yield on high credit bonds, you have to purchase bonds that are 20+ years in maturity. If/when rates go up, these bonds will go down in value.
International equities: We’ve transitioned away from emerging markets and more towards developed markets. The weakening Euro is starting to make European equities look cheap and should boost earnings for European companies who will sell more goods and services.
Taxable fixed income: We continue to favor the mortgage bond market and to a lesser extent the high yield market. We have been wary of high yield debt in the oil and energy sector and try to keep duration within 5 years.
MLPs: Master limited partnerships (MLPs) invest in pipelines, provide tax advantaged income and have gone through various stages of getting beat up this year. On a yield basis, these investments are starting to look interesting.
Venture capital: Please don’t. You should not invest in the next Uber of “insert silly idea.”
Private equity: If appropriate for the investor, we think there are still compelling evaluations and investment opportunities in later stage technology companies, especially those with large profit margins, high growth and recurring revenue models.
Hedge funds: This is another asset class that has been beat up lately. We think that for appropriate investors, hedge funds can serve as an excellent way to diversify and hedge against a volatile market.
How we create your asset allocation My mentor, the legendary Joe Leach, once told me “if you can’t simply explain why you do something, then you simply shouldn’t be doing it.” So, here’s a brief description of how we form our asset allocations models.
There are studies galore, some that have won the Nobel Prize, xxi which demonstrate how asset allocation is the single most important determinate of long-term performance. This means that how you allocate is more important than when and how often you trade. For this reason, as an investor, you should be very interested in how and why investment advisors (and now robo-advisors) come up with their asset allocations.
Many advisors and firms, Vitreous Partners included, will use terms such as “proprietary algorithm” to describe how they come up with their asset allocations. This makes most people envision supercomputers, complex formulas and high-school calculus. Indeed, our asset allocations do use very complex and intricate models. However, the elements that are proprietary are the inputs to this methodology (i.e. our views of the past and how we contemplate the future) as well as how those inputs correlate to each other. As I describe our methodology and outline how we come to our views of the past and future, I’ll explain why I believe our process at Vitreous Partners stands apart from the rest.
Step 1: Correlation Matrix: We build a Correlation Matrix that shows how different asset classes and investments have historically correlated to each other over time (1 = perfectly correlated).
How often does your advisor update this matrix? Chances are not very often. Outdated data is of no use to anyone, least of all you.
The Correlation Matrix is our view of the past (you can see an example below). Although past performance and correlations do not guarantee future results, we do believe it is important that we revisit and update this matrix regularly.
Step 2: Market Assumptions: To build our view of the future, we conduct extensive research on an ongoing basis on each asset class. In doing so, we are determining how we believe each asset class will perform and how much volatility we might expect to see in the next 5 to 10 years. This process involves a tremendous amount of data collection, analysis and discussion. Unlike the Correlation Matrix, these data points reflect the “proprietary” opinion of the advisor and/or the firm.
What are the opinions of your advisor? How often do they revisit their assumptions? Many robo-advisors (automated allocation software) are taking in assumptions from others (large investment banks and equity researchers). We think some of those opinions should be discounted, sometimes dramatically.
The data may also be coming from academia, which is typically (in my opinion) about 5 years behind in what is actually happening in the market.
At Vitreous Partners, we formulate our own opinions based on a wide array of data and experience, and do so regularly.
Step 3: Passive Investment vs. Active Management: Passive investment means investing in the index, which represents the benchmark for the asset class (think S&P 500 for large cap stocks). Active management means that a manager is selecting the underlying investments, not just buying the index (think mutual funds, money managers and hedge funds). For each asset class, we monitor exchange-traded funds (also know as an ETFs) as well as active managers (mutual funds, money managers and hedge funds). We then make the determination on a client-by-client basis on whether to use a passive ETF or an active manager for each asset class. Things we consider include the time horizon, investment goals and tax status of our clients.
Many believe that passive investment is the way to go, as it cheaper (lower fees), and many times passive investments beat active management in performance. Although we agree in some instances, we don’t always believe passive investment is the best course of action. Specifically, we may choose active managers that are hedging their positions (buying insurance against a market drop) or managers that are investing in asset classes that are less competitive (specialized international managers or private equity managers).
Step 4: Creating Allocations: Once you have the correlations, standard deviation and expected returns of your asset classes, you can start to piece together an asset allocation. Using a program called “Monte Carlo Simulation,” you can statistically test your allocations to find potential outcomes of your asset allocation.
Monte Carlo Simulations are created by a computer program, which takes the raw input data from the advisor (market and asset class assumptions, correlations, expected cash flows etc.) and produces an array of potential outcomes tied to probabilities. This is not new technology, but it is improving all the time and we endeavor to be at the cutting edge of its developments.
Using these outcomes we can create a spectrum of potential allocations on the risk/reward scale.
Step 5: Tailor Allocations to the Investor: Armed with an array of different potential outcomes and after going through a detailed fact finding meeting with our client, we will sit down and review the allocations and our clients’ risk/reward profile. We’ll advise the client on what we believe to be the pros and cons of each allocation and go back to our simulations to demonstrate how we believe the various allocations will perform in the context of the client’s particular situation.
We believe investing is a partnership with our clients. We want them to understand why we invest the way we do and how we come to those conclusions.
Step 6: Investment Portfolios: Once we agree on an asset allocation as a road map of how we want to invest the portfolio, we will start to invest in each asset class. Although we believe that asset allocation is critical, we also believe that we want to invest in a particular asset class when we believe valuation is attractive.
Step 7: Tactical Allocation Changes: Many advisors, firms and robo-advisors believe that once you have an allocation, you should stick to it and not change anything. Ever.
We believe you should stick to a plan but we also believe that you should get off the tracks if you think you are about to be run over. Conversely, we want to purchase beaten down asset classes and investments when we think it is a good entry point.
We monitor the markets, including stocks, indexes, rates bonds and currencies as well as news that may affect these markets 24 hours a day, 365 days a year. We use a combination of technology and human research to make sure we are connected and aware of the shifting landscape as close to real time as possible, and we make changes when we believe it is prudent to do so.
Step 8: Reporting and Communication: Knowing our clients and their needs is the first priority for the firm. We make it a point to have regular communication and meetings and to be on call at all times. The markets never sleep. Why should we?
We also endeavor to give assistance to our clients in any and all aspects of their financial lives. We aren’t just wealth managers, we aim to be trusted partners with our clients. We strive to provide service and advice above and beyond our clients’ portfolios. This includes discussions on estate and tax planning, mergers and acquisitions, private stock positions, concentrated stock positions and life insurance.
Technology is changing the landscape of every industry, including wealth management. We fully embrace and welcome this change. We are constantly investing in updating the methods, programs and ways we collect, process and communicate data.
I believe that Vitreous Partners is set apart from our peers by our dedication to make personalized recommendations to our clients, both in investing and beyond. We value the advantages of using technology but also understand the limitations of robotic interaction. If there is anything we have learned throughout history, it is that tools are only as good as the hands that wield them. For example, computers are largely responsible for flight navigation. However, I don’t know anyone who doesn’t want a pilot in the cabin. Why would you put your portfolio on autopilot?
The ingredients to our “secret sauce” are work, care, honesty and communication. Nothing less.
We don’t take our responsibilities lightly, and we are honored and humbled by the trust we are given by our clients. Thank you for your continued confidence.
As always, please do not hesitate to contact me with any questions, comments or just to say hello.
Wishing you and your family a very beautiful and joy-filled spring.
All the best,
Rob Santos, CEO Vitreous Partners
Disclaimer: This document is for informational use and intended solely for the recipient. It may not be reproduced or redistributed without the prior written consent of Vitreous Partners, LLC. This is not an offering or the solicitation of an offer to purchase an interest in any investment. Any such offer or solicitation will be made to qualified investors only by means of a confidential offering memorandum and only in those jurisdictions where permitted by law.
i Federal Reserve Bank of St. Louis