Are Interest Rates Signaling a Recession?

January 31, 2023 — Sam H. Fawaz

According to Investopedia, the yield curve shows the relationship between bond yields (the interest rates on the vertical axis) and bond maturity (the time on the horizontal axis).

Long-term bonds generally provide higher yields than short-term bonds because investors demand higher returns to compensate for the risk of lending money over an extended period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion because a graph showing bond yields in relation to maturity is essentially turned upside down.

Imagine going to the bank and being told that a 1-year certificate of deposit yields 4.0%, but the 5-year CD only yields 3.0%. Few people would lock up their money for five times as long and earn a lower rate. This is an example of a yield inversion.

A yield curve could also apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. Although Treasuries are often referred to as bonds, maturities up to one year are called bills, while maturities of two to 10 years are called notes. Only 20- and 30-year Treasuries are officially called bonds.

The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late November, the difference has been at levels not seen since 1981. The biggest separation in 2022 came on December 7, when the two-year was 4.26%, and the 10-year was 3.42%, a difference of 0.84%. Other short-term Treasuries have also offered higher yields;  the highest yields in early 2023 were for the six-month and one-year Treasury bills. (1) 

Predicting Recessions

An inversion of the two-year and ten-year Treasury notes has preceded each recession over the past 50 years, reliably predicting a recession within the next one to two years. (2)  A 2018 Federal Reserve study suggested that an inversion of the three-month and ten-year Treasuries may be an even more reliable indicator, predicting a recession within about 12 months. (3) The three-month and ten-year Treasuries have been inverted since late October 2022, and in December 2022 and early January 2023, the difference was often greater than the inversion of the two- and 10-year notes. (4)

Weakness or Inflation Control?

Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests investors believe the economy will continue to grow and interest rates will likely rise with the growth. In this scenario, an investor typically would want a premium to tie up capital in long-term bonds and potentially miss out on other opportunities in the future.

Conversely, an inversion suggests that investors see economic challenges that are likely to push interest rates down and typically would instead invest and lock in longer-term bonds at today’s yields. This increases demand for long-term bonds, driving prices up and yields down.

Note that bond prices and yields move in opposite directions; the more you pay for a bond that pays a given coupon interest rate, the lower the yield will be, and vice-versa.

The current situation is not so simple. The Federal Reserve has rapidly raised the benchmark federal funds rate (short-term) to combat inflation, increasing it from near 0% in March 2022 to 4.50%–4.75% today. The fed funds rate is the rate charged for overnight loans within the Federal Reserve System.  The funds rate directly affects other short-term rates, which is why yields on short-term Treasuries have increased rapidly. The fact that 10-year Treasuries have lagged the increase in the federal funds rate may mean that investors believe a recession is coming. But it could also reflect the confidence that the Fed is winning the battle against inflation and will lower rates over the next few years. This is in line with the Federal Reserve’s (The Fed) projections, which see the funds rate peaking at 5.0%–5.25% by the end of 2023 and then dropping to 4.0%–4.25% in 2024 and 3.0%–3.25% in 2025. (5)

Inflation has been slowing somewhat in October-December, but there is a long way to go to reach the Fed’s target of 2% inflation for a healthy economy. (6)  The fundamental question remains the same as it has been since the Fed launched its aggressive rate increases: Will it require a recession to control inflation, or can it be controlled without shifting the economy into reverse?

Other Indicators and Forecasts

The yield curve is one of many indicators that economists consider when making economic projections. Among the most closely watched are the ten leading economic indicators published by the Conference Board, with data on employment, interest rates, manufacturing, stock prices, housing, and consumer sentiment. The Leading Economic Index, which includes all ten indicators, fell for nine consecutive months through November 2022. Conference Board economists predict a recession beginning around the end of 2022 and lasting until mid-2023. (7) Recessions are not officially declared by the National Bureau of Economic Research until they are underway. The Conference Board view would suggest the United States may already be in a recession.

In The Wall Street Journal’s October 2022 Economic Forecasting Survey, most economists believed the United States would enter a recession within the next 12 months, with an average expectation of a relatively mild 8-month downturn. (8) More recent surveys of economists for the Securities Industry and Financial Markets Association and Wolters Kluwer Blue Chip Economic Indicators also found a consensus for a mild recession in 2023. (9)

For now, the economy appears strong despite high inflation, with a low December 2022 unemployment rate of 3.5% and an estimated 2.9% 4th quarter growth rate for real gross domestic product (GDP). Nonetheless, the indicators and surveys discussed above suggest an economic downturn in the next year or so. This would likely cause some job losses and other temporary financial hardship, but a brief recession may be the necessary price to tame inflation and put the U.S. economy on a more stable track for future growth.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so are your financial plan and investment objectives.

(1), (4) U.S. Treasury, 2023

(2)  Financial Times, December 7, 2022

(3) Federal Reserve Bank of San Francisco, August 27, 2018

(5) Federal Reserve, 2022

(6) U.S. Bureau of Labor Statistics, 2022

(7)  The Conference Board, December 22, 2022

(8) The Wall Street Journal, October 16, 2022

(9) SIFMA, December 2022

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Is America in Decline?

March 7, 2015 — Sam H. Fawaz

In 1945, the U.S. made up more than half of the world’s total gross domestic product (GDP), which basically means that half the world’s economy took place inside U.S. borders. Today that figure is just under 22%.

Does that mean America is in decline?

There seems to be a bull market in doomsayers these past few years, as we’re all reading arguments that the U.S. is slowly losing its grip on global preeminence. The rhetoric today sounds a lot like the hand-wringing back in the 1980s when Japan was allegedly taking over the global economy, and before that, when the Soviet Union had more missiles and a Sputnik circling over our heads.

There’s no easy way to define the overall quality of an economy, but probably the most thorough assessment comes out each year via the World Economic Forum’s Global Competitiveness Rankings. The most recent report ranked 144 countries around the world, including Qatar (16), Moldavia (82), Namibia (88), Lesotho (107) and the unhappy states of Chad (143) and Guinea (144), whose citizens eke out their lives on per capita incomes of $1,218 and $564 a year, respectively.

The survey looks at 12 “pillars” of economic competitiveness, including labor market efficiency, the quality of primary education and higher education, infrastructure, the strength of institutions, innovation, business sophistication, technological readiness and the sophistication of the financial markets. Each of these categories are broken down into dozens of subcategories, which are separately evaluated. For instance, when looking at the strength of each country’s public institutions, the World Economic Forum researchers consider whether people in a given country have strong property rights and intellectual property protection, whether there is corruption and the routine payment of bribes, whether the citizens enjoy judicial independence and a solid legal framework, and how well investors enjoy shareholder protection.

In the most recent survey, the U.S. ranked third overall, with an overall rating of 5.5 on a scale of 1-6. Ahead of it were Switzerland (5.7) and Singapore (5.6). China, the country that you most often hear cited as the all-powerful up-and-coming economy, ranked 28th, two rungs below Saudi Arabia, one rung above Estonia. Brazil and India, which are sometimes mentioned as powerful competitors to U.S. economic hegemony, are ranked 57th and 71st, respectively.

The point of the rankings is to show which countries have created the healthiest (or, in the cases of Chad and Guinea, the least-healthy) economic climate for future growth. But of course there are other ways of measuring competitiveness, including the bottom line (as mentioned at the top of the article) of percentage of the world GDP, and whether you’re moving up or down.

US and Global GDP through 2014

By that standard, the U.S. is indeed moving down. If you look at Figure 1 above, which shows the size of the overall global and U.S. economies since 1991, you see that the U.S. has enjoyed steady economic growth, while the world at large has essentially taken off like a rocket. The years following the collapse of the Soviet Union, when several billion people were suddenly allowed to become capitalists, have been good for world growth. When China shifted from a communist to a capitalist economic posture, this added fuel to the rocket. The democratization of computer technology and the global Internet has empowered value creators everywhere.

The U.S., Europe and Japan, in other words, no longer have a monopoly on capitalism. And that’s a good thing.

Is there a better way of evaluating how the U.S. economy is holding up in an increasingly competitive world? Figure 2 below looks at the first chart from a slightly different angle. Since 1991, what percentage of all the world’s business has been happening in the U.S., vs. Europe, Japan, China, India, Russia and Brazil?   How much of the total global economy did each nation claim in each year, and how has that balance changed over time?

US GDP Market Share through 2014

What you see there is that the U.S. is still in the lead by a pretty wide margin, and in recent years has actually stabilized its percentage of total global GDP. The decline has come mostly because a lot of smaller emerging markets, plus China and, to a certain extent, Brazil, India and Russia, have all been growing. At the same time, America’s traditional competitors—Europe and Japan—have been sinking. If you want to point a finger at decline, perhaps that’s a better direction than the U.S.

Does the U.S. face economic challenges? Of course. Is our political system a mess? Sure. Could things be better? Certainly. But if you sift through a lot of variables with a fine-toothed comb, you discover that the U.S. has created a better environment to grow and prosper than almost anywhere else, and it has held its own with the roaring growth of the emerging markets while the other developed nations are losing ground. More than a fifth of all economic activity still happens in the U.S., and the long, slow decline in that figure is not due to stagnation at home, but abundant growth all around the world. That’s not something to worry about; it’s something we should be celebrating.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://reports.weforum.org/global-competitiveness-report-2014-2015/rankings/

http://www.economywatch.com/economic-statistics/year/1990/

http://theamericanscene.com/2008/05/07/a-post-american-world

TheMoneyGeek thanks guest writer Bob Veres for writing this post.

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The Psychology of Investing: How We Cope With Risk

February 8, 2015 — Sam H. Fawaz

Researchers have found that investors have a tendency to psychologically exaggerate declines in the performance of an investment and to minimize gains. It’s a phenomenon with a complex sounding name — “myopic loss aversion” — but also one that makes a simple point: Psychology plays a role in our investment decisions. Understanding that role, the subject of this second installment of a three-part series on investment risk, may help you stay on course toward your long-term financial objectives.

Word Play

Individuals subconsciously “frame” expectations based upon how the information is presented to them. For instance, would you prefer to invest in a security that has a 40% chance of yielding negative returns or one that has a 60% chance of yielding positive returns? Many people would choose the latter, even though the same investment opportunity was offered in both cases.

Running With the Pack

It’s human nature to want to choose investments that have performed well. On the other hand, many of us are naturally risk-averse. Sometimes these inclinations combine to make us less effective investors. For instance, do you know people who wait to invest until they hear of a security that consistently produces above-average returns? Then, sensing a “safe bet,” they purchase this investment — often when it’s at peak value. If the investment drops in value, they move their money to what they perceive as a less risky security or even pull out of the market altogether — even if such a move clashes with their long-term goals.

This sort of short-term thinking creates risk, too. When investors move in and out of the market, they’re practicing an investment tactic known as market timing. The risk is that they’ll mistime the market and lose out on potential gains. Even professional portfolio managers admit that it can be difficult to predict market moves.

Personal Experiences and Our Portfolios

Research has shown that individuals who grew up during the Great Depression are more likely to invest conservatively, while those who entered the market during the mid-1990s expect high returns and tend to invest more aggressively. Being aware of how past experience may influence your perceptions, can help you avoid financial strategies that may work against you.

So What Can You Do?

Several strategies may help you minimize the role that emotions and psychological tendencies play in your investment decisions. Stay focused on your long-term goals and not the market’s short-term moves. And rather than reviewing your investments’ performance every week, consider scheduling quarterly or semi annual portfolio reviews with a qualified financial professional.

Finally, develop — and stick to — a well thought out plan that’s based on your goals and your personal tolerance for risk. Look for more on these and other strategies that may help you cope with risk in the final installment of this series.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

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The Swiss Franc and Your Portfolio

January 21, 2015 — Sam H. Fawaz

You’ve almost certainly read about the recent drop in the global (and U.S.) stock markets, as a result of the “shocking” announcement by the Swiss central banking authority that it would not force the Swiss franc to trade at 1.2 euros.  Be prepared to be shocked: you can now buy a Swiss franc with a euro.

If you’re like most of us, you’ve probably wondered why this shocking development would have anything to do with the enterprise value of the individual companies that make up the various global indices.  What’s the story here?

The story is actually pretty simple—and surprisingly, isn’t being told very clearly in the press.  The Swiss National Bank had been artificially holding the Swiss franc at 1.2 euros for the past three years.  Why?  Because the value of the euro has been sinking on global markets.  A lower euro means everything manufactured in the Eurozone is less expensive for outside buyers, which is great for exports. By keeping the franc at a steady cost vs. the euro, the Swiss National Bank was protecting Swiss watches, chocolate products and high-end medical diagnostic equipment from becoming more expensive in the countries where Switzerland does most of its export business.

This policy suddenly became more difficult, in part because the European Central bank is expected to announce, on Thursday January 22, what economists delicately call “monetary easing”—buying government bonds, lowering interest rates, and giving banks and corporations more access to more euros.  The inevitable result would be a lower euro compared to other currencies.  Every time the Swiss Central Bank buys euros and sells francs, it is putting money in the pockets of global currency traders and a variety of hot money speculators who have bet that the Swiss will continue their policy.  These traders would have reaped a huge windfall if the euro dropped and the bank continued to fight an increasingly expensive battle to maintain parity.  The effect would have been a transfer of billions of dollars from Swiss taxpayers to shady speculators.

But why does any of this affect the value of U.S. stocks, or stocks in Europe, for that matter?  Why were floor traders on the New York Stock Exchange experiencing what one described as ‘once-in-a-career’ market turbulence, and others described as a ‘massive flight to safety?’  Certain exporting companies in Switzerland will be negatively affected and have to adjust their profit margins downward to stay competitive.  But U.S. companies aren’t selling their goods and services abroad in Swiss francs, and European companies will be slightly more competitive, globally, after the expected monetary easing announcement.

The only answer that makes any sense is that hot money traders dislike any kind of surprises, and they hit the “sell” button whenever they’re startled by news that they didn’t anticipate.  Then they wait until they have a better understanding of what’s going on.  And, since these short-term traders make up a majority of all the actual buys and sells, the markets tend to trade lower even though no fundamental economic reason exists for them to.

This provides a great opportunity for all of us to see the difference between short-term headline moves in the market and long-term fundamental shifts.  Make a note to, a month from now, see if you still remember the fact that the Swiss central bank is no longer supporting the franc against the euro.  At the same time, look to see if any major shift has occurred in the business operations or profitability of U.S. companies due to this adjustment in currency values overseas.

There will be known and unknown consequences as a result of this action.  Other countries may decide to manipulate their currencies as well.  Over the coming months, you might have to pay a little more for a Swiss watch, and chocolate manufactured in Switzerland might be pricier as well.  You will want to steer clear of parking your money in the Swiss central banking system, which is now paying an interest rate of negative three quarters of a percent.  If you’re a global options trader who took the wrong side of the bet, this was terrible news for your returns this year.  But the underlying value of the stocks in a diversified investment portfolio aren’t likely to become less valuable based on the latest trading price of options denominated in Swiss francs.

If you would like to discuss your portfolio or any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.forbes.com/sites/marcelmichelson/2015/01/16/swiss-franc-u-turn-is-realistic-move-as-snb-cannot-stop-tide/

http://www.businessweek.com/news/2015-01-15/swiss-franc-surges-to-record-high-against-euro-as-snb-ends-cap

http://money.cnn.com/2015/01/15/investing/interest-rates-negative-switzerland-ecb/index.html

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2014 Investment Report: Dare to Believe?

January 4, 2015 — Sam H. Fawaz

Looking back on 2014, people are going to say it was a great year to be an investor. They won’t remember how uncertain the journey felt right up to the last day of a year that saw the S&P 500 close at a record level on 53 different days. Think back over a good year in the market. Was there ever a time when you felt confidently bullish that the markets were taking off and delivering double-digit returns? I know I didn’t.

The Wilshire 5000–the broadest measure of U.S. stocks and bonds—finished the year up 13.14%, on the basis of a strong 5.88% return in the final three months of the year. The comparable Russell 3000 index will go into the history books gaining 12.56% in 2014.

The Wilshire U.S. Large Cap index gained 14.62% in 2014, with 6.06% of that coming in the final quarter. The Russell 1000 large-cap index gained 13.24%, while the widely-quoted S&P 500 index of large company stocks posted a gain of 4.39% in the final quarter of the year, to finish up 11.39%. The index completed its sixth consecutive year in positive territory, although this was the second-weakest yearly gain since the 2008 market meltdown.

The Wilshire U.S. Mid-Cap index gained a flat 10% in 2014, with a 5.77% return in the final quarter of the year. The Russell Midcap Index gained 13.22% in 2014.

Small company stocks, as measured by the Wilshire U.S. Small-Cap, gave investors a 7.66% return, all of it (and more) coming from a strong 8.57% gain in the final three months of the year. The comparable Russell 2000 Small-Cap Index was up 4.89% for the year. Meanwhile, the technology-heavy Nasdaq Composite Index gained 14.39% for the year.

While the U.S. economy and markets were delivering double-digit returns, the international markets were more subdued. The broad-based EAFE index of companies in developed economies lost 7.35% in dollar terms in 2014, in large part because European stocks declined 9.55%. Emerging markets stocks of less developed countries, as represented by the EAFE EM index, fared better, but still lost 4.63% for the year. Outside the U.S., the countries that saw the largest stock market rises included Argentina (up 57%), China (up 52%), India (up 29.8%) and Japan (up 7.1%).

Looking over the other investment categories, real estate investments, as measured by the Wilshire U.S. REIT index, was up a robust 33.95% for the year, with 17.03% gains in the final quarter alone. Commodities, as measured by the S&P GSCI index, proved to be an enormous drag on investment portfolios, losing 33.06% of their value, largely because of steep recent drops in gold and oil prices.

Part of the reason that U.S. stocks performed so well when investors seemed to be constantly looking over their shoulders is interest rates—specifically, the fact that interest rates remained stubbornly low, aided, in no small part, by a Federal Reserve that seems determined not to let the markets dictate bond yields until the economy is firmly and definitively on its feet. The Bloomberg U.S. Corporate Bond Index now has an effective yield of 3.13%, giving its investors a windfall return of 7.27% for the year due to falling bond rates. 30-year Treasuries are yielding 2.75%, and 10-year Treasuries currently yield 2.17%. At the low end, 3-month T-bills are still yielding a miniscule 0.04%; 6-month bills are only slightly more generous, at 0.12%.

Normally when the U.S. investment markets have posted six consecutive years of gains, five of them in double-digit territory, you would expect to see a kind of euphoria sweep through the ranks of investors. But for most of 2014, investors in aggregate seemed to vacillate between caution and fear, hanging on every economic and jobs report, paying close attention to the Federal Reserve Board’s pronouncements, seemingly trying to find the bad news in the long, steady economic recovery.

One of the most interesting aspects of 2014—and, indeed, the entire U.S. bull market period since 2009—is that so many people think portfolio diversification was a bad thing for their wealth. When global stocks are down compared with the U.S. markets, U.S. investors tend to look at their statements and wonder why they’re lagging the S&P index that they see on the nightly news. This year, commodity-related investments were also down significantly, producing even more drag during what was otherwise a good investment year.

But that’s the point of diversification: when the year began, none of us knew whether the U.S., Europe, both or neither would finish the year in positive territory. Holding some of each is a prudent strategy, yet the eye inevitably turns to the declining investment which, in hindsight, pulled the overall returns down a bit. At the end of next year, we may be looking at U.S. stocks with the same gimlet eye and feeling grateful that we were invested in global stocks as a way to contain the damage; there’s no way to know in advance. Indeed, we increased our allocations to overseas markets in 2014 as a matter of prudent re-balancing.  For 2014, that proved to be a tad early, providing a bit of a headwind.

Is a decline in U.S. stocks likely? One can never predict these things in advance, but the usual recipe for a terrible market year is a period right beforehand when investors finally throw caution to the winds, and those who never joined the bull market run decide it’s time to crash the party. The markets have a habit of punishing overconfidence and latecomers, but we don’t seem to be seeing that quite yet.

What we ARE seeing is kind of boring: a long, slow economic recovery in the U.S., a slow housing recovery, healthy but not spectacular job creation in the U.S., stagnation and fears of another Greek default in Europe, stocks trading at values slightly higher than historical norms and a Fed policy that seems to be waiting for certainty or a sign from above that the recovery will survive a return to normal interest rates.

On the plus side, we also saw a 46% decline in crude oil prices, saving U.S. drivers approximately $14 billion this year. On the minus side, investments in the energy sector during 2014 proved be a downer to portfolios. Oil, like most commodities, tends to be cyclical, and should turn back upward should the rest of the world find its footing and show healthier signs of growth. Should crude continue to slide, we may see collateral damage in the form of lost jobs, shuttered drilling projects and loan defaults by independent, not so well capitalized producers. This would be your classic case of “too much of a good thing.”

The Fed has signaled that it plans to take its foot off of interest rates sometime in the middle of 2015. The questions that nobody can answer are important ones: Will the recovery gain steam and make stocks more valuable in the year ahead? Will Europe stabilize and ultimately recover, raising the value of European stocks? Will oil prices stabilize and remain low, giving a continuing boost to the economy? Or will, contrary to long history, the markets flop without any kind of a euphoric top?

We can’t answer any of these questions, of course. What we do know is that since 1958, the U.S. markets, as measured by the S&P 500 index, have been up 53% of all trading days, 58% of all months, 63% of all quarters and 72% of the years. Over 10-year rolling time periods, the markets have been up 88% of the time. These figures do not include the value of the dividends that investors were paid for hanging onto their stock investments during each of the time periods.

Yet since 1875, the S&P 500 has never risen for seven calendar years in a row. Could 2015 break that streak? Stay tuned.

Sources:

Wilshire index data: http://www.wilshire.com/Indexes/calculator/

Russell index data: http://www.russell.com/indexes/data/daily_total_returns_us.asp

S&P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–

http://money.cnn.com/2014/09/30/investing/stocks-market-september-slump/index.html

Nasdaq index data: http://quicktake.morningstar.com/Index/IndexCharts.aspx?Symbol=COMP

International indices: http://www.mscibarra.com/products/indices/international_equity_indices/performance.html

Commodities index data: http://us.spindices.com/index-family/commodities/sp-gsci

Treasury market rates: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

http://blogs.marketwatch.com/thetell/2014/06/30/one-chart-explains-the-unexpected-first-half-treasury-rally/

Aggregate corporate bond rates: https://indices.barcap.com/show?url=Benchmark_Indices/Aggregate/Bond_Indices

Aggregate corporate bond rates: http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/

http://www.reuters.com/article/2014/12/31/us-usa-markets-2015-analysis-idUSKBN0K908820141231

http://moneyover55.about.com/od/howtoinvest/a/bearmarkets.htm?utm_term=historical%20performance%20of%20s&p%20500&utm_content=p1-main-7-title&utm_medium=sem&utm_source=msn&utm_campaign=adid-ac372107-3fb5-4c61-a1f3-6ab4e1340551-0-ab_msb_ocode-28813&ad=semD&an=msn_s&am=broad&q=historical%20performance%20of%20s&p%20500&dqi=S%2526P%2520500%2520yearly%2520performance&o=28813&l=sem&qsrc=999&askid=ac372107-3fb5-4c61-a1f3-6ab4e1340551-0-ab_msb

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As Inflation Fears Fade, Deflation Moves Front and Center

December 31, 2014 — Sam H. Fawaz

As the Federal Reserve winds down its massive bond-buying program, the widely predicted after effects — rising interest rates and inflation — have thus far failed to materialize. The yield on the bond market’s bellwether 10-year Treasury note, which started 2014 at 3.03%, had fallen to 2.33% as of October 29.1 Similarly, inflation, as measured by the U.S. Bureau of Labor Statistics key benchmark, the Consumer Price Index, has risen just 1.7% in the past year and has averaged 1.6% since the Fed first initiated its bond-buying program four years ago.2

Currently, concerns over inflation have been replaced by an opposite economic condition: deflation, defined as two quarters of falling prices within a 12-month period.3

Deflation, a Good News/Bad News Story

The paradox of deflation is that it can create good as well as bad conditions. When prices on essential goods and services drop, consumers are left with more disposable income to spend on nonessential items. Case in point: Plunging oil prices have spelled relief at the pumps, as the average national price for gas has now dropped below $3.00 a gallon for the first time since 2010.4

But when prices tend to fall across the board, the effect can turn negative for the economy, companies, and governments alike. Consumers put off making major purchases in the hope that prices will fall even further. That purchasing stalemate can be disastrous for a consumer-driven economy like the United States’, which garners about 70% of its GDP from consumer spending.

When spending stalls, companies’ revenues suffer and pressure mounts to cut costs by laying off workers, freezing or reducing wages, or raising the price of the goods they produce — all of which can further stymie consumer spending and deepen the deflationary cycle.

Debt is the other major problem associated with deflation. On the consumer side, when wages are stagnant or declining, consumer spending power declines, and it becomes more difficult to pay off debts — even fixed-rate debt such as home mortgages — because the value of that debt relative to income increases.

The same scenario plays out for corporations and governments, causing cash-flow shortages, tax revenue shortfalls, liquidity problems, and even bankruptcy.5 Deflation fears are particularly pronounced in Europe, where sluggish economic growth has much of the continent teetering on the brink of recession. To a lesser extent Japan and China are facing similar woes.

On the Right Side of the Problem

The good news/bad news nature of deflation has everything to do with what is driving the drop in prices of goods and services. For instance, if it is a lack of demand — as many economists say is currently the case in the Eurozone — deflation could be damaging. If, however, it is due to a boost in supply — such as the oil and gas boom in the United States — it can prove beneficial to economic growth.6

Either way, analysts say that U.S. investors should benefit from current conditions for the time being. The S&P 500 Index has gained 6.3% thus far this year (as of October 26), while the Stoxx Europe 600 Index has fallen 0.3%. Meanwhile, virtually all major currencies are devaluing against the dollar in an attempt to export deflation to the United States.6

If you would like to discuss your current portfolio asset allocation or any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

I wish you great health and prosperity in 2015!

 

Sources:

1USA Today, “First Take: Beginning of the end of easy money,” October 29, 2014.

2U.S. Bureau of Labor Statistics, Consumer Price Index, September 2014.

3The Economist, “The dangers of deflation: The pendulum swings to the pit,” October 25, 2014.

4AAA’s Fuel Gauge Report, November 3, 2014.

5Yahoo Finance, “Why deflation is so scary,” November 3, 2014.

6Bloomberg, “U.S. Gains From Good Deflation as Europe Faces the Bad Kind,” October 26, 2014.

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Is Your Portfolio “In Style” or Making a Bad Fashion Statement?

December 24, 2014 — Sam H. Fawaz

It is fairly common knowledge that a retirement portfolio’s carefully constructed asset allocation can become unbalanced in two cases: When you alter your investment strategy and when market performance causes the value of some funds in your portfolio to rise or fall more dramatically than others. But did you know there is also a third scenario? Your portfolio can become unbalanced due to unexpected changes in the funds’ holdings.

Getting the Drift

The phenomenon known as “style drift” generally occurs when a fund’s manager or management team strays beyond the parameters of the fund’s stated objective in pursuit of better returns. For example, this may occur when a growth fund begins investing significantly in value stocks or when a large-company fund begins investing in the stocks of small and midsized companies. As a result, the fund’s name may not accurately reflect its strategy.

If style drift occurs within the funds held in your portfolio, it could alter your overall risk and return potential, which may influence your ability to effectively pursue your financial goals.

Feeling the Effects

While some fund managers embrace a strategy that provides significant flexibility to help boost returns, and indeed such flexibility often proves quite successful, investors need to remember that too much flexibility can also present a threat to their own portfolio’s level of diversification. Investors need to consider their ability to tolerate unexpected changes in pursuit of higher returns.

For example, let us assume an investor allocates her equity investments equally between growth funds and value funds with the hope of managing risk and increasing exposure to different types of opportunities. If the manager of the growth fund begins to invest heavily in value stocks, the investor could end up owning two funds with very similar characteristics and a much greater level of risk than she intended.

Truth in Labeling?

Although most investment companies, including those represented in your retirement plan, adhere to stringent fund management standards, you may not want to simply judge a book by its cover, so to speak. An occasional portfolio review can help ensure that you remain comfortable with each fund’s management strategy.

For a comprehensive look at each fund and to evaluate its potential role in your portfolio, take the time to study its prospectus and annual report to determine how much flexibility the fund manager has in security selection. Also, look carefully at the fund’s holdings to see if they are in line with the stated objective. If you discover something that appears amiss, it may be appropriate to rebalance your portfolio accordingly.

If you would like to discuss your current portfolio asset allocation or any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Have a Merry Christmas!

Posted in Fee-only, Financial Planning, General, investing, markets, retirement planning. Tags: , , , , , , . 1 Comment »

How Do the Markets Really Work?

December 21, 2014 — Sam H. Fawaz

We all do it.  But what do we really know about investing?  A recent post about investing wisdom features a lot of interesting (and often overlooked) facts and figures, plus some insights from Warren Buffett, Jeremy Siegel, William Bernstein, Nobel laureate Daniel Kahneman and a few economists you may have heard of.

Regarding market predictions, the post had this to say: The phrase “double-dip recession” was mentioned 10.8 million times in 2010 and 2011, according to Google. It never came. There were virtually no mentions of “financial collapse” in 2006 and 2007. It did come. A similar story can be told virtually every year.

According to Bloomberg, the 50 stocks in the S&P 500 that Wall Street rated the lowest at the end of 2011 outperformed the overall index by 7 percentage points over the following year.

Many of the items offered insight into how our investment markets actually work.  For instance:

  • Since 1871, the market has spent 40% of all years either rising or falling more than 20%. Roaring booms and crushing busts are perfectly normal.
  • Apple increased more than 6,000% from 2002 to 2012, but declined on 48% of all trading days during that time period. (Investing is never a straight path up.)
  • Polls show Americans for the last 25 years have said the economy is in a state of decline. Pessimism in the face of advancement is the norm.
  • A broad index of U.S. stocks increased 2,000-fold between 1928 and 2013, but lost at least 20% of its value 20 times during that period. People would be less scared of volatility if they knew how common it was.
  • There were 272 automobile companies in 1909. Through consolidation and failure, three emerged on top, two of which went bankrupt. Spotting a promising trend and identifying a winning investment are two different things.
  • According to economist Tim Duy, “As long as people have babies, as long as capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”

The post had a few zingers about some of the best-paid executives in the financial and investment community:

  • Twenty-five hedge fund managers took home $21.2 billion in 2013 for delivering an average performance of 9.1%, versus the 32.4% you could have made in an index fund. Hedge funds are a great business to work in — not so much to invest in.
  • In 1989, the CEOs of the seven largest U.S. banks earned an average of 100 times what a typical household made. By 2007, that had risen to more than 500 times. By 2008, several of those banks no longer existed.

And finally, if you want to understand the difference between daily fluctuation and the underlying growth of value in the markets, consider this:

Investor Ralph Wagoner once explained how markets work, recalled by Bill Bernstein: “He likens the market to an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner.”

If you would like to discuss your current portfolio or any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Source:

http://www.businessinsider.com/things-everyone-should-know-about-investing-and-the-economy-2014-12

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Should We Fear—Or Cheer—Plunging Oil Prices?

December 18, 2014 — Sam H. Fawaz

Chances are, you’re celebrating today’s lower gas prices.  AAA reports that the national average price of gas is $2.48 today, the lowest since December 2009.  The result: an estimated $70 billion in direct savings for U.S. consumers over the next 12 months.  At previous prices, the average American was spending about $2,600 a year on gasoline, so the 20% price decline would result in $520 more to save or spend.

It gets better.  Even though gas prices (and, therefore, the cost of driving) have plummeted, the Internal Revenue Service is raising the standard mileage rates that people can deduct on their tax return for business travel, from 56 cents in 2014 to 57.5 cents per business mile driven next year.

Only the investment markets seem to think that cycling an extra $70 billion into the U.S. economy is a bad thing.  This past week, large cap stocks, represented by the S&P 500 index, saw their prices fall by 3.5%—their biggest drop since May 2012. Why?  The only possible explanation is that rapid Wall Street traders believe that lower oil prices will harm the economies of America’s trading partners, and therefore impact the U.S. economy indirectly.

So let’s take a closer look.  While U.S. consumers are cheering the decline in oil prices, and non-energy producing nations like Japan and countries in the Eurozone are seeing a boost in their economies, who’s NOT celebrating?

As it turns out, some of the biggest losers are American domestic shale oil producers, who basically break even when oil prices are at their current $50-$60 a barrel levels.  Any further drop in prices would slow down domestic energy production, and probably create a floor that would keep prices from falling much further.

Another big loser is the socialist government in Venezuela (remember Hugo Chavez?), which needs oil prices above $162 a barrel to pay for all of its social programs.  You can also sympathize with Iran, which reportedly needs oil prices to move up to $135 barrel to stay in the black, due to continuing sanctions from the world community over its nuclear program, and the high cost of supporting Hezbollah and its own military ventures in the Middle East.

The biggest loser is probably Russia, which requires oil prices of at least $100 a barrel for its budget to withstand international sanctions and finance its own military adventures against neighboring nations.  Economists are projecting that Russia will fall into a steep recession next year, when GDP could decline as much as 6%.  The nation is experiencing what economists call “capital outflows” of $125 billion a year—a fancy way of saying that wealthy Russians are taking money out of Russian banks and either investing abroad or putting their rubles in banks located in more stable foreign jurisdictions.  And in the process, they are exchanging their rubles for local currency, as a way to protect against the recent free-fall in Russia’s currency.  Bloomberg News recently published the below graphic which many Americans will find entertaining, but which is probably not happy news for Russian President Vladimir Putin.

Fear or Cheer Plunging Oil Prices

It’s interesting that the markets seem to be worrying about low oil prices when the economies with the most to lose are not only less than minor trading partners, but actual political enemies of U.S. interests. Cheaper oil will eventually be regarded as a plus for our economic—and political—interests, but the downturn suggests that Wall Street traders are hair-trigger ready to be spooked by anything they regard as unusual.

If you would like to discuss your current portfolio or any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.marketwatch.com/story/5-countries-that-will-be-the-biggest-losers-from-oils-slide-2014-11-20?page=2

http://blogs.piie.com/realtime/?p=4644

http://www.accountingtoday.com/news/irs-watch/irs-raises-standard-mileage-rate-for-businesses-72990-1.html?ET=webcpa:e3476082:a:&st=email&utm_content=buffer4179f&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

http://www.forbes.com/sites/northwesternmutual/2014/11/27/lower-oil-prices-give-a-gift-to-consumers/

Posted in Consumers, energy stocks, Financial Planning, General, markets, retirement planning. Tags: , , , , , . Leave a Comment »

Relative Prosperity

November 30, 2014 — Sam H. Fawaz

You might have read that the U.S. investment markets are jittery on the news that Japan has experienced two consecutive quarters of economic decline—the official definition of a recession.  But if you turn the news around, it offers us a reminder that, however much we complain about slow-growth recovery from 2008, Americans are actually part of one of the most robust economies in the world.

The statistics tell an interesting story.  The U.S. economy is growing at a rate of about 2.95% for the year, which is (as the complainers correctly point out) slightly below its long-term pace.  But this doesn’t look so bad compared to the 2.16% growth average for the G7 nations in aggregate, and our growth numbers are well ahead of the European Union, whose economies are expanding at an anemic 1.28% rate this year.

Look deeper and our story looks even better.  The current recession is Japan’s fourth in six years, despite long-term stimulus efforts that make the Fed’s QE program look like a purchase at the candy store.  Europe is rumored to be teetering on the edge of recession, which would be its second since the 2008 meltdown.  The published GDP figures coming out of China (which are very unreliable due to heavy government editing) could drop to about half the long-term rate this year, and Brazil entered recession territory last summer.

But what about the 5.8% unemployment rate in the U.S.?  That’s better than the 10% rate at the end of 2008, but it’s not good—right?  Compared with the rest of the world, America’s jobs picture looks downright rosy.  The list, below, shows that only 13 countries have lower jobless rates than the American economy, and some of those (Malaysia, Russia, Saudi Arabia) may be giving out numbers that their leaders want to hear.  Yes, it would be nice if the long, sustained GDP growth we’ve enjoyed these last six years were faster, and we all hope that the unemployment rate continues dropping.  But compared with just about everywhere else, life in the U.S.—on the economic front, at least—is pretty good

Global unemployment rates

Malaysia (2.7%)
Switzerland (3.1%)
South Korea (3.5%)
Japan (3.6%)
Norway (3.7%)
Taiwan (3.9%)
Denmark (4.0%)
Brazil (4.9%)
Russia (4.9%)
Germany (5.0%)
Mexico (5.1%)
India (5.2%)
Saudi Arabia (5.5%)
UNITED STATES (5.8%)
Indonesia (5.9%)
Pakistan (6.0%)
United Kingdom (6.0%)
Australia (6.2%)
Israel (6.5%)
Canada (6.5%)
Chile (6.6%)
Philippines (6.7%)
Venezuela (7.0%)
Czech Republic (7.1%)
Argentina (7.5%)
Sweden (7.5%)
Netherlands (8.0%)
Austria (8.1%)
Colombia (8.4%)
Finland (8.5%)
Belgium (8.5%)
Iran (9.5%)
Turkey (10.1%)
France (10.2%)
Ireland (11.0%)
Poland (11.3%)
Egypt (12.3%)
Italy (12.6%)
Portugal (13.1%)
Iraq (15.1%)
Spain (23.7%)
Nigeria (23.9%)
South Africa (25.4%)
Greece (25.9%)

If you would like to discuss your current portfolio/asset allocation or any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:
http://www.washingtonpost.com/business/economy/japan-recession-europe-stagnation-cast-pall-over-global-economic-outlook/2014/11/17/5cd81612-6e8f-11e4-ad12-3734c461eab6_story.html

http://www.washingtonpost.com/world/japans-economy-tips-back-into-recession-in-another-blow-for-abe/2014/11/16/9a8f2e94-8c9c-44cf-a5e8-b57a470fd61f_story.html

http://www.washingtonpost.com/world/japans-abe-says-tpp-trade-talks-with-us-are-near-the-final-stage/2014/11/07/24ba0b42-63a8-11e4-ab86-46000e1d0035_story.html

http://www.washingtonpost.com/world/british-prime-minister-david-cameron-says-red-warning-lights-flashing-on-global-economy/2014/11/17/acc29d06-c38f-49a1-b478-30d334fd3389_story.html

http://www.tradingeconomics.com/country-list/unemployment-rate

http://www.economywatch.com/economic-statistics/year/2014/

http://vicshowplanet.blogspot.com/2014/08/brazils-economy-falls-into-recession.html

https://uk.news.yahoo.com/ebrd-says-russia-certain-fall-economic-recession-122646029–business.html#PklpsIB

http://online.wsj.com/articles/chinas-slowdown-raises-pressure-on-beijing-to-spur-growth-1413893980

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