We believe it is a disservice when advisors provide prospects with an investment allocation report in their first meeting that shows 10-year historical returns of a sample portfolio. Inevitably, the prospect will anchor to those returns as what the advisor will be able to deliver in the future, missing a minor detail of whether the advisor actually followed this allocation over the previous 10 years. Regardless, this sets an expectation of returns that completely ignores current prices.
The Impact of Emotions
What is clear to advisors that have been in the business for a long time, is that emotion management is a widely underappreciated skill. It is our emotional side that short-circuits our ability to achieve investment success. We have written in previous newsletters about how investors are 2 times more concerned about market losses than missing the upside of market gains. Also, we know that many investors would rather buy assets that have been going up in price rather than assets that have been falling (opposite of what we do at shopping malls). In addition, we know that investors are much more comfortable failing conventionally (because everyone else is failing). All of these behaviors illustrate the strong pull of our emotional minds over our logical minds. It’s the very reason why market pundits try to sensationalize market moves with words like plunge, tank, death spiral, crash. Incidentally, I just pulled these words right out of Yahoo! Finance’s current news feed.
Independent events are defined as events not affecting the probability of another event occurring. A coin toss is a perfect example. You can flip a coin and land on heads 7 times in a row. The fact that the coin landed on heads several times will has no impact on the probability that it will land on tails on the next flip. In other words, knowing the outcome of past coin flips does not give insight into the outcome of future coin flips. The same can be said for the outcome on the roulette table, craps table, or any dice throwing game. With the stock market, however, there are dependencies. A series of price declines increases returns going forward. In the financial world, this is called reversion to the mean or mean reversion. It essentially states that the market will overshoot or undershoot the average, but return to the average over time.
Price, as measured by Nobel prize-winning economist Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), has a 60% predictive probability over 10-year periods. This is not just true in the U.S., but globally. It is based on the mean reversion. Look at the following two charts for U.S. and emerging market (EM) stocks. One line reflects CAPE measurements. The other represents measure 10-year annualized returns.
Source: Research Affiliates
Based on these two charts, you can see the fairly strong, inverse correlation of CAPE and future returns.
The table below, courtesy of Convex Capital using Robert Shiller’s data, shows the compounded annual 10-year U. S. equity market return ranges for 927 months between January 1927 and March 2004, based on where CAPE was at the beginning of the period.
Today, U.S. stocks are at a CAPE of 25. Historically, this has resulted in:
- negative 10-year returns 31% of the time (30/97)
- 0-5% 10-year annualized returns 33% of the time (32/97), and
- 5-10% 10-year annualized returns 36% of the time (35/97)
Here’s the bottom line. Corporate earnings, taken in the aggregate, are fairly stable. The price an investor pays for those earnings (P/E) varies considerably. Buying at lower P/Es produces high probabilities of better long-term returns. P/Es are unreliable for short time horizons. Therefore, as prices drop, it translates into earning higher future returns.
The Case for Emerging Markets
Let’s use current CAPE measurements and compare 10-year relative return forecasts (again, a 60% predictive measure) of emerging markets (EM) versus U.S. stocks. You can see that EM is now priced to outperform the U.S. market by almost 5% annualized over the next 10 years. We added a small dose of EM dedicated exposure in the first quarter of 2014, when the relative valuation measured a 3% outperformance of EM versus U.S. Remember, this graphic does not predict short-term outperformance today, any more than it did 2 years back. What was relatively cheaper before is only cheaper now. As a result, we will look to add more exposure to EM. To put a 5% relative outperformance in perspective in dollar terms, a $100,000 investment would deliver $63,000 more in upside over 10 years (63% difference). That leaves quite a margin of error in case EM performance undershoots.
This chart can serve both as a case for EM and a case against U.S. stocks over a 10-year period. The lower the EM CAPE ratio compared to the U.S. CAPE ratio (right scale), the higher the subsequent relative return in emerging markets compared to the US.
The Ability to Weather the Storm
In order to participate in the upside potential of the equity markets over a 10-year period, it is essential to have enough assets with lower downside exposure to provide 7-10 years of cash flow to ride out volatility. For retirees, the ability to draw cash from their portfolio during market turbulence is more critical than investors whose cash flow is being met by earned income.
Near-term cash needs (5 years or less): Checking, savings, money markets and high-quality, intermediate term bonds allow for cash flow accessibility with minimal risk of principal impairment. Intermediate term bonds have not had a negative 2-year return in the last 29 years of market data. Even with significant interest rate increases, it would be very difficult to produce a negative return over a 3-year period.
Intermediate-term cash needs (5-10 years): This category would include assets that have higher volatility than cash or high quality bonds, but less volatile than stock or stock mutual funds. We use a heavy dose of Ironclad Managed Risk (IRONX) to provide for intermediate term cash needs. The concept of the fund is based on the characteristics of the put/write index, which has never had a negative 5-year return since its inception in 1987. By comparison, rolling five-year returns of the S&P 500 during that time frame have been negative 25% of the time.
Other than normal rebalancing, we are going to be making some shifts in client portfolios. The shifts will allow us to add to compelling long-term opportunities without meaningfully increasing portfolio risk. The actual moves will depend on the risk criteria for each client.
Specifically, our objectives are as follows:
- Modestly increase emerging market stock exposure
- Eliminate direct U.S. stock exposure (continue to hold U.S. through global funds)
- Modestly reduce global stock exposure
- Modestly reduce credit risk in fixed income (shift to higher quality bonds).
Please call us and schedule a meeting if you would like more details.
Annual Net Worth Statements
We are in the process of preparing personal Net Worth Statements as of December 31, 2015. Taking an accurate picture of assets and liabilities on an annual basis is an important financial planning tool that improves our ability to serve you. These statements allow us to answer these questions:
- Should any existing financial accounts be consolidated in the interest of simplification?
- Should there be any changes in asset ownership that will minimize income taxes?
- Should there be any changes in asset ownership that will minimize estate taxes or probate expenses?
- What is the nature of any current debt? Should any debt be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement feasibility or retirement security?
- Have there been any additions to personal property requiring insurance coordination?
- Were there any purchases, sales or gifts of real estate interests?
- Were there any changes in asset ownership not communicated to us? Ownership changes impact insurance, taxes and estate planning.
Please respond promptly to our request for this information. Contact your service advisor if you have any questions or need assistance in completing this request.
Information for Tax Return Preparation
It is time to begin gathering the information needed to prepare 2015 tax returns. It is a good idea to keep a current year tax file and fill it with any documents you know will be needed to prepare your returns, such as charitable contribution receipts, property tax bills, and copies of estimated tax payments made. Financial institutions, including Fidelity, will be sending out Form 1099s with information on dividends and capital gains. We will send you a report of 2015 planning fees paid from taxable accounts. Note that fees paid from IRAs have already provided you with a tax break, since payments are not treated as taxable withdrawals. Therefore, they are not deductible on Schedule A of your Form 1040.
Annual Delivery of Privacy Statement
We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.
Information Filing - Securities and Exchange Commission (SEC)
The Securities and Exchange Commission requires all registered investment advisors to update the information on file with the agency on Form ADV within 90 days of year end, or March 30. We intend to revise the form and post it on our website by that date. If you do not have access to our website and desire a copy of that form, please contact us.
2016 Annual Tax Planning Limits
A summary of key tax planning limits for the current year is attached for your reference.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA