February 14, 2018
Dear Clients and Friends,
February has ushered in some significant volatility in the stock market, with most of that being experienced on the downside. We are reminded that the stock market often takes the stairs on the way up and the elevator on the way down. With the threat of higher interest rates, this is a good time to review how interest rates impact asset prices.
The Economist published an article that was titled “The bull market in everything”. The underpinnings of these high valuations in most assets classes has to do with the extraordinary low interest rate environment. Below is a chart from Deutsche Bank that displays equity and bond valuations over the last 200 years.
The valuation models that exist in real estate are similar to those across all long-term assets. Let’s use this asset class to highlight how impactful rates have been.
One of the standard valuations models used in real estate is calculated by taking Net Operating Income (NOI), which is income after expenses, but before interest and depreciation, and dividing it by the capitalization rate (CAP rate or required rate of return). The CAP rate is directly impacted by moves in the prevailing interest rates.
Let's use the following assumptions for a particular property:
NOI of $300,000, an initial CAP rate of 8%, and a property value of $3,750,000 (300,000/.08).
If the CAP rate drops to 7% (as a result of a declining interest rate environment), then the property value increases to $4,285,714 ($300,000/.07) or a 14% increase in valuation. As rates drop further, the impact becomes more pronounced.
CAP Rate Change Valuation Change
8% to 7% +14%
7% to 6% +16.7%
6% to 5% +20%
5% to 4% +25%
The cumulative change from 8% to 4% is 100%!
This is exactly what has played out in the equity and bond markets over the last several years. Holders of long-term assets have been rewarded primarily by the change in rates, not the change in underlying earnings. What happens if the exact opposite happens and we go from a 4 to 8 CAP over time? The cumulative decrease would be 50%.
There are a contingent of advisors that will run a portfolio based on the old 60/40 stock/bond mix and maintain this type of portfolio because it’s true and tried. This ignores the fact that we have been in a declining interest rate environment for the last four decades. Rates dropped to the lowest point in history when the 10-year Treasury hit 1.3% in the summer of 2016. While bonds have traditionally provided the backstop against a drop in the equity markets, as rates approach zero, they simply can’t provide the protection necessary to avoid large portfolio declines.
This overwhelming macro risk has caused us to look outside of the mainstream assets for “alternative” drivers of risk and return. The drivers all have one thing in common – none are directly impacted by the change in the level of interest rates, and in most cases, earn a higher return if rates ratchet upward.
The most likely cause for rates to go higher is inflation. Another could be the shifting demographics in developed countries, where net spenders start to outnumber net savers over the next couple of years. Finally, global central banks have purchased bonds to help drive rates down. The reduction or complete elimination of their bond demand will also have an impact on rates.
When comparing a depression to inflation (Q32017 Newsletter), Ben Inker of GMO, an institutional money manager wrote, “If we imagined something that caused inflation expectations to rise to 5% and real rates to rise to 3%, the fall for the 60/40 portfolio goes to 52%. As a reminder, these losses are not to the worst trough level for the market, but the fair value that the stock and bond markets should oscillate around.”
When asked what would help determine stock valuations (April 2017), Warren Buffett said, “If I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth, I would not ask you about who was going to be president… a million things I wouldn’t [ask],” he continued. “I would ask you what the interest rate is going to be over the next 20 years on average.”
According to Ray Dalio (Jan 2018), manager of the world’s largest hedge fund, "You can't have a significant rise in interest rates without knocking over the whole asset markets."
Changes in Investment Allocation
Emerging market value stocks (EMV) are the most reasonably priced equities globally. They have significantly lagged both U.S. and other developed market stocks since the credit crisis. We will be doubling EMV exposure through an additional purchase of the Pimco RAE Fundamental Plus EMG Institutional (PEFIX) and reducing global equities by the same amount. The net impact of this move is to have the same amount in equities, but increase EMV and reduce exposure to both U.S. and other developed market stocks.
For better or for worse, market indices have become the de-facto measuring sticks for portfolio performance. Consider this:
- The S&P 500 gave back all of its gains from the late 1990s by February of 2003. Adjusted for inflation, the February 2003 S&P 500 index level was lower than it was in November of 1996.
- The credit crises produced even worse results. The inflation-adjusted level of the S&P 500 was lower in March of 2009 than it was in July of 1995.
Nonetheless, the S&P 500 continues to be the most widely used U.S. benchmark for investment portfolio performance.
A small number of our clients review their financial information on a frequent basis. For some, this is a fairly benign exercise, but for others, it invokes comparisons to what the financial media highlights on a daily basis, namely the stock and bond markets.
While about 60-70% of the investments in your portfolio are expected to track the major indices, the remaining 30-40% will not. This will have a meaningful impact on how your portfolio moves compared to a traditional blended stock/bond allocation. As a result, it is not meaningful to compare the daily, weekly, monthly, or quarterly price movements of your portfolio with the daily market commentary seen or heard on mainstream media outlets. We believe the uniqueness of our investment mix is warranted in light of current valuation levels and will result in better risk-adjusted performance over the long-term.
As investors, we have behavioral biases that can drive investment decisions. The 24-hour availability of financial news has exacerbated the negative impact of these biases. This has implications in both bear and bull markets and makes taking the long view more difficult.
1. Herding. We all run in herds — large or small, bullish or bearish. Institutions herd even more than individuals, with investments chosen by one institution predicting the investment choices of other institutions by a remarkable degree.
2. We Prefer Stories to Analysis. Narratives (stories) help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts they represent. We inherently prefer narrative to data, often to the detriment of our understanding. The analysis and interpretation of data is really, really hard. A corollary to this problem and to confirmation bias is what Nassim Taleb calls the “narrative fallacy”, which is looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen.
3. Recency Bias We are all prone to recency bias, meaning that we tend to extrapolate recent events indefinitely into the future. Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash. The peak recommended stock weighting came just after the peak of the internet bubble in early 2001, while the lowest recommended stock weighting came just after the lows of the financial crisis. That’s recency bias.
Gains and Losses Reported on Fidelity.com or on Fidelity Statements
A few of our clients that use Fidelity.com to monitor their investments misinterpreted data that Fidelity shows on their “Positions” screen. The Total Gain/Loss section (or Unrealized Gains or Losses shown on statements) is meant to serve as a tax-related item, not a performance metric. Fund distributions can greatly distort the numbers to make it look like you are losing money in a fund even with positive performance.
Say you bought AVRPX on 1/2/2017 at a price of $10.48. The fund earned 10.47% for the year, but ended the year at $10.10. Your Fidelity screen would show a loss of 3.63%, which is the result of dividing the negative change in price by the purchase price (10.10 – 10.48) / 10.48 = -3.63%.
What that screen fails to take into account is that the fund paid out a distribution in cash of $1.488 per share, which increased the actual return by 14.2% (1.488/10.48).
Please call Ravi if you have any questions about understanding actual rates of return.
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Annual Net Worth Statements
We are preparing personal Net Worth Statements as of December 31, 2017. 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 if you have not already done so. Contact your service advisor if you have any questions or need assistance in completing this request.
Information for Tax Return Preparation
We recommend that all clients maintain a current year tax folder to hold all tax-related documents needed to prepare returns. This folder can include: charitable contribution receipts, out-of-pocket medical expense receipts, property tax bills, copies of estimated tax payments made, W-2s, and 1099s from banks and brokerage firms.
We have sent out the following reports to assist with tax preparation:
Fees Paid to Schiavi + Dattani Fees paid from taxable accounts, not IRAs, could provide a deduction on Schedule A
Qualified Charitable Distributions (QCDs) QCDs reduce taxable amount of distributions from IRAs
529 Plan Contributions by PA Residents Pennsylvania allows a deduction for contributions to 529 plans
Note that fees paid from IRAs have already provided you with a tax break, since payments are not treated as taxable withdrawals. Therefore, they were not included in our annual fee report and are not deductible on Schedule A of your Form 1040.
If you made a Qualified Charitable Contribution (QCD) from your IRA as part of your required minimum distribution, make sure your tax preparer handles the distribution correctly on your return. The IRA custodian does not reduce the reported distribution by the amount of the QCD because they cannot vouch for the validity of all charities receiving these donations.
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 – SEC
The SEC 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.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA
President Vice President