Big Drop In Stock Market And Uptick In Volatility. Should You Be Worried?

Absolutely you should be worried. Especially if you are over-weight equities in your portfolio. See that gap between the most recent drop (today) and yesterday? If that gap remains (i.e. the Dow Jones Industrial Average is unable to see buying enough to drive it to fill the gap any time soon), then stocks are headed lower. That means that longer term stock owners will be looking for selling (profit-taking) opportunities. We have been telling anyone who will listen that we have thought and continue to think that stocks are expensive on a number of metrics (see our most recent Weekly High Rock Video).

The selling pressure is coming from simple re-balancing of portfolios. If you have continued to be long equity assets through the run-up in prices, then you have automatically become over-weight.

Big money managers who do monthly re-balancing are turning into big sellers because they have become over-weight, simply on the increase in prices.

I just saw, on a business channel, the head of a wealth management operation of a bank tell us viewers not to worry. 

Well, I would suggest that would depend on whether your portfolio has been properly re-balanced or not.

We run a report weekly to stay on top of how balanced our client portfolios are (part of the being nimble that is a benefit of working with a small money manager) relative to the allocation targets in their Investment Policy statement.

Is volatility making a comeback? 

Probably too soon to tell. It depends on what kind of follow-through selling or buying materializes over the next few trading days. Normally after a period of below average volatility, there is eventually a spike higher. Lately, those spikes have not seen much follow-through.

So you need to ask yourselves: how much do I value my sleep?  If today's price action worries you, then you best get a handle on your portfolio balance or re-balance.

One thing I know is that our High Rock Private Clients do not need to lose sleep.

Smart Risk

The Consumer Price Index rose by 1.9% in 2017. That's what we are told by Statistics Canada, based on their estimation of what the average household consumes.

As I say every time I write about this data, each household will have a different set of circumstances depending on what you consume and where you consume it.

Apparently it was cheaper to live in Ontario in 2017 (+1.5%) and more expensive to live in Saskatchewan (+3.4%).

Transportation, Shelter (Natural Gas prices) and Restaurant Food appear to be the key drivers of prices over 2017.

When the more volatile Food and Energy components are removed, however, the "core" rate of inflation rose at a more modest rate of 1.2%. 

The Bank of Canada (Central Bank of the Year), whose sole mandate is to maintain stable prices, likes to remove the more volatile components to see how the other (less volatile) components are fairing sees something from 1.6-1.9%.

They do expect higher inflation in the future, but have been suggesting that for over a year now. The longer term averages for total CPI have been in the vicinity of 1.6% over the last several years.

So what is important?

For your household, the most important issue for projecting wealth is the forecast for your cost of living: income less expenses will determine your ability to save.

Growing your savings at a rate at or above the future cost of living is the only way you can maintain your purchasing power in the future (real growth).

That makes the assumption of inflating your cost of living a very major input into the forecast of your wealth. Few folks take the time to truly consider the implications of this.

Currently, you can buy a Government of Canada 90 day T-bill for about 1.2% (the interest on that is fully taxable as income at your marginal rate), which is the least risky investment possible.

But if your cost of living is rising at an annualized rate of closer to 2%, that is certainly not going to cover it. So in order to stay ahead of inflation, you need to take some risk.

How much risk do you need to take?

It depends on what annual average return you want to achieve. It is all relative: history over the last 10 or so year cycle (top to bottom and back to top of the current market/economic cycle) suggests that a portfolio balanced with  a 60% diversified global equity ETF and 40% of a Canadian Bond Index ETF will give you something near 5.5%. The risk factor, the ability of this portfolio to swing up or down from its average (standard deviation from the mean), is about 5.5 as well. That means that the return per unit of risk taken is about 1. In essence you may get a year of 10% growth, but you may also have to put up with a year of 0% growth from time to time as well. We all love the former (exciting stuff), but we do not love the latter (scary stuff). 

You can find ways to avoid the swing potential (volatility) by reducing the risk factor (and increasing the return per unit of risk). That is what we do at High Rock. That is why our clients pay us a fee. We manage the risk so as to (as best as is possible) avoid the swings, which over the long term will enhance portfolio growth (ultimately less portfolio downtime from which to recover).

When equity markets are rising in price, risk is also rising (risk that lower prices will follow, inevitably), risk that may not necessarily be in your best interest. Managing risk then becomes essential.

You do have to take risk to beat inflation. Taking smart risk is the only way to do so.

"Nearly 1/3 Of Investors Said Their Financial Adviser Didn't Explain Fees At All"

Sometimes I am just blown away at how little progress there has been in the way of improving financial literacy and the way financial institutions encourage investing, while at the same time finding ways to mislead a good portion of the investing public about what they are paying for and how it is paid. 

If you can, read this recent Globe and Mail article: "Canadians still in the dark about investment fees despite major changes in disclosures".

"A 2017 study by Credo Consulting Inc. found that 62% of investors still think that they do not pay for the financial advice they receive".

If you can, friends, please forward this story or this blog on to someone you may know who may not be as well-informed. I try to keep those of you who allow me your precious time, as best as my limited writing skills will allow, to open up the possibility that there is more than meets the eye in the world of financial advice.  Or perhaps send them to follow me on twitter @jstomenson as I do my part to encourage whoever I can reach to go and ask the tough questions of those who are providing financial advice.

I have worked for large banks and financial institutions at a high enough level to fully understand who works for whom. I asked the tough questions of senior management: "Who do you work for? The client or the shareholders?

Without hesitation, I was told it was the shareholders.

So what about the client?

The client is the source of revenue that powers earnings and profitability the funnels back to the shareholders in dividends and improved share prices.

The best way to improve earnings is to increase revenues and lower costs. What are the costs? In a wealth management division, client service is a cost. So how best to cut those costs? Reduce the service factor. So that is how the financial services business is evolving: bring in the clients, but limit their personal service (i.e. robo-advice).

I met with a prospective client last week: a very busy, career-driven, thirty-something (I would say "millenniel", much more communication-savy than me) who was blown away that I would come to her office to meet!

Service is never free. The regulators have made a lukewarm attempt to force advisors to show their clients how they are paid.

The evidence presented in the Globe and Mail article (above) tells me that there is still a great deal of naivete in the investing world (at the client level) and that the efforts to bring clarity to it has obviously not worked (so far). Furthermore, the conflict of interest of mutual fund companies paying commissions to advisors who sell their mutual funds has still not been resolved.

I need not tell you all that we started High Rock Private Client to bring clarity and transparency (above the regulatory requirement) to those who paid attention, but the conversation needs to reach far more, less-informed folks. I and they need your help.

No Surprise, Bank Of Canada Raises Rate

We chatted about this on our first weekly video of 2018 yesterday.

If you want the full frontal, you can see it all here: http://www.bankofcanada.ca/wp-content/uploads/2018/01/mpr-2018-01-17.pdf.

Here is what I think: The Bank of Canada is looking fully in the rear view mirror and projecting that forward, hoping growth will continue, albeit to a lesser degree and also hoping that the risks that they have identified don't play out to any great extent. That concerns us and raises our risk awareness.

They have identified that the consumer is vulnerable and that higher debt service costs will be a problem for indebted households, slowing the consumer down.

The green bit is the shrinking of the consumer impact on the economy. 

The wild card question is: how might this effect the housing market with all the other constraints (new lending requirements: stress-tests, etc.)? Certainly for those who can no longer afford to service their debt, they may need to consider an asset sale. If all that they have is their home, that will potentially exacerbate the issue. Throw in all the new, unsold development and the boomer looking to downsize or cash in and that could be enough to push the housing market over the cliff, if they all race to the exits at the same time.

Of course, NAFTA part 2 or no NAFTA at all will likely also apply economic brakes. The recent strength of the $C is also a factor (exports become more expensive).

As I stated earlier, the BOC has all of this considered in their assessment of risks to their outlook, but if they all start to come together simultaneously, it could spell disaster.

Remember, as the 2 year bond yield and 30 year bond yield spread (differential) narrows toward 0 (it is at 0.57% now), the risk of a recession rises. So we will also have to keep an eye on that:

Stay Tuned!

Wealth Management: What Are You Paying For And What Are You Getting In Return?

(artwork by Grahame Arnould)

With an assist to Stan Buell and the Small Investors Protection Association (SIPA) for re-tweeting a blog from a year and a half or so ago that contained the following quote in regards to CRM2 (which came into effect on July 15, 2016), whereby "Investment firms are to provide an annual report that shows, in dollars, the charges and other compensation paid to the firm and your advisor for products and services provided":

"This all sounds beneficial, but if you own any mutual funds you're only going to get a fraction of the total picture. The disclosed fees that are paid to your firm and your advisor will not include the management fees charged by the mutual fund managers."

"This to me is one of the, if not, the biggest con jobs ever pulled off by the investment industry on the Canadian investing public".

"Where else in your life would you agree to have someone provide them with a service and allow them to take money out of your account without telling you how much they take - every month?"

So friends, about three years ago, Paul Tepsich and I came up with an idea: let's get in front of this CRM2 thing and create a completely transparent money and wealth management offering for individuals and families.

All in 1.15% management fee (plus or minus .05% for ETF MER's, depending on your portfolio structure): If you have $500,000 under management with us you pay $419.17 per month. 

In a non-registered account that is tax deductible. Effectively, you are paying a fraction of the management fee after tax considerations.

The MER taken by the mutual fund company or ETF manager is not tax deductible.

It literally staggers me when I talk to prospective clients who have a "great" relationship with the advisor / salesperson at their banking / financial institution who is prepared to pay an MER (in many cases of 2% or more) for any reason. Even ETF MER's which are considerably more reasonable are not tax deductible, so you would want to minimize those as best as is possible.

More importantly what do you get for your fees?

At High Rock Private Client, we begin with a Wealth Forecast (prepared by our Certified Financial Planning, CFP, professional) which is very specific to your personal situation. This allows us how to assess your goals, objectives and desire for risk and prepare a tailored investment strategy for you.

Some might think that every advisory offering does that. Do they? How well do they do it? If you find yourself in a "basket" of mutual funds and / or ETF's then you are not getting a personally tailored portfolio. 

Robo advice offers a selection of "baskets". And so they should perhaps from a business operation perspective: it makes sense to bundle their offerings to minimize the cost of management and limit their face to face time with clients. But that is not how we operate. We are in the business of looking after people: personal service.

A Wealth Forecast is not worth the paper it is printed on unless it is constantly monitored, regularly updated and adjusted for the inevitable changes that occur in a dynamic life.

We sit down with our clients to review every client portfolio every six months or so to determine where we are in the plan relative to where we want to be and if necessary, make changes to the strategy to stay current with whatever changes are happening in our client's lives.

When I see bank advisors selling GIC's to clients who have mortgages or lines of credit (instead of telling them to pay down the mortgage or line of credit), I shake my head.

You will likely not get long-term (averaged over many years) double digit returns, but our attention to risk will also not likely put you in harms way, which ultimately means less potential volatility and a better sleep at night. That is our fiduciary responsibility to our clients. You will not get that from your advisor at your bank / financial institution, because they do not have to provide it for you.

Low fees, better wealth and portfolio management, personal service, fiduciary duty. 

And all the same safety and security of a bank: Canadian Investor Protection Fund (CIPF), Ontario (B.C., Alberta, Saskatchewan) Securities Commission licensed.

Simply a better alternative. 

Smoke And Mirrors: This Time It's Different?

From yesterdays Globe and Mail: "After a long slumber, Canadian retail investors are back as a powerful force, in fact the online systems they trade through can't seem to handle the volume."

OK folks, that is the latest warning signal, accompanied by "new record" stock prices:

Investors are "all in" (you may need to click on the chart above to enlarge it), or at least almost "all in".

One thing is for certain, all of the good news is baked in to current prices, further stretching valuations. With analysts anticipating a 13.1% rate of earnings growth for 2018,  the 12 month, forward looking Price to Earnings ratio (18.4 times) for the S&P 500 is almost 30% above its 10 year average (14.2 times).

Remember reversion to the mean ?

US tax reform and deregulation excitement, bitcoin euphoria and "high" marijuana stock trading volumes are perhaps over-shadowing the reality of higher interest rates on the horizon (with household debt at record levels).

All previous economic downturns have come on the heels of rising short-term interest rates that flatten the yield curve (the difference between 2 year and 30 year bond yields) to zero.

In Canada that differential has narrowed to 0.58% from over 1.50% at the beginning of 2017.

In the US, to 0.85% from over 2.00% at the beginning of 2017:

One more 1/4% increase in Canadian short-term interest rates by the Bank of Canada should just about push us in that direction (despite recent decreases in unemployment).

The anticipated two or three 1/4% increases by the US Federal Reserve should just about do it for the US.

Remember also that all previous recessions in the US have followed closely on the heels of an upturn in the US unemployment rate that intersects and crosses through the 3 year moving average:

At the moment the differential is 0.7.

Is it different this time?

Many will find technical rationalization (smoke and mirrors, I think) to say that it is. Many of them, the so-called experts are heavily invested in stocks right now and really want to see retail investors buying into the hype so that they can unload their investments at these record prices. Of course, that's what the "smart" money was doing last time (when it was also different). 

As I say over and over again, risks are high and rising and at High Rock, we are taking this into consideration. Are you?

Past Performance Is Not A Guaranty Of Future Returns

That is the disclaimer that we are required by our regulators to impart to our clients and prospective clients in order to make sure that we do not confuse the issue of the potential for future investment portfolio performance. Many advisors may have this disclaimer in small print somewhere in their literature, but unlike us, they are not nearly as forthcoming.

At High Rock, we also follow with a commitment to our clients to work our hardest to provide them with what we consider are the best possible risk-adjusted returns: returns that consider exactly how much risk (standard deviation from the mean, also known as the potential for loss) comes into play while attaining reasonable portfolio growth. (see chart below)

You all (Y'all) may be looking for something more exciting, you won't find it here. We don't sell excitement. You can possibly find that at your local casino. As a risk manager, I can tell you (and I am certain that you already know this) casino odds favour the house (not the gambler). Lottery tickets, by the way, are worse.

We sell long-term comfort and restful nights (with low fees, fiduciary responsibility, family wealth management, tailored investment strategy and 24/7 personal client service). 

We focus on risk first. I know that is a repetitive message, but it is our mantra. We also invest our money in the exact same assets as our clients, so if I don't like the near-term risk scenario for myself (and Paul and I discuss this daily), I will not be comfortable allowing our clients to have excessive risk.

We have not changed our view for 2018, we see plenty of risk on the horizon. Unlike those who are comforted by high and rising US stock markets, we see that as risk that is high and rising. Safety lies in greater allocations to cash and cash equivalents.

Short-term  (1 year returns) can and may be misleading and our understanding of natural human cognitive biases (behavioural finance) tells us that the "recency effect" will tend to create expectations based on the recent past to be extended into future decision making.

Expectations of a continuation of equity market performance going forward are easily influenced by what has been occurring (record highs in some markets).

This should (and does for us) raise caution flags. Our longer-term (5 year) absolute and risk adjusted returns for a balanced and globally diversified investing strategy (with a tactical application) are a reflection of our ability to drive portfolio growth, with a much better return per unit of risk taken (but does not necessarily guarantee future performance). 

Do not let 1 year equity market returns skew your judgement. Those returns come with high and rising risk and as we expect, if volatility (which has been historically low) returns to more normal levels (reversion to the mean), that could spell trouble for portfolios with too much risk.

And as I have said before and will say over and over again (ad nauseum), most individual investors (and a good portion of their advisors) have very little understanding of the risk in their investment strategies, even if they are in a nicely balanced ETF portfolio (which is why the regulators insist on the above disclaimer). Especially when equity markets are moving higher.

Fortunately for our clients, we do.

Wishing you all a happy, healthy and prosperous new year!!