US Interest Rates May Go Up By A Full 1% This Year!

So say some analysts, following new US Federal Reserve Chairman Powell's first testimony to the House Financial Services Committee. His "personal outlook for the economy has strengthened since December".

As we suggested on our weekly video, there is plenty of economic data coming at us this week and today the Conference Board suggested that the US Consumer is the most confident that they have been since 2000!

Interestingly, the US consumer is also facing record debt levels: 

And if interest rates go up, that is going to have an impact on their ability to service that debt. Which may also impact their spending (and the consumer is 2/3 of the US economy). At the moment, however, it appears that the tax cut euphoria is winning the day and giving hope that incomes will experience a an up-tick to assist in covering the higher costs of household debt. We shall see.

Meanwhile, both stock and bond markets reacted with selling and correlations look like, for the moment, that they are not necessarily providing protective cover.

While the stock market up-trend from 2009 remains intact until the S&P 500 breaches the lower trend-line at about 2250,

The higher levels of volatility in financial markets and the prospect of higher interest rates (and less liquidity in the financial system) may give pause to those that are still bullish of equity markets this late in the cycle. 

Risk is at its highest levels when prices are at their highest levels. This is meaningful to us at High Rock.

Canadian CPI Year To Year +1.7%: 

How Does This Compare To The Change In Your Cost Of Living ?

January and the beginning of a new year drives a significant number of inquiries about what we do at High Rock for our Private Clients. Wealth and portfolio management encompasses much more than just investing. Planning and forecasting play a major role. As I have suggested many times (ad nauseum), you only have to take risk when safe investments don't give you enough return and growth in your savings and assets to stay ahead of the increase in your cost of living.

A 90 day Government of Canada T-bill which is the safest of all assets available trades at or about 1.2% on the wholesale market. After all the commission and fee deductions, etc., a retail or individual investor would be lucky to get 1%.

So we can call 1% the Risk-Free rate of return (at the moment). 

Let us just suppose that your cost of living increases each year at or about the average rate of the Consumer Price Index (CPI). The base was set at 100 in 2002 and 16 years later it sits at 131.7, so it has averaged close to a 2% increase for the last 16 years. For comparison purposes (to your own personal circumstances), this is the "basket of goods" and the % weight assigned to each major category:

Depending on what, how and where you consume, there will be some discrepancy between your household spending and the above, but let's settle on 2% as a rounding number.

You are not going to be able to stay ahead of your increased cost of living by investing in risk-free assets at or about 1%.

How much risk do you have to take?

It does not take much to get the phone ringing off the proverbial hook (although these days it is mostly panic emails) at High Rock when volatility strikes and investors get a taste for just how much risk they have in their portfolios.

Needless to say, even a nicely balanced 60% equity portfolio felt the full impact of the most recent correction, let alone some of the 100% equity portfolios that have been knocking on our doors.

Even if you only read my blogs once in a while, you will know that what we do at High Rock goes much deeper than just popping our clients into a "one size fits all" balanced portfolio.

It takes a much greater amount of work and research to determine what risk is appropriate relative to each of your goals. That is why we do what we do. We want to make sure that we are upholding our fiduciary duty to our clients. That means that we must always be conscious of what risk we place you in when we build an investment strategy and why it is that we are taking that risk.

Your cost of living, which is very particular to your family, is a very important aspect of the planning process. The greater our understanding of that, the greater the understanding of what risk you have to assume to keep the growth of your money well ahead of the inflation in it.

Investing is so much more than gambling on a collection of companies future growth and cash flow. It is understanding why you need to take that risk in the first place and is that risk appropriate for you to be taking.

Should You Borrow To Invest?

It is RRSP deadline time. You have until March 1st to make a contribution for the Tax year of 2017. The maximum contribution that you can make is 18% of your 2016 earned income, up to a maximum of $26,010 (less any pension adjustment).

A common question around this time of year is: "should I borrow to max out my RRSP"?

And my simple and yet rather complicated answer is:

It depends!

If you go to this link: Tax Calculator, you can figure out what your tax savings will be for your income and contribution level.

Then you have to factor in the cost of borrowing.

Lets just say that you borrow $20,000 at 5%, that is going to cost you $1,000 in interest over the course of the year. That interest is not tax deductible.

According to the tax calculator (above), if your income for 2017 is $100,000, your tax savings (if you reside in Ontario) would be $7,622.

Here is the catch: at some point in the future, you are going to have to pay income tax on the $20,000 when you withdraw it from your RRSP (or perhaps your RRIF if you take it out after you turn 72).

We all have no idea what our income tax rates will be in the future, but we can all likely expect that tax rates are not going down.

We also have no idea what return we will achieve on the invested $20,000, but history suggests that 6% (before fees) should be a reasonable expectation for a globally diversified and balanced portfolio (but remember, always, that historical performance is not a guarantee of future returns).

Fees: you have to make sure that whatever you invest in, that you are very cognizant of the costs of investing. 

If you buy (or your advisor buys for you) a mutual fund, what are his / her fees and what is the Management Expense Ratio (MER, found in the small print).

For example, the RBC Balanced Fund takes 2.16% (lower right of the above) for its troubles. It's 10 year return has been 3.7%. Add in the MER and it has been 5.86%, so close to the 6% before fees number that I suggested above, although they beleive that they should get about 2/3 of your return for their trouble.  Amazingly, $5.6 billion think that this is OK (that is the amount of money invested in the RBC Balanced Fund). 

Oh and by the way, at High Rock we can basically cut that in half and offer all sorts of inclusive personal service and fiduciary responsibility.

Most importantly, we will do a Wealth Forecast for you that will help determine if it is appropriate for you to borrow for your RRSP or not. For that matter, we can tell you if, given your personal financial circumstances, whether borrowing to invest makes any sense at all.

Here is my point: you can crunch the simple math and determine if that works for you. However in the larger context of your goals and objectives, time lines and risk tolerance, does it make sense?

Only if it fits into your plan. So you need a plan to determine if it makes sense, otherwise you are rolling the dice. Are you a gambler? Or are you a steward of your families wealth? 

Big difference.

Plan first.

Risk, Value and Volatility

Last Friday (Feb. 9), the S&P 500 hit a level (2532), which was almost 12% lower than the Jan. 26 high at 2873. This brought one measure of value, the Price to Earnings (P/E) ratio for  12 month forward looking earnings (earnings growth for 2018 is expected to be about 18% taking new US tax reform into account) down close to the 5 year average near 16 times

(see last Saturday's blog for the chart on this).

Our risk models turned green at this point and our orders for investing recently added client cash saw many of their target prices met and we bought equity assets for our clients and ourselves (because we invest in the same assets as our clients).

Volatility created value (risk levels fell with falling stock prices) and we were able to take advantage of it. Buy and hold strategies were basically stuck on the sidelines.

Yesterday, after about an 8% increase in the S&P 500, risk levels rising again and the 12 month forward P/E values rising to over 17 times, we took some of that risk off of the table. Who can argue with an 8% profit over one week?

Point being is that we were hard at work, monitoring our risk metrics because that is how we mange money, by risk. If stock markets go higher, we will continue to take risk off of the table.

If, as we suspect, there will be more volatility as central banks draw liquidity out of the global financial system as they gradually reduce quantitative easing (and institutions are forced to sell assets), there will be more opportunity to find better value as prices settle at more realistic levels.

One of our more attentive clients sent me this market letter mid-week: The Advent of a Cynical Bubble by market strategist James Montier (worth a look for sure), which interestingly invokes the musical chairs metaphor which I often use, but the week of Feb. 5-9 was certainly an excellent example. Needless to say, last week (on much lighter volumes) brought back the overdone "buy the dip" crowd, pushing market prices back to levels that are less-realistic. 

This push and pull of buyers and sellers could keep volatility relevant for some time to come, especially if the reality of lower levels of liquidity brings greater institutional selling into fewer and fewer "buy the dip" types who are running out of juice.

For our clients, we will monitor all the goings on and continue to do the work of buying value opportunities which enable us, over longer periods of time to reduce risk and portfolio volatility.

In the mean-time, the buy and hold crowd will watch their portfolios swing erraticaly in value, while we build it in ours.

Tactical Or Buy And Hold?

Stocks are about 9% off of their highs and down a little over 2.5% on the year (ACWI ETF converted to $C). If you bought stocks after October 2017, you are offside. Bonds are down too, the Canadian Bond Index ETF (XBB) is lower (year to date) by about 1.7%.

A fully invested 60% equity, 40% fixed income portfolio, based on those two ETF's is lower by a little over 2% so far this year. 

With an increased allocation of cash of 20-30%, you likely could have saved about .50% or about $2,500 on a $500,000 portfolio since January 1.

Dennis Gartman, long-time market commentator and trader suggested on BNN that market tops are made of volatile moves as those we have seen over the last couple of weeks and that we may have begun a bear market (in stocks).

Prominent economist Mohamed El-Erian suggests that it is unsettling and that as I suggested above that diversification is not working. However, he does say that it could put markets on a firmer footing: 

"Although it is painful in the short-term, this correction could underpin healthier markets in the longer term. It reminds participants of the importance of respecting, and better pricing, volatility and liquidity. And, with improving actual and prospective growth, the sell-off can be part of a transition from liquidity-driven valuations to ones built on better economic and corporate conditions, thereby narrowing the gap between elevated asset prices and fundamentals -- and the concern for future financial stability that comes with such a gap. "

More here: https://www.bloomberg.com/view/articles/2018-02-09/10-things-to-know-about-the-stock-market-selloff

What I know is that stocks got a lot cheaper relative to earnings and that is a key fundamental that we (at High Rock) have been monitoring for sometime: VALUE

And another thing that I know is that I would rather have cash in my portfolio so that I can grab some bargains when I see them. So I do. So do Paul and Bianca. So do all of our clients, because we manage our personal money in exactly the same way as we manage our client's money.

We manage risk first. When risk is high, we accumulate cash. We do not chase returns. When prices come down to more reasonable levels we look for value.

Is there better value now? Certainly, at least by the above chart it has not been this good since 2016. Will values get better? Maybe. But it sure is nice to have options for buying into better value. 

If you have a fully invested buy and hold strategy you are going to just have to sit and wait it out.

What kind of work is a buy and hold strategy advisor doing at this time? Not looking for bargains. Perhaps advising his / her clients to "sit tight". Very strategic!

90% Of Canadians Do Not Have A Formal Financial Plan

100% Of High Rock Private Clients Do

From a piece by Jonathan Chevreau in The Financial Post: "The magic number for retirement savings  is $756,000, according to a poll of Canadians" and "while that is the average amount individual Canadians believe they'll need to amass, up to 90 per cent don't have a formal plan on how to get there."

I can tell you that everybody we (High Rock Private Client) work with has a formal plan. We call it a Wealth Forecast. In fact we will not build a portfolio strategy without one (and it is prepared by our Certified Financial Planning professional). As experts in wealth and portfolio management, we would never presume that a "one size fits all" mix of assets (stocks and bonds) is correct for everybody, something that separates us from the standard of many financial and robo-advisors.

Not only do we prepare a plan up front, there is no obligation to work with us if you don't like the plan and the accompanying strategy (or us for that matter). We know that you not only need a starting point, but regular monitoring and updating to keep the plan current. The starting point and projected net worth forecast is not worth the paper it is written on, if it is not re-visited at least one or two times per year. Life is dynamic and  change happens on many fronts and that needs to be reflected in your plan.

Everybody's goals are different and the path to achieving them is different. The average amount of dollars suggested in the above mentioned article is just a number. It does not tell you the lifestyle associated with that number. That lifestyle is purely personal: where you live, how you live, what activities you choose for retirement are yours to determine.

We can tell you if they are realistic. 

We can also tell you how you are going to get there.

We cannot predict the short-term swings in the value of investment assets in financial markets. We can, with our ability to manage risk, predetermine a long-term goal for the growth of your financial net worth: focusing on protecting your capital first and then getting the long-term average annual rate of return you require to meet your objectives for the future, while at the same time keeping the risk we need to take to get it at the lowest level as is possible.

As I have stressed in many of my previous blogs, risk is always going to be necessary to stay ahead of inflation. At the moment, the current and future expectations of the rate of inflation (or annual increase in your cost of living) can be open to a wide debate. In all likelihood, however, it is rising.

This all has to be built into your plan.

Problem is, you need to take the steps to get that plan created and executed. We are happy to help you get going, but you have to want it first.

Confidence Is Shaken

Yesterday, volatility (in stock markets) jumped to levels not seen since September of 2016 (pre-election) and before that, all the way back to 2012.

Clearly, that was not as much fun (for many) as those folks in the photo are having. The computer generated "algo" trading jumped in mid-afternoon, just in time to fill all the "stop-loss" orders at pre 2018 prices. That manifestation took about 10 minutes or less to drop the Dow Jones Industrial Average by about 800 points. The swings may get more violent before volatility eases up.

But, despite some buying that followed, the technical damage has been done to the market.

Investors who borrow to invest (which is at record levels per the chart above) now face margin calls that require them to put up more cash against their purchases as prices have declined so significantly. In other words they are going to have to sell something to raise cash. That selling could exacerbate the current volatility.

Further,  all the buying done in January is "offside". Those investors are going to be very nervous.

Human behaviour (behavioural finance) becomes pretty important in these instances. We humans hate losses. So much so, that we tend to want to sit on a bad situation and hope that it gets better. We are very patient to wait for losing positions to at least get back to even. In all likelihood this could "trap" all those investors who were late to the party and will sit and wait until they can no longer take the pain. 

Even if there is new buying into the correcting markets, there is now likely going to be good selling if and when markets get back to January levels as those investors who bought in January get an exit opportunity.

We have probably seen the highs, at least for some time to come.

A note to clients reading this blog: While you are not completely immune from the devastation wreaking havoc on stock investors (unless your exposure to equities is zero), you are limited to your exposure because we have been and are under-weight the equity asset class, so the impact is minimal.

I have reached out to a number of you directly, but feel free to get in touch to discuss your situation specifically, if you wish.

The Economy vs. Stocks

What is wrong with this picture?

There is a common myth propagated by those who promote the ownership of the equity asset class  (or stocks) that a strong economy will drive corporate earnings, which in turn should drive stock prices (generally) higher.

But over the last nine years or so, that story has been sold to everyone who will listen (would-be investors mostly) by the investment community who, by the way, have a lot of vested interest in seeing a rising stock market. Even the more appropriate "fee-based" financial advisors who offer a balanced approach (but usually leaning more aggressively toward stocks) reap the rewards when higher stock prices drive portfolio values higher.

And prices have been driven higher and higher (with the hype) bringing the value of those prices into question (because economic growth has not).

As long as they are able to keep you invested, the advice community get paid their commissions. If the portfolio values rise, they get paid a little more. So they all want you to be "fully" invested at all times. That is what pays for their Mercedes', downtown condos and country homes. They sell you the idea that you need to be fully invested all the time. 

The investment community gets real nervous when the real world begins to interfere with their cozy lifestyle and rush about telling everybody to "hang in there" when they see that the state of their happy world starts to come under pressure.

A good portfolio manager (very different in many ways from a Financial / Investment Advisor, because they have a legal fiduciary responsibility to always put their client's interests first, before their own: i.e. the way that they are paid), on the other hand, manages risk. That means that they are avoiding over-priced assets and always searching for value opportunities with which to invest on behalf of their clients (which also means that they have more work to do). They don't buckle under the pressure of "the flavour of the day", especially when it is not justified. For a short period of time, like when tech and telecom drove stock markets to ridiculous levels in 2000-2001, their wisdom might be questioned, but in the end it is ultimately the long-term that will tell the tale.

Sometimes you do have to adjust your strategy. 

I was once what you would now call a Financial Advisor, but I didn't like the methodology that was being used. So, I evolved. The world evolves with time. Old fashioned ideas get replaced by new and updated ideas and methods. It is never easy leading the change. Often it draws criticism from those whose old fashioned methods are challenged and re-fashioned. 

If you don't think that stocks are expensive, then prepare yourself for a fairly significant adjustment in the value of your portfolio, while you ride out the storm.

If you want to take advantage of the opportunities that will become available as volatility rises, then maybe it is time for a second look at your current strategy.

When Traditional Balance Fails: Bonds and Stocks Falling Together

Right now cash (and / or cash equivalent securities) is the only place that you might avoid the price declines in both stocks and bonds. We (at High Rock) have championed the rationale for a more tactical investing strategy which allows us to move to a more defensive strategy when we are uncomfortable with owning expensive assets. Cash (and cash equivalents) are defensive assets.

Sometimes, being defensive becomes an enormous advantage. The correlations between stocks and bonds are expected to balance each other out in traditionally balanced portfolios. We have argued for quite sometime that those traditional correlations are not so dependable any more with asset prices being as lofty as they have been.

That is certainly the case at the moment.

Stocks (gold line) are falling, bond yields (white line) are rising (prices falling), and the correlation (green at the bottom) is moving to 1 (which is 100% correlated), which completely defeats the fully invested stock/bond balance. That is a double whammy to the downside of a fully invested (very little cash on hand) portfolio.

The upside of having some cash on hand is the ability to be able to buy these newly discounted assets at better prices.

This is certainly good news for our clients. 

If stock buyers are full up on their recent purchases (which drove that asset class to some record prices), there will not be much ammunition left to to do much buying on the way down (see Paul's blog from yesterday), so those discounts may come fast and furious.

The good news for bond holders is that eventually the exodus from stocks will likely put some buying pressure on higher quality bonds as the money moves to safer assets out of riskier assets, so the correlation move to 1 will start to go back the other way. But, between now and then expect your fully invested, balanced portfolios to give back some of their recent growth.

The good news is that, if you have some $US assets, the $US usually becomes a desired currency for safety, so that may take some of the sting out. If you have some $US assets.

Bitcoin? Well that has not been a good place to hide. See my blog from Nov. 29 http://highrockcapital.ca/scotts-blog/too-much-money-chasing-too-few-assets.

Right now my friends, cash is a great asset to give you some peace of mind. Enjoy!