If Hindsight Is 20/20, The Future Is?

I was supposed to be driving up to the Collingwood / Thornbury area today, but was warned off by the weather and highway driving reports (whiteouts). It got me thinking, because I am getting a sense that this is what central bankers are looking into at the moment.

Suffice it to say, the picture out the front window is not all that clear. History will tell us that the U.S. Federal Reserve has raised interest rates and caused recessions 13 times since 1950 (that is one pretty interesting statistic on their forecasting abilities). This is then followed by a need to lower interest rates (and usually rather quickly), but it is usually too late for the economy (hence the ensuing recessions).

Most recently this happened in 2007. We all know what followed.

Stock markets get excited to see the Fed (or the BOC, for that matter) change the tune. However, the less exciting /excitable and more rational bond markets (which do lead all financial markets) look at it as a grim reality.

Stock markets that trade off of last quarters earnings are stuck in "hindsight" mode. Hoping that the end of interest rate increases will draw stock market happiness is the very thing that will help the sellers, loudly touting the re-kindling of the bull-market, while they unload to the all the FOMO's (those with the "Fear Of Missing Out"). 

In technical terminology, this is the "right shoulder" of the "head and shoulder formation". The head being last summers all-time highs (S&P 500) and the left shoulder last January's highs:

And that is what we see happening as the late stage of the economic cycle draws to its finale: the global economy slows, central banks wake up to the fact that, once again they overdid it on the tightening side (especially with the very highly leveraged / record amounts of debt reality). Recessions are not good for future earnings and as a result, last years earnings (hindsight) matter very little in the grander scheme of things. Stock markets do not like recessions (or even slower economic growth). 

Capital preservation is important to carry us to the other side, where the new cycle will offer fresh opportunity, which is what we will be waiting for at High Rock. Jumping in now is fraught with peril (like driving in a whiteout). Best to be patient, wait for things to start to clear.

Do Not Fight The Fed!

One of the first lessons we learned back in our early bond trading days was "don't fight the Fed!". For all of us mere mortals, that is trader speak for understanding the ramifications of U.S. Federal Reserve Monetary Policy (or any central bank for that matter, but the Fed certainly has the greatest clout). 

If the Fed is tending toward easy monetary policy, generally speaking, that is good for asset (bonds and stock) prices as they add liquidity to the financial system and (as in the above chart) the monetary base (gold line) grows (more money sloshing around in the system). If it is extraordinary easy monetary policy, as it was in the post financial crisis days with "Quantitative Easing", it was a breeze for asset prices to rise (as the S&P 500 did through to the middle of 2015): all that money had to be put somewhere.

On the other hand, if the Fed is tightening and removing liquidity, there is a tendency for asset prices to move lower as there is less money in the system chasing  asset prices. The Fed has been reversing QE since 2016, effectively tightening, and at the same time, raising interest rates as well.

The Trump tax cut, fiscal or government stimulus (as opposed to monetary stimulus), provided a temporary offset to the Fed tightening, generally masking the shrinking monetary base and giving stock investors a rather false sense of security to go on their early and mid 2018 buying sprees. 

It all fell apart when liquidity became an issue in the last quarter of 2018 and heading into year-end many realized that they needed to raise cash and ouch, reality bit. Hard! Assets were for sale, especially expensive stocks.

Just because the Fed has adopted a more conciliatory tone does not mean that they are finished tightening. They still have an enormously large balance sheet to unwind, reducing liquidity and the monetary base and that will continue even if they pause hiking interest rates. Oh and just to add another wee twist, at the same time the European Central Bank is ending their version of QE.

As is clear in the above chart, the monetary base is going to lead equity markets over the longer-term. Stock investors who have been on a recent (and very short-term) buying spree may find themselves a little early to the party.

One of the most widely watched economic forecasting agencies, the International Monetary Fund (IMF) announced yesterday that they were lowering their global growth forecasts. Just in time to throw a little cold water on the early 2019 stock rally party.

And, in case you have not noticed, the record U.S. government shutdown continues and is adding to the gloomier economic outlook.

However, it is the week of that famous Scottish bard, Robbie Burns birthday and vast quantities of Haggis and single malt scotch are likely to consumed to console those who are somewhat over indulging in the U.S. equity market!

Ae fond kiss, and then we sever; 
Ae fareweel, and then for ever!
Deep in heart-wrung tears I'll pledge thee, 
Warring sighs and groans I'll wage thee. 
Who shall say that Fortune grieves him, 
While the star of hope she leaves him? 
Me, nae cheerful twinkle lights me; 
Dark despair around benights me. 

Nobody Likes to See A Negative Return

But when you take the necessary risk to get growth in your portfolio (see my series of blogs Why I write This Blog Part 1-3), which we all have to do (to stay ahead of inflation), there is a chance that it can happen from time to time (it happened in 2015 and again last year in global stock markets (see table above on the far right!). Unfortunately we are all human beings, charged with emotion and we are very attentive to pain, a negative return is painful and our first reaction to pain is to seek comfort from that pain. 

If you were an investor back in 2007-08, balanced portfolios shed something in the vicinity of 15-20% (partly depending on the fees and costs paid). In each of 2009 and 2010, they were up by close to the same. So by 2010, If you hung in there (many were scared off into buying low yielding GIC's and bond funds) you were back in the black and growing again!

As tempting as it may be to exit the pain of a negative return (because it lowers the longer run annual average too), it is the least wise move to make.

The balanced portfolio above is made up of 25% global equity (ACWI ETF), 25% Canadian equity (S&P TSX) and 50% Canadian Bond Index (XBB ETF). The combined performances of these benchmarks is highlighted in gold along the bottom (there are no fees or costs included in this analysis other than embedded ETF MER's).

2018 (1 Year) is not pretty. However it is only a point in time. Most of the negativity happened in the October through December period.

Here is how that same (more or less) table looked just 3 months prior:

The 5 year annual average return is almost 2 full percentage points lower at the end of December. Does that mean that you should flee your investment portfolio for GIC's? 

Absolutely not.

Sadly, with the global economy headed toward recession (natural end of cycle circumstances), the worst may not be over. That is our expectation at High Rock, we put a 50-60% probability that equity markets will move lower before they get much better. So we will continue to hold cash and cash equivalent (HISA funds) until we get the great buying opportunity we expect that we will see. 

We think that this could set us up for double digit returns in the future. You will not get those sitting in GIC's (especially if they are locked in and you have a change of mind / heart as many may when they start to see stock markets recovering, who knows what penalties you might have to pay to escape the clutches of that particular financial institution). 

As always, past performance is no guarantee of future returns, anybody who tells you otherwise is not only breaking the rules set out by the regulators, but is trying to sell you something that you likely shouldn't buy. But at High Rock we work darn hard (harder in difficult markets, believe me) to get ourselves the best possible risk-adjusted returns.

Negative returns in 2018 perhaps (but not as negative as fully invested portfolios), but it is, as I stated earlier, just a point in time. There will be better returns in the future, we believe (but do not guarantee!). Do not be frightened by the volatility, it presents opportunity. Most importantly, do not bail out, because once you do, you will likely not be able to get back in in time. 

US Unemployment Rates And Recessions

With an uptick in the unemployment rate in the U.S. last week, it brings us back to a chart that we have been monitoring off and on for some time now: that is the historical relationship between the current rate of unemployment and the 36 month (3 year) moving average. When the current rate (white) has crossed through the 36 month moving average (gold) in the past, it has signaled the beginning of a recession (blue).

As of the most recent data, the gap between these two lines is now 0.5%.

With the U.S. government shutdown an estimated 800,000 workers are out of work. About 400,000 of these will be counted as unemployed when the survey data for January are gathered if they are still unemployed on Saturday January 12th. A Wall Street Journal article today suggested that this could add 0.1 to 0.2% points to the unemployment rate when announced on February 1.

That could narrow the gap to only a few basis points. If the trend continues upward as economic slowing progresses we could be looking at the intersection of these two lines in a matter of a few months.

China has lowered GDP expectations. Germany, the largest of the Eurozone economies experienced negative Q3 GDP growth.  the UK is dealing with Brexit. Global growth is clearly slowing and tighter monetary policy is having its impact on the U.S. economy. Lower oil prices and higher Canadian interest rates are impacting the Canadian economy. The best unemployment numbers may be behind us.

The stock markets may have paused technically, after the volatility on Christmas and New Year's eves. At the moment it is a market for traders and gamblers. Investors can be patient. we think that there could be at least some 10% further downside (or perhaps more) for global stocks before the economic slowing / recession takes hold. Stock markets usually lead the economy by about 6 months or so. This will present opportunity.

As Paul stated at the end of his blog yesterday: " Bottom Line", we have a plan.

Why I Write This Blog (Part 3)

10) We can tell our clients what their return per unit of risk taken is: (as in the table above) which is the average compound annual total return divided by the risk. The Actual HR PC (High Rock Private Client) has had a 5 year average total return of 4.32% after fees. That includes the 2 difficult years of 2015 and 2018. But it is still better than the 60/40 benchmark portfolio average annual return and when you include the risk (the 60/40 benchmark has significantly more risk), a substantially better Return per Unit of Risk taken profile. In fact the HR PC profile is better than the Return Per Unit of Risk for than any of the other comparative indexes: S&P 500, TSX, Canadian Bond Index ETF (XBB) or the All Country World Equity Index (ACWI) ETF. 

That is because we do our homework on the risk that we take.

11) If you are not getting this kind of reporting from your advisor, what are you paying for? Most investors do not have a good understanding of the risk that they take. That is why I write this blog, because you should understand the risk that you are taking and why.

12) How much risk do we have to take? That will become clear when you create a financial plan. At High Rock, we call it a Wealth Forecast and it is inclusive in our fees. A fee-only financial planner will cost in the vicinity of $200 per hour, so it is a pretty good deal we offer with the expertise of our in-house Certified Financial Planning professional (at least semi-annual reviews included). If we do not have a plan, we cannot fully understand or appreciate the risk we need to take that is necessary to get us to our goals.

My friends, so many people out there take, or are unknowingly taking, way more risk than they have to. I have this conversation so often, but it is worth repeating: why take more risk than you have to?

You need to take risk, but you can take good, calculated risk, not just some vague advice that suggests that a good balanced 60/40 portfolio will get you 7% as some supposed experts might suggest. What is that theory?  And be wary of the cost.

In any event, I hope that I have answered the key question: I write this blog to inform the 500 or so monthly readers (and apparently growing) that there are too many folks investing out there who are under-serviced and over-charged and not fully informed of the risk factors that might keep them from reaching their financial goals. And I ask your help in spreading the word: there are safe alternatives to (as Larry Bates would call it) "Old Bay Street", where you can get to keep more of your money as it grows and compounds faster for you and at the same time limit the risk that you need to take.

Why I Write This Blog (Part 2)

5a) As I hoped you all deduced from yesterdays blog: if we do not take risk in our investments (i.e. we stick our money in a savings account, GIC or T-bill), we will not be able to stay ahead of the annual increase in our cost of living and definitely increase the possibility that we might run out of money before we run out of life. Nobody wants that to happen.

5b) If we give our money to a bank or financial institution mutual fund salesperson who calls him / herself a financial advisor, the lack of fiduciary responsibility and cost of doing so is not necessarily providing you with safety. In fact the fees and costs combined with the lack of fiduciary responsibility increase the risk that you will not be able to meet your goals. That is bad risk.

5c) We know that we have to take risk, but we want to take good, calculated risk. Not bad risk.

6) As portfolio managers, we specialize in finding good risk for the purposes of investing, over the long-term: getting the best possible risk-adjusted average annual compound returns over multiple years. I want you all to take a good close look at the table and chart above: the 5 year Total Return Data for a number of investment vehicles.

7) First and foremost, all of our data (in the above chart) is historical. We (at High Rock) nor anybody else for that matter can accurately predict the future. Some people say that they can, if they tell you that, run away and run away fast, because they have an agenda to sell you something and they will use it to persuade you of buy into their scheme. That is why the regulators require us to provide the disclaimer: "past performance is not a guarantee of future returns".

8) However, we also know that all things economic and financial are cyclical, so there may be some message buried in the historical data. So we do an enormous amount of research to determine, historically, what kind of risk each investment we purchase for our and our client portfolios has posed. In the above chart, the vertical axis is return (compound annual average return on a monthly basis), the horizontal axis is risk (as measured by the standard deviations of those monthly returns) the lowest being zero, the highest on the chart being 12. That is the proverbial return vs. risk equation that we financial geeks all talk about in broad terms. We go beyond the broad terms and determine how each investment sits on that particular chart. 

It would be difficult to put any individual company stocks on the chart above because even some of the best companies have more risk than the 12 that is the highest level of risk displayed. We all talk about diversity of investments because owning just one company's stock (all your eggs in one basket) would give you way too much risk (off the scale). If you owned all the stocks in the S&P 500 (which is equivalent to owning all 500 companies and plenty of diversity across economic sectors), you would have a risk level of 10.9 (blue diamond on the chart) that has returned 8.45% annual average compound return over the last 5 years. Which means that while historically, the return has been good, the potential downside (of 1 standard deviation) is close to 11%, which could easily wipe out any gains in a given year. That is still a lot of risk to have, considering that recent volatility has produced swings of more than 1 standard deviation.

9) So depending on our long-term goals we have to consider this in our portfolio mix. Optimally, we want the combination of all of our investments to reside inside that blue box in the north-east quadrant where the best return per unit of risk resides. And that is what we work so hard to do at High Rock for our and our client portfolios.

More tomorrow.

Why I Write This Blog (Part 1)

1) We all need to invest, to grow our money at a rate that is faster than the pace of the inflation that erodes our purchasing power. 

2a) We cannot grow our money at a rate faster than inflation (currently running at an annual rate of about 2-2.5%, depending on where you live and what you consume) unless we take risk. At the moment, the risk-free (safest) rate of return is the same as a 90 day government of Canada T-bill, about 1.7% (on the wholesale market, if you are lucky you can get one at the retail level, after fees and costs, for about 1.5%). 

2b) Or, as so many Canadians do, unwittingly, is give your money to those vaunted banking and investment institutions who have deluded us over many years that our money is safe with them and either put it in a savings account (earning next to nothing) or GIC (earning, but completely tied up at or about 2%). Safe? Only insured up to $100,000 by the Canadian Deposit Insurance Corporation (CDIC). 

If you need your money ( back, from the bank), you will likely have to pay a penalty or an increased fee for your savings / chequing account.

Banks: borrowing from their clients at 0-2% and lending it back out at the prime rate (if your lucky) currently at 3.95%, or 5 year mortgages at 5% are doing way better than you are (if you give them your money). They continually announce record profits for their shareholders on the backs of their clients (who are not even keeping pace with inflation).

2c) When you are enlightened enough to realize this (and they sense it), they (your banking / financial institution) will steer you towards a financial advisor who is basically  just a conflicted salesperson. When they sell you a mutual fund, they are paid by the bank's mutual fund department (or any of the other mutual fund companies whose funds they sell you). They may or may not explain this to you up front. It doesn't matter, it is still a conflict of interest. 

A study by the Canadian Securities Administrators in 2015 determined that "There is conclusive evidence that commission-based compensation creates problems that must be addressed."

2d) In order to be a fiduciary (i.e. have fiduciary duty to your client), you cannot have any conflict of interest.

Therefore, financial advisors (who are not portfolio managers) do not have fiduciary responsibility for their clients.

We see financial abuse by financial advisors constantly, especially when new clients come to us from these horrible relationships. I see it daily when I go to the IIROC website under "disciplinary cases" and it is only the very tip of the iceberg.

3) In case I have not been able to convince you of my absolute passion for calling out the bad behaviour, done mostly at the unsuspecting investor's expense for the profit of banks and financial institutions and their commissioned representatives, you may / should stop reading this drivel.

4) Can you do better (than putting your money in the bank or in mutual funds)? Absolutely! and there are lots of alternatives with equal safety features (to banks) some, like High Rock, actually do have a fiduciary responsibility to you. But not many. The Small Investor Protection Association (SIPA) suggested that about 3% of financial advice givers fell into the category of fiduciaries (no conflict of interest). That, in and of itself, should frighten you. That adds so much more potential risk (to the equation) when you get bad and expensive advice. Far from safe.

5) Back to risk, because we have to take risk to get ahead of inflation and taxes. I.E. we have to get better returns in the growth of our money above and beyond the increase in our cost of living and 1.5% in a Government of Canada t-bill or 2% in a bank GIC will not cut it.

If you are still reading, you may ask what many readers ask: why are you preaching to the converted? 

In the hope that some of the 500 or so souls who do find their way to my ranting (so the statistics indicate) over the course of the month are not yet clients and / or not yet converted. It is not too late!

If you do know someone who is so very attached to their non-fiduciary advisor and has put themselves at increasing levels of risk as a result, perhaps send this on. 

More on planning, risk and return tomorrow.