Where Is the Stock Market Headed?

With the Dow Jones Industrial Average having dropped over 2,000 points since its peak a week and a half ago, this is the $64,000 (or more) question.  The recent market surge resulted to a large degree from too much optimism.  Market players have selectively focused on the good news (strengthening economy, big corporate tax cut, rising employment levels), while shrugging off the bad news (growing signs of inflation, rising interest rates, and increasing political discord).  Life is like a rose--pretty petals, but thorns as well.  If you ignore the thorns, you'll get an ouchie sooner or later.

So what happens after today's ouchie (1175 points off the Dow)?  The recent market surge seems similar to the valuation-driven bull markets of 1987 and 2000, which resulted in sizable drops of 25% to 30% in the Dow followed by gradual recoveries that took two to three years.  But we should bear in mind an earlier drop off. In 1973, the stock market (measured by the S&P 500) peaked after a long run up, not unlike the one we've had since 2009.  Then, it declined some 40% or more and didn't recover until some seven years later.  The 1970s were also a time of rising inflation and political scandal (Watergate), with the only resignation of a President.  Political turmoil affects economies and stock markets (look at Venezuela, where a lot of folks can't even get a square meal because of political strife).

Expect more market turmoil tomorrow, the next week, the next month, and maybe the next year.  The market could easily drop some more.  We're running out of good news.  There may be little major legislation coming out of Washington, given the political quagmire.  The Fed may go easy on the tightening, but it's not going to cut interest rates simply to support stock prices.  It's already done that, perhaps too much--and today's drop was likely a consequence.  The economy seems to be slowly gaining altitude.  But there's nothing going on that will provide it a quick major boost.  The federal government can't increase the deficit, given its recent deficit-funded splurge with the tax cut bill.  Corporations seem not to be rushing to increase reinvestment of their tax savings.  The Trump administration may spark a trade war with China and other nations.  And the stability of the federal government cannot, in these times that try our souls, be taken for granted.

History teaches that it's not a great idea to sell your stocks in an effort to staunch losses.  People who try to time the market generally fail to get back in and enjoy the resurge that will likely come (although the resurge could be a long time coming). Instead, try to spend less and save more.  Keep your investments diversified.  And don't stop knocking on wood.

Why You Should Worry About the Rising Stock Market

The stock market keeps rising, setting new records just about every week.  The S&P 500 has risen over 15% since Election Day 2016, and shows no signs of slowing down.  That's an annualized rate of over 20% a year, which is exceptionally good for an aged bull market as we have.

The election of Donald Trump as President was seen as a major reason for the rally.  He promised infrastructure spending, tax reform and other measures that should stimulate the economy.  But his Presidency has sunk into a quagmire of chaos, incoherence and unpredictability. These, coupled with the legal risks emanating from special counsel Robert Mueller's investigation, should have triggered market retrenchment.  But stocks have hardly blinked before levitating some more.  Whatever is driving the market, it doesn't have much to do with the Trump Presidency.

Accommodative monetary policy in Europe and Japan is also said to be a reason for the market's buoyancy.  Foreign central banks have been printing money, and some of it supposedly has found its way into the U.S. markets.  But the dollar has been falling recently, indicating liquidity is flowing out of our markets, not in. That's not a formula for a rally.

Corporate earnings, although pretty decent, aren't dramatically better than last fall.  They don't explain the lighter-than-air quality of stocks today.

So what's going on?  Let's consider that over half of all stock market transactions consist of computerized trading.  Machines are trading with machines, using algorithms known to very few.  These algorithms verge on alchemy.  They rely on statistical correlations that may or may not hold true in the future.  These correlations can be disrupted by unexpected government policy, political upheaval or conflict, economic change (such as the effective collapse of OPEC as a functional cartel), and technological change (such as the fracking that just blew up OPEC).  They also utilize artificial intelligence, seeking to learn from their ongoing experiences in the market and modifying their algorithms as a result of what they learn.  Thus, the humans may have difficulty anticipating what the programs will do tomorrow.  And the programs may produce a positive or negative synergy or other interaction that humans have not foreseen.

Computerized trading is opaque.  That is, in real time, no one knows for sure if a trade or a series of trades involved a machine or two machines or none.  One should avoid anthropomorphism in today's stock markets.  In other words, one should not ascribe human motives, intentions or characteristics to market activity.  There may be no reason comprehensible to humans for today's stock prices.  When computers use artificial intelligence to trade stocks, the valuation of financial assets may be fundamentally changed, and changed beyond human comprehension.  You may think that stock prices are whacked out--and you could be correct from the human perspective.

Homilies like stocks are excellent long term investments and will protect against inflation were derived at a time when people dominated the financial markets and established the asset valuations on which these notions were based.  If machines that function opaquely suddenly become dominant, how can humans understand the valuations determined by the machines?  More succinctly, how can you tell what's a good price and what's a bad price anymore?

There are many more questions than answers in a machine-dominated market.  When the market keeps setting new record highs in machine-dominated trading, be careful.  We are bravely, or not, going where no investors have gone before.  And no one really knows what's going to happen.

Consider a House To Hedge Against Inflation

The housing market, having walloped the bejesus out of tens of millions of Americans, may seem an unlikely hedge against inflation.  But history shows that home prices tend to move up briskly during inflationary times.  During the 1940s, inflation burst out, driven first by World War II rationing and then by pent up consumer demand after the war.  Consumer prices moved up about 72%.  Census Bureau data indicates that housing prices moved from a national average of $2,938 in 1940 to $7,354 in 1950 (unadjusted for inflation).  That's an increase of 150%.

During the stagflation of the 1970s, consumer prices rose 112%.  Housing prices rose from a national average of $17,000 in 1970 to $47,200 in 1980, an increase of 178% (unadjusted for inflation).  You can find Census Bureau data on housing at https://www.census.gov/hhes/www/housing/census/historic/values.html.

The data show that housing prices rose faster than inflation during two of the most inflationary decades in the past 75 years.  Of course, the sales prices of houses don't tell the entire story.  You can't directly compare prices of housing against prices of stocks or inflation-adjusted bonds like U.S. Treasury TIPS, because housing requires periodic lawn mowings, plumbing repairs, new roofs, maintenance of HVAC systems, and replacement of dishwashers.  It's also taxed locally every year, and sometimes hit up for special assessments if the water or sewer systems need to be gussied up.  But you'd directly or indirectly bear those expenses anyway if you rented.  So owning a house and capturing the upticks in value might work out well for you during inflationary flareups. 

Why would housing be such a good inflation hedge?  Professional economists might be tempted to wheel out a wagon load of regression analyses to demonstrate their erudition.  But the simple and obvious explanation is that a hard asset with substantial utility will have significant value no matter what the paper currency is doing.  A house provides shelter, warmth, indoor plumbing, and a private place to pig out on high fat, high sugar, low nutritional value junk foods while long-term parked in front of a 124-inch TV, parboiling your brain without the neighbors seeing what a couch burrito you really are.  Market forces will adjust the paper value of that hard asset upward when the fiat currency is going haywire.

At the moment, inflation seems to be spotted about as often as the ivory-billed woodpecker.  But that doesn't mean it's extinct.  History shows that inflation can be quiescent for long periods of time, and then burst forth like an oil well blowout.  Inflationary pressures right now are doing a fan dance, often out of sight but still faintly visible in profile.  Ultimately, unless the Fed and other central banks can repeal market forces, their massive money prints and asset purchases of recent years will eventually inflate paper currencies.

 Housing, like politics, is first and foremost local.  Some markets would make mediocre investments no matter what (like areas with high unemployment).  Some types of housing, like condos, may not be ideal for inflation hedging.  Their values tend to be less stable than that of the 4-bedroom, 2 1/2 bath Colonial with the white picket fence and English sheep dog.  A house isn't a substitute for sensible investment diversification.  Stocks, TIPS and perhaps other assets might also play a role as reasonable inflation hedges in a well-diversified portfolio. 

It's hard to have confidence in housing after the free fall in prices of recent years.  But investment success can often come from buying disfavored assets.  Buying bubbly assets like bonds (especially junk bonds) isn't likely to be the epitome of financial perspicacity.  Home sweet home, be it ever so humble, may work out better if inflation rears its ugly head.

Looking for Bernie Madoff

If you could get the candid assessment of the financial markets from a lot of investors today, it would probably be something like returns are low and risks are high. That explains why so much money, especially that held by individual investors, remains in bank accounts, money market funds, ultra short bond funds and other relatively low risk places. The financial markets have given us so many unpleasant surprises in the last 3 years, people are afraid the future holds more.

At the same time, with incomes stagnant and inflation increasing (regardless of government statistics and what high ranking government officials claim), many are under pressure to seek higher returns from their savings. There's nothing wrong with looking for a better return. Just remember that, even though we now live in the era of the endless bailout, there still isn't a free lunch. Unless you're a major bank, a sovereign nation, or a very large business corporation. Stocks and lower rated bonds might offer greater potential for profit, but they also offer greater potential for loss. Risk and reward walk hand-in-hand down Wall Street.

Some investment products include guarantees against loss. These often are touted by insurance companies and should be scrutinized closely. The promise against loss is going to cost you. It could be in the form of tight limits on upside returns (i.e., if the product generates a return, the insurance company is going to keep a good portion of it), stiff penalties for early termination or withdrawal, and in other forms. Remember that if the markets perform poorly and your return is zero, even though your losses are also zero, you would have been better off in passbook savings. (That's not a theoretical point; anyone who put money in passbook savings ten years ago instead of stocks is ahead of the market.) While no one knows what the future will bring, investing in a no-lose product doesn't mean you'll win.

Even though many insurance companies might want to sell you a lousy deal, in general they aren't fraudsters. The worst thing you could encounter in your quest for higher returns is the markets magician who claims to consistently produce good, albeit not spectacular yields, day in and day out, year after year. No one can do that, period. If you meet anyone who says he or she can, put your hand on your wallet and run away. Fast. No matter how tempted you are, and no matter how good the sales pitch sounds, don't invest.

The biggest frauds are perpetrated, not because the bad guy lies, but because investors lie to themselves. They convince themselves that lead can indeed be turned into gold. They brush aside contrary evidence and the rationality of naysayers. They want to hear, however improbably, that good returns can be secured with no risk. They seek out the con artists who promise the sun, the stars and the moon.

Bernie Madoff didn't have to find many of his victims. They found him, and they were ready to believe every word of his web of lies. He'll be in prison for the rest of his life. But there are plenty of latter day Bernie's around. Often, the gullible and greedy will find them. As a matter of law, the con artist is liable and should be punished sternly. As a matter of reality, if you go looking for a latter day Bernie Madoff, you'll probably find him. And you'll regret it.

Exchange Traded Funds for Beginners

A relatively new product of the financial services industry has been getting a lot of publicity lately. That's the exchange traded fund, or ETF. The ETF is type of mutual fund that you can buy or sell while the stock market is open. By contrast, traditional mutual funds are bought or sold only after the stock market closes. (You can send in an order for shares of a traditional mutual fund any time, but the order will be filled only after the market closes, at a price based on the closing prices of the stocks and/or bonds that the mutual fund holds.) Although ETFs have been around for about 15 years, they have attained widespread popularity only recently. If you're unfamiliar with them, here are a few basic points.

1. ETFs generally have low costs and expenses, but you have to buy them through a stockbroker. That means you pay a commission. In addition, ETFs have two prices in the market: the "ask" price at which you buy them, and the "bid" price at which you sell them. The "ask" price will be higher than the "bid" price, and the difference between the two--called the "spread"--is a cost of investing. That's because if you buy at the ask price and immediately sell, you'll lose some money from selling at the lower bid price.

Consequently, ETFs are not always the lowest cost product. A low-cost traditional mutual fund may actually be cheaper, because you can buy it without paying a commission or incurring the "bid-ask spread" as a cost of investing. If you're saving small amounts at a time (e.g., $100 or $200 a month), a traditional mutual fund is a cheaper way to invest than an ETF.

2. ETFs are based on market indexes--in other words, the stocks or bonds they hold are the same ones that comprise a market index. For example, an ETF that mimics the S&P 500 will hold the 500 stocks in that index. ETFs started off with broadly based market indexes, like the S&P 500, and were often good choices for long term investment. However, more recently, ETFs have been created to represent increasingly narrow sectors of the stock markets--like just telecommunications stocks or stocks of one particular country. The narrower the index, the more risky the ETF, because it is less diversified. It may provide excellent returns, or terrible losses. The more you invest in narrowly-based ETFs, the more attention you'll have to pay to the overall diversification of your portfolio. In other words, the more work you'll have to do managing your money.

3. ETFs are often tax efficient, in that they are not required to distribute capital gains each year to investors. Investors report gains on their tax returns only when they sell their ETF shares at a profit. But a carefully managed mutual fund can also achieve a high degree of tax efficiency.

4. ETFs theoretically should trade at the same price as the aggregate prices of their underlying assets. This, however, doesn't always occur. Variations in supply and demand at any particular moment can cause an ETF to trade at a discount or premium to the value of its underlying assets. In addition, technical market problems can cause pricing problems. Trades that occur in the underlying stocks and bonds necessarily are reported after they occur. There is always a time lag between trade prices of the underlying assets and the trade price of the ETF. While the time lag may be minor in normal market conditions, when things become hot and heavy, trade reporting in the underlying assets may become delayed, and discrepancies between the value of the underlying assets and the price of the ETF can occur. If this happens, you could pay too much (or get a bargain) on ETF shares. Conversely, you might sell at a price that either is too high (good for you) or too low (bad for you). But, because you won't know about the trade reporting problems, you won't have any idea until after-the-fact whether you got a good or bad price.

5. You can trade an ETF like a stock. In other words, you can own it for minutes, or even seconds, and then sell it. You can sell it short, buy it on margin, use a limit order and the like. Some people may be tempted to trade ETFs short term because they have so many trading options. Stock brokers may encourage such short term trading because it generates commission income for them. However, the history of the stock markets teaches that short term trading generally is less profitable than long term buying and holding. Indeed, many people lose money, rather than make it, when engaged in short term trading. Be cautious using ETFs for short term trading. With their commission expenses, the bid-ask spread, interest charges on margin debt and the risks of trading short term, ETFs probably offer the typical individual investor few advantages, if any, for short term trading.

The ETF is a good long term investment option. If you buy and hold it, you get the most out of it. If you trade ETFs short term, you might money. But you might lose it. You wouldn't use a spoon to eat a steak. Don't use an ETF in ways that aren't likely to help you.

Crime News: whatever financial shape you're in, be glad you don't have to steal toilet paper. http://www.wtop.com/?nid=456&sid=1164394.

Why the Average Investor Does Well

An investor who tries to be average will probably do well. How can average be well? Because success in investing requires balancing risk and reward. Risk and reward walk hand-in-hand down Wall Street. The higher the potential payoff from an investment, the greater the risk of loss. The lower the payoff, the safer the investment is likely to be. The payoff from stocks can be good; sometimes, very good. But you can also lose your shirt. The payoff from a bank account is much lower. But they are federally insured up to $100,000, so your risk of loss is essentially zero (unless you have over 100K in the bank).

Many, and perhaps most, people underestimate financial risk. The proof of this is in the tendency of markets to become over-valued and then deflate painfully. The stock market did this in the late 1990s and 2000. The real estate market did it in the early 2000s and is still deflating today. Going back in time, stocks did it in the 1970s and the 1920s. Real estate boomed and busted in the early 1980s and then again in the late 1980s and early 1990s. These cycles occur because people tend to underestimate the potential for markets to fall and buy too much.

On the level of the individual investor, the problem shows up as the tendency to “chase returns.” As we discussed in our May 20, 2007 blog “Why the Tortoise Ends Up Wealthier Than the Hare” (http://blogger.uncleleosden.com/2007/05/why-tortoise-ends-up-wealthier-than.html), investors often invest when an asset is increasing in value and sell after it has dropped. They end up buying high and selling low. That’s not much of a way to make money. Buying and holding is a better long term strategy.

If you control your risks, you’ll get lower returns. But that also means smaller swings in the ups and downs of your portfolio, so you'll be less tempted to buy too much when prices are rising or sell too soon when they're falling. In other words, if you try to get returns that approximate market averages, you’ll be taking reasonable risks while enjoying the potential for the long term returns that the stock market offers. Your portfolio will swing up and down more gently, and that will lessen the temptation to buy into an asset bubble.

An easy way to invest in a well-diversified portfolio with reasonable risk is to use lifecycle or target date funds. These mutual funds are designed for long term retirement planning, and the fund personnel allocate your money into a diversified portfolio for you. You don't have to do the investment strategizing yourself. For more information about these funds, read our May 16, 2007 blog, “Investing Made Simple” (http://blogger.uncleleosden.com/2007/05/investing-made-simple.html).

So, just this once, you can ignore your parents and try to be average. You might be rewarded for it.

Monster News from Loch Ness: http://www.cnn.com/2007/WORLD/europe/05/31/britain.lochness.ap/index.html

The Downsides of Saving for College Expenses

Just as a parent will wake up at 3:00 am to feed a hungry new born, a parent will save for the child's college expenses. Many commentators recommend that you first fund your retirement, and use any remaining money for college savings. The idea is that you don't want to be a burden on your kid(s) when you're old. Given the amount of money it takes to retire comfortably, most people would have little left for college expenses if they actually took care of retirement first. But the parental instinct to provide for the child--be it with food or with an education--extends beyond financial rationality. People will save for the educational expenses of their children, even at the cost of adequately funding their own retirements.

That being the case, they should be aware of some of the pitfalls and downsides of saving for college expenses. The 529 Plan and the Coverdell account are heavily promoted today, especially the 529 Plan. Both a 529 account and a Coverdell account offer tax advantages--the money you put into them isn't tax deductible, but the earnings are not taxed if they are used to pay college expenses. Coverdell accounts can also be used to pay primary school expenses. Some states offer deductions from state income taxes to their residents who open an account in a 529 Plan offered by that state.

However, there are the downsides, which you not hear much about. Each 529 Plan has only a limited number of investment options. The plan itself, and the investment options, may impose high costs and fees on your account (as much as 3% per year in some cases). That's a hefty burden. Even with the tax shelter offered by the 529 Plan, fees at that level seriously reduce your long term returns. If you compare an expensive 529 Plan against an inexpensive taxable account (one where you pay taxes on realized investment gains each year), the inexpensive taxable account can produce greater wealth.

Another problem with 529 Plans is that if the money in your 529 account isn't used for college expenses, you can retrieve it only after paying state and federal income taxes, and a 10% penalty on the earnings. So you have an exit strategy problem if Junior doesn't go to college; or does go, but doesn't graduate. Something like 1/3 to 1/2 of all college freshman do not graduate. If you save for college expenses in an inexpensive taxable account, you have no exit strategy problem and may even come out ahead.

A 529 Plan is a good idea if you can find one with low costs. You can search for low cost 529 Plans at www.savingforcollege.com. Among the plans that appear to have low costs are the Utah Educational Savings Plan Trust, the Virginia Education Savings Trust, the South Carolina Future Scholar 529 College Savings Plan (Direct-sold), and the New York 529 College Savings Program--Direct Plan. Note that you don't need to be a resident of a state to participate in its 529 plans. Also, you have to contact each of these states directly to open an account--these plans are not sold by brokers (which probably accounts for much of their low costs, since no one gets a commission for selling you one).

Finding Coverdell accounts with low costs tends to be easier than it is for 529 Plans, since you can open a Coverdell with a wide array of financial institutions. One downside of the Coverdell account is that you can only contribute $2,000 a year (the 529 Plan's limit is $12,000--or $24,000 for a married couple--a year). Also, the Coverdell can only be used by people subject to certain income limits. The Coverdell has a severe exit strategy problem: if the account assets aren't used for educational purposes by the time the child who is the beneficiary of the account is 30, the child gets the remaining assets (subject to payment of state and federal income taxes and a 10% penalty on the earnings). You don't get any of the money back for your retirement or any other purpose.

Persons having incomes below $78,100 if they're single, or $124,700 if they're married filing jointly, may be able to avoid paying some or all of the taxes due on the interest income of U.S. Savings Bonds that is used for college expenses. So U.S. Savings Bonds actually provide a tax shelter for college savings for persons meeting the income requirements. Since Savings Bonds can also be used to fund your retirement, they don't have an exit strategy problem. They're also simpler than 529 Plans and Coverdell accounts.

The tax sheltered plans--529 and Coverdell--also require extra work at tax time, especially when your taking money out to pay for educational expenses. If you're concerned about the downsides of 529 Plans and Coverdells, just save for college expenses in low cost taxable investments like well-diversified mutual funds or U.S. Savings Bonds.

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