We are delighted to announce the addition of a new member of the team, Howard Fleming, to Red Tortoise. Howard and I worked together from 2001 through 2004. Howard is well credentialed with the CFA®, CPA, CFP® designations and has over 25 years of experience. He is particularly experienced delivering comprehensive financial planning, tax, and family office services to wealthy families. Howard embraces our fiduciary culture and easily passes my litmus test – I would trust him to manage the assets for Julia and my boys as well as my non-nuclear family and friends should something happen to me (for the record, I have no plans or reason to think I won’t be around). We continue to seek growth so I ask that if you know or meet families who would appreciate a fiduciary culture, our process and our fee structure, please introduce us.
Summary. In response to the recent inversion of the U.S. Treasury yield curve, Red Tortoise’s investment committee voted to reduce the weightings to equity by 5% across all risk levels.
Unusual times call for unusual actions. We loathe trying to time movements in the stock market, and our capital market forecasts have a horizon of ten years. In this circumstance however, both data and theory support reducing equity exposure. Here we explain what the yield curve is, what its shape suggests, what inversion is and what it signifies. We also describe what has happened in the stock market after previous inversions. It bears repeating often and loud that past performance is no guarantee of future performance. We will also note our reasons why this time might be different. Finally, we discuss what might cause us to reverse the call or move further.
The interest rates implied by bond prices are called yields. For our purposes, we are only looking at the 10-year Treasury Note and the 3-month Treasury Bill. Here’s the concept. Interest rates are the prices paid for borrowing money. As demand for money increases relative to supply, rates rise. As demand falls, so do rates. In what’s called a normally shaped yield curve, the curve slopes upward meaning that interest rates on longer term bonds are higher than shorter term bonds[i]. An inverted yield curve occurs when the rates on longer term bonds are lower than shorter term bonds[ii].
When longer-term rates are lower than short-term rates the bond market is signaling that future demand for money will be lower suggesting a weaker economy, even a recession[iii].
At Red Tortoise, we believe markets work well (not perfectly), and investors discount what they expect to happen in the future. Markets try to predict the economy and as a whole do a reasonable job. Therefore, we don’t try to use current economic conditions to predict the future. Rather, we think the market is a predictor of the economy. The future is hard to predict, even for markets. So let’s look at some data.
Going back to 1962, we collected the data and found 51 events defined as when the spread between the 10-year and 3-month rates went from positive to negative. On average, the stock market as represented by the S&P 500 index was lower over the next 1, 3, 6, 9, and 12 months with the lowest average decline occurring at the 6 month mark.
In short, the economic theory that an inverted yield curve suggests a weaker economy ahead combined with historical data is the basis for our decision. The investment committee further decided that absent new information we would unwind the trade in 6 months again based on the historical record.
What could cause our call to reduce equities to go wrong? While the 51 inversions that we identified preceded negative stock market returns on average, not all were negative. About 2/3 were negative and 1/3 were positive, including one six-month period which was up 22%[iv]. So even based on history, the market may go up from here. Topping our list of what could go wrong is that the Fed might take action to stimulate the economy. Additionally, the government might take action which would be stimulative such as reversing tariffs.
Regardless of the outcome, we are comfortable with our decision because we have identified a risky environment even if the risk does not materialize, and because we have both theory and data to support our decision. We are in the uncomfortable position of hoping we are wrong, because we’d rather the market go up than down.
We will continue to monitor markets. Absent any changes we would unwind this trade in 6 months. We also might reverse the trade earlier should we see strong signs of strength. Should we see signs confirming greater weakness we also might further reduce our equity allocation.
(revised March 28, 2019)
[i] There are three main theories for the shape of the yield curve. The liquidity preference theory says lenders require more interest to lend money for longer periods. The preferred habitat theory says that some borrowers and lenders prefer particular time periods and this supply and demand dynamic plays out at different maturities. The third is the expectations hypothesis which is that the yield curve is a harbinger of future rates. For example, if the rate on one year borrowing is 1% and the rate for two years is 2%, then one can infer that the one year rate will be about 3% one year in the future. The idea is that the two year period is made up of two one year periods. If the first year is 1%, the second year would have to be 3% for the rate to average 2% over two years (we’ve used some simplified math here).
[ii] The yield curve inverted on March 22nd with the 3-month at 2.46%, and the 10-year at 2.44. Yesterday the curve was still inverted with rates at 2.44% and 2.39% respectively. Source: https://www.treasury.gov
[iii] We’ll be happy to send you additional research on this, just ask.
[iv] The 22% rise occurred after the inversion on October 28, 1974. The economy had entered into a recession in November of 1973 which ended in March 1975. The yield curve inverted on June 1, 1973. The investment committee looked at the 1974 inversion and concluded it was not representative of the current environment because we are not now in a recession.
Fiduciary (noun): a person to whom property or power is entrusted for the benefit of another.
Recently, the “fiduciary rule” has been in the news. As the home page on our website says “We hold ourselves out as professionals and fiduciaries meaning that it is our legal and ethical duty to put your interests ahead of our own.” We hope that is clear to you.
What’s clear to us is that a lot of investors have more trust in their advisors than is warranted. Brokers and advisors are not always required to put their clients’ interests first. There have been unsuccessful efforts to change this. As reported by CNBC:
The 5th Circuit Court of Appeals ruled on March 15 that the Labor Department overstepped its authority by creating the so-called fiduciary rule, parts of which went into effect last year. In general, the rule requires advisors and brokers to put their clients’ interests before their own when advising on retirement accounts such as 401(k) plans and individual retirement accounts.
Advisors and brokers do not have to put their clients’ interests first. In our opinion this can lead to higher fees and less appropriate investments.
If you have questions, let us know. If you know someone who could benefit from our services and fiduciary standard, we’d like to know that too.
What is home country bias? How can it hurt your investment performance? How do you recognize it? How can you neutralize it?
At the time of this writing, we expect higher returns from non-US stocks than U.S. stocks. We are writing this out of concern that home country bias may hurt investors’ performance. We stop short of saying that investors shouldn’t be biased; rather, we believe investors should be conscious of home country bias and comfortable with its effects if they are going to be biased.
What is home country bias (HCB)? It’s the tendency for investors to prefer investments in their domestic market. For example, U.S. investors tend to prefer U.S. investments.
How prevalent is HCB? According to a study by Vanguard, U.S. investors have about 80% of their equity investments in the U.S. despite the fact that U.S. equities are only about 50% of the global equity market. This is also true globally: Australians allocate 66% of their investments to their home country versus a global market weight of 2%; in Japan it is 55% versus 7%; in the U.K.it is 26% versus 7%.
Why might a HCB hurt you? When U.S. stocks underperform markets in other countries, over-weighting U.S. stocks will detract from your performance. That’s pretty obvious. Some will also argue that global diversification is less risky than concentrating on your home market. That may be, but the advantage is small given that the U.S. market has historically tended to exhibit less volatility than foreign markets. Of course, HCB helps your portfolio when the U.S. market is outperforming.
Here are the ten year return expectations from Research Affiliates as of July 31, 2017:
|U.S. Large (S&P 500)||2.6%|
|Emerging (a.k.a. Developing)||8.7%|
International developed includes countries such as Germany, France, Japan and the U.K. Emerging includes China, Russia and Brazil. Source: Research Affiliates
A global stock investor holding 50% US, 40% international developed, and 10% emerging (which is close to the global market value weights) would have a 5.3% expected return as compared to an investment in the S&P 500 with a 2.6% expected annual return. If the investor has 60% of their portfolio in equities, they would expect an additional 1.6% annually. This increased return would add about 15% to an investor’s portfolio (before taxes and inflation) over the 10 years due to compounding.
Why a HCB might be right for you? Even if the absolute return and risk is expected to be lower, you may still choose to tilt toward the U.S. for a variety of reasons. Doing so may make you feel better or safer or satisfy patriotic wishes. While you may not actually be safer with your bias, you may feel that way just as people may feel safer in a car than a plane.
How to tell if you have a home country bias? If you compare your performance to the S&P 500 or Dow indices without consideration of international stocks, you clearly have a bias. Technically and mathematically speaking, you have a bias if your weight to U.S. stocks exceeds the weighting of U.S. stocks in the global market.
Why only discuss the bias related to equities and not fixed income? In our case, we use fixed income mainly to control risk. Investing in U.S. bonds avoids currency risk. Additionally, many of our clients are taxable and municipal bonds offer tax advantages that foreign bonds do not. We will consider non-US fixed income in portfolios, but generally these are substitutes, at least to an extent, for equities.
What should an investor do? Our recommendation is to consciously select a benchmark that reflects your preferences. If your preference is for the best investment performance and you permit global investments, then your equity benchmark should be a global stock index such as the MSCI All Country World Index (ACWI). At this time, the exchange traded fund based on this index (the ticker is ACWI) has a weighting to the US of about 50%. If you are uncomfortable with this weight, then you can select a blend of indices that represents the U.S. (e.g., the S&P 500 or our preference the Russell 3000) and an index of non-U.S. stocks (e.g. ACWIxUS). For example, one might choose an allocation of 75% to the Russell 3000 and 25% to the ACWIxUS. After establishing a benchmark, one can then tilt their portfolio according to one’s expectations about the markets.
You have two investment options. You can invest in cash which returns 0% each day, and you can invest in a stock which on any given day has a 50% random chance of losing one-half of its value and a 50% chance of doubling. How should you allocate your money between the two? To be clear, over time if you buy and hold the stock, you expect a zero growth because ½* 2 = 1
It may seem that there is no way to make money, but that wouldn’t make for an interesting post. In fact, you could expect to make about 6% per day on average if you could trade without transaction costs.
Put ½ your money in cash and ½ in the stock and rebalance to that proportion every day. You would expect that on half of the days the stock will go down and your portfolio will be worth 0.75 of its previous value. This is because you would have the half that you put in cash plus one-half of the half you put into stocks. On the days the stock goes up, your portfolio will be worth 1.5x as much because you will have the half you invested in cash plus 2x the half you put in stocks.
Thus, every two days we’d expect the portfolio to grow by a factor of 0.75 * 1.5 = ¾ * 3/2 = 9/8. Over n days, the growth factor would be (9/8)^(n/2).
Thus if you started with $1, you’d expect to have $361 over 100 days.
Even if both your investment choices are lousy, there still might be a way to make money. Imagine your investment choices are stocks A and B. On any given day there is a 50% random chance that A will only be worth 10 cents on the dollar – it loses 90% of its value. There is a 50% chance it will double. Thus over time, we’d expect to lose money if we only held that stock. In fact, after two days, we’d expect to have twenty cents on the dollar. That doesn’t sound good. Stock B is exactly the same except when A loses 90%, B will double and when A doubles, B loses 90%. So now we have 2 lousy individual investments (but the good news is they move out of synch). Let’s split our money between the two and see what happens.
Each day our portfolio will grow by a factor of (0.5 * 0.1) + (0.5 * 2) = 1.05. Yes, even though both stocks on average lose money each day, we would make 5% each and every day.
In the absence of transaction costs, one can make money on volatility just by rebalancing. You can even make more than the best performing investment. The tough question is why aren’t we all rich?
While this is not investment advice and is for entertainment / educational purposes, it does suggest the benefit of diversifying and rebalancing.
If you are fascinated by this and you like math, you may want to read the paper “Universal Portfolios” by Thomas Cover.