Following Up On 2017’s ‘Sure Things’

At the start of each year, Larry Swedroe (Director of Research at The BAM Alliance) put together a list of predictions gurus make for the upcoming year—sort of a consensus of “sure things.” We keep track of the sure things with a review at the end of each quarter.

With March behind us, it’s time for our first review. As is our practice, we give a positive score for a forecast that came true, a negative score for one that was wrong and a zero for one that was basically a tie.

The Predictions

Here, then, are the first-quarter results. Each sure thing is followed by what actually happened, and the score.

  1. The Federal Reserve will continue to raise interest rates in 2017. That leads many to recommend that investors limit their bond holdings to the shortest maturities. Economist Jeremy Siegel even warned that bonds are “dangerous.” On March 15, 2017, the Federal Reserve did raise interest rates by 0.25%. However, despite the prediction of rising rates actually occurring, through March 31, 2017, the Vanguard Long-Term Bond ETF (BLV)returned 1.78%, outperforming its Short-Term Bond ETF (BSV), which returned 0.56%; and its Intermediate-Term Bond ETF (BIV), which returned 1.26%. Score -1.
  2. Given the large amount of fiscal and monetary stimulus we have experienced and the anticipation of a large infrastructure spending program, the inflation rate will rise significantly. On March 15, 2017, the Bureau of Labor Statistics reported that the Consumer Price Index for All Urban Consumers increased 0.1% in February on a seasonally adjusted basis. It also reported that the index for all items less food and energy rose 2.2% over the last 12 months; this was the 15th-straight month the 12-month change remained in the range of 2.1-2.3%. The February increase was the smallest one-month rise in the seasonally adjusted all-items index since July 2016. However, in January, the index rose 0.6%, and the all-items index rose 2.7% for the 12 months ending February; the 12-month increase has been trending upward since a July 2016 trough of 0.8%. We’ll call this one a draw. Score 0.
  3. With the aforementioned stimulus, anticipated tax cuts and a reduction in regulatory burdens, the growth rate of real GNP will accelerate, reaching 2.2% this year. We’ll have to wait to get the first quarter figures to make a call on this one. Score 0.
  4. Our fourth sure thing follows from the first two. With the Fed tightening monetary policy and our economy improving—and with the economies of European and other developed nations still struggling to generate growth and their central banks still pursuing very easy monetary policies—the dollar will strengthen. The U.S. Dollar Index (DXY) ended 2016 at 102.38. The index closed the first quarter at 100.35. Score -1.
  5. With concern mounting over the potential for trade wars, emerging markets should be avoided. Despite those mounting concerns, through March 31, 2017, the Vanguard FTSE Emerging Markets ETF (VWO) returned 10.87%, outperforming the S&P 500 Index, which returned 6.07%. Score -1.
  6. With the Shiller cyclically adjusted price-to-earnings ratio at 27.7 as we entered the year (66% above its long-term average), domestic stocks are overvalued. Compounding the issue with valuations is that rising interest rates make bonds more competitive with stocks. Thus, U.S. stocks are likely to have mediocre returns in 2017. A group of 15 Wall Street strategists expect the S&P 500, on average, to close the year at 2,356. That’s good for a total return of about 7%. As noted above, the S&P 500 Index returned 6.07% in the first quarter. Score -1.
  7. Given their relative valuations, U.S. small-cap stocks will underperform U.S. large-cap stocks this year. Morningstar data shows that at the end of 2016, the prospective price-to-earnings (P/E) ratio of the Vanguard Small-Cap ETF (VB) stood at 21.4, while the P/E ratio of the Vanguard S&P 500 Index ETF (VOO) stood at 19.4. Through March 31, 2017, VB returned 3.74%, underperforming VOO, which returned 6.05%. Score +1.
  8. With non-U.S. developed and emerging market economies generally growing at a slower pace than the U.S. economy (and with many emerging markets hurt by weak commodity prices, slower growth in China’s economy, the Federal Reserve tightening monetary policy and a rising dollar), international developed-market stocks will underperform U.S. stocks this year. Through March 31, 2017, the Vanguard FTSE Developed Markets ETF (VEA)returned 7.81%, outperforming VOO, which returned 6.05%. Score -1.

Analysis Of Results

Our final tally shows that five sure things failed to occur, while just one sure thing actually happened. We also had one draw and one too early to call. We’ll report again at the end of the second quarter.

The table shows the historical record since I began this series in 2010:

Only about 25% of sure things actually occurred. Keep these results in mind the next time you hear a guru’s forecast.

This commentary originally appeared April 10,2017 on ETF.com

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© 2017, The BAM ALLIANCE

Brexit – Our Perspective (Q&A)

Britain’s decision to exit the European Union has brought with it all the expected trappings of a significant news event – projections of crazy market volatility, wild headlines and a fair dose of uncertainty about the long-term impact on the global economy and our individual financial lives here at home. Many questions immediately arise as we pay close attention to how the event will play out in the weeks and months to come. But our perspective is the same as it has always been in times like these. Your financial plan is built with diversification and your personal risk tolerance in mind – it’s designed to weather the ups and downs that inevitably follow significant world happenings. Jared Kizer, Chief Investment Officer for the BAM ALLIANCE, reminds us of this below:

 

What did British voters decide?
To the surprise of many – including stock and bond markets – Britain voted to leave the European Union (EU) by a margin of 52 percent in favor of leaving (i.e., “Brexit”) and 48 percent in favor of remaining. The general belief from the economic community is that this decision will weaken the British and European economies since Britain both imported and exported a significant amount of its economic consumption and production, respectively, to continental Europe.

 

How have markets reacted?
At the time of this writing, stock markets have fallen precipitously and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the British pound has dropped by about 8 percent against the U.S. dollar.

 

Why have markets reacted so violently?
Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.

 

Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. We emphasize, though, that while these market moves have been swift, this is normal market behavior when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.

 

Why has the U.S. market reacted so strongly to Britain’s decision?
We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the U.S. market. The European market is a significant trading partner for many U.S. firms, so it’s not surprising to see U.S. stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.

 

Will Britain’s decision precipitate a global recession?
It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.

 

How did markets get this wrong?
While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rearview mirror. This particular vote was expected to be close, so markets weren’t certain but were tending toward a “remain” vote.

 

What will markets do from here?
While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualized stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.

 

It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.

 

What should I do with my own portfolio?
Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.

 

Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasize high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.

 

How will this impact Federal Reserve interest rate policy?
As we have previously noted, interest rates have dropped dramatically in reaction to the vote. In early trading, the 10-year yield is at about 1.5 percent after having been at about 1.75 percent one day earlier. These early movements in interest rates indicate the market does not expect the Fed to increase interest rates at any point during the rest of the year. The primary ways this would likely change are either an unexpected increase in the rate of inflation or unexpectedly positive developments in the U.S. and global economy.

 

Do international and emerging markets stocks still deserve a place in a well-diversified portfolio?
International and emerging markets stocks comprise about half of the world’s equity market value, so we continue to believe that a well-diversified stock portfolio should include a significant allocation to international and emerging markets stocks. While both have underperformed U.S. equities over the last five and 10 years, that does not mean they will continue to do so. We have seen periods in the past when international stocks have outperformed U.S. stocks for a long period of time only for that to reverse in the future. Further, international stocks are trading at significantly lower prices than U.S. stocks, indicating expected returns are higher for international stocks compared to U.S. stocks.

 

What role do currencies play in this situation and in my portfolio?
Initially, we are seeing the U.S. dollar and Japanese yen appreciate against most other currencies, while the British pound is falling precipitously. The international funds we use do not hedge foreign currency, so when the U.S. dollar appreciates relative to other currencies, this negatively impacts their returns. The long-run academic evidence, however, shows that hedging currency risk has minimal impact on an overall portfolio and that it can be beneficial to have exposure to currencies other than the U.S. dollar for a portion of an overall portfolio.

Webcast Recording: Testing Your Mettle: Headlines, Market Swings and Your Financial Plan with Larry Swedroe and Jared Kizer

Investors often hear about the importance of focusing on the long term when it comes to meeting your financial goals. But when the market shows its volatile side like it has recently, and the headlines scream ‘Panic!,’ it can be hard for even the most disciplined among us not to second-guess our plan.

Meredith Boggess (Marketing Director at The BAM ALLIANCE) moderates a proactive discussion and Q&A with Director of Research Larry Swedroe and Chief Investment Officer Jared Kizer. Using the current market swings as just a starter for broader discussion, Larry and Jared provide perspective for those tuned into the market activity and discuss how equity activity can and should be viewed through the lens of our investment policy and overall approach to financial planning.

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