Retirement Investing Outlook July 2016

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Our aggressive and passive portfolios continue to handily outperform their target retirement date benchmarks. On the other hand, the short-term rebound in U.S. stock prices has resulted in our active balanced and growth portfolios (for conservative investors or those at or near retirement),to fall to the point where we’re merely matching the benchmark target date funds.  That said, we’re still comfortably ahead over time.
As the year progresses we expect our active portfolios to further separate themselves from the target date funds due to the restrictions set in place for those fund managers and our market indicators.

U.S. Stock Market

Although a lot appears to have changed since our last issue, we’re essentially at the same point now that we were then with the exception of the chaos caused by the Brexit vote. Thus the following bears repeating.

With the Tobin Q ratio, median Price-to-Sales ratio and debt margin again sitting near historical highs at a time when earnings are decelerating, there continues to be more downside risk than upside potential in the U.S. Stock Market.

In the April issue I mentioned that the last three times the market rallied to reach such lofty valuations (September 2014, July 2015 and December 2015), the market declined by at least 8% or more in the ensuing couple months. The market again corrected with the UK vote to leave the EU causing another abrupt, although short-term correction showing the underlying risk and skittishness of investors.

The August-October months tend to be the most volatile of all months with many of the largest historical corrections occurring in or beginning with October.

Consider the following when measuring the current risk in the market.

• There have been 5 consecutive quarters of corporate sales declines.

• I’ve warned that the P/E ratio can be misleading due to financial engineering. This is evidenced by reported earnings being 25 percent lower than pro forma figures. Additionally, the gap between GAAP and adjusted [non-GAAP] EPS is the widest since the last crisis. Companies are trying to “inflate” earnings.

• David Stockman, former Director of the Office of Management and Budget under President Ronald Reagan recently pointed out that GAAP earnings have already declined 18% from their peak levels, leaving the stock market trading at 22 times earnings. While this might be acceptable in a high growth market, it leaves stocks extremely overvalued on an historical basis based on today’s earnings growth projections.

• If not for corporate stock buybacks, equities would have had negative outflows in the first two quarters of the year.

• Profit margins typically top out prior to the stock market. Profit margins peaked four years ago and have fallen steadily since leading to eroding top growth. Rising wages will further erode already declining corporate profit margins. Corporations have combatted this with cost cutting and stock buybacks to bolster bottom line growth (earnings per share). 50% of the inflows into the stock market the first quarter of 2016 were due to stock buybacks alone. This cannot continue forever.

Bonds

While everyone has been anticipating bond yields to rise and thus bond prices to fall, the exact opposite has happened. Negative rates in much of the world and global economic uncertainty has created an unprecedented demand for U.S. bonds. There is simply nowhere else for those seeking yield and safety in the form of bonds to go. This has led to some stellar returns for bonds in the first half of the year.

For a short period of time the 10-year Treasury bond fell to 1.4%, just a hair above its record low. If economic indicators continue to deteriorate and Brexit fears lead to further uncertainty, I anticipate further declines in yields and price appreciation in the bond market.

I view the spread between the 10-year US Treasury bond yield and the federal funds rate as a strong leading economic Indicator. The yield spread between the two predicts economic growth when it is positive and a recession when it is negative. The spread has been narrowing which tends to indicate further economic weakness ahead.

Tip: Treasuries are negatively correlated to stocks which essentially means that they don’t move in the same price direction and are considered a safe haven when stocks appear overvalued.

Global Markets

Emerging markets have staged a nice rally over the last few months helped by the higher dollar. Emerging markets stocks managed to register 8.6% gain in the first-half this year, outperforming developed markets by 5.5%. This is the sectors best first-half performance since 2009.

That said, I continue to be worried about China’s debt levels and capital flight out of the country. Substantially more money has left China than entered so far this year looking for safer alternatives. China’s corporate bond defaults surged in the second quarter while corporate bond sales fell the most in almost five years. The expansion of credit, loose monetary policy and a widespread belief that asset prices would be supported by government programs has encouraged speculation through cheap financing which has created asset bubbles that are starting to deflate.

As we look outside of China, the EU could be falling apart as the European banking system will be tested and further referendums to leave the EU could materialize. Brazil and Venezuela continue to wallow in political and economic crises. The collapse in oil prices have lest Russia and Saudi Arabia in serious financial trouble.

All in all, the uncertainty over global economic growth and stability is well warranted which will continue to put pressure on international stocks and currencies.

Going Forward

We’re going to reiterate our position going forward for the next 3-6 months. With the recent price recovery in equities, the U.S. stock market is again at historically high valuation levels.
This makes it a particularly dangerous time for individual investors as they have the highest percentage of their total assets allocated to stocks over the last four decades. In addition, borrowing to gain further leverage is at historically high levels as evidenced by the NYSE Margin Debt Levels.

This is partially due to investors wholly buying into the myth of passive investing. Financial planners want you to believe that all you have to do is passively invest a large percentage of your retirement funds into equities and over time, you’ll achieve an average annual return of 9% based on historical numbers and retirement comfortably. It doesn’t work that way.

One thing that I try to drill into individual investors heads is the myth of “passive investing”

Wall Street would love you to believe that passive investing cures all ills because it limits their liability, increases the amount of your assets they get paid to manage and thus creates higher profits for them in the long-term. It’s easy for investors today to buy into the passive investing theory because it’s simple and they’ve never had to live through the dismal returns of the stock market from 1896-1932 or 1962-1974. They’ve also been lulled into a false sense of security after the last two recoveries due to unprecedented central bank intervention.

Here’s where passive investing really fails investors.

When stock market valuations are at historical highs such as they were in 1998-2000 and 2007-2008, stock market returns going forward are NOT projected to be 9%. Projected returns were 2% a year or less over the next 2-10 years. Throw in a negative economic event such as the dot com bubble or financial collapse and short term returns can be disastrous.

We are now in such a time.

After the recent recovery, 2016 stock valuations stand at historically high levels. Despite all the “fear” in the market, investors are taking on more risk than ever. They are repeating the exact same behavior they did in 1998-1999 and 2007-2008 when stock market valuations sat at today’s level.

Are you willing to take on such risk? Or do you need to make adjustments your investment portfolio?

Those questions are even more pertinent if you’re close to retirement or a risk adverse person.

With the recent rise in prices, our financial models going forward continue to show a high risk – low return environment going forward based on current valuations and profit levels for the U.S. Stock Market. Therefore we continue to suggest following strategy number one to improve long-term returns by switching to a more conservative portfolio.

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