Current Market Conditions and Short-Term Expectations:
Whenever the major US stock indexes reach new highs, or tumble unexpectedly, we hear from a few of our clients with worries about the near future. The S&P 500 (a broad index representing the largest US-based companies) hit new all-time highs in late April, and dropped almost 7% from those highs during May — reached another new high in July, and dropped in August. So our clients are calling: Do we think the markets are too high, and are about to tumble further? Do we think there will be a recession, and with it a new bear market? Will the next bear market be as bad as the Tech Crash, or the more recent “Great Recession”? Here is a sketch of our current thinking.
We don’t believe that we can predict the near-term future with any confidence (see our previous post on predictions). We are really happy that the markets are doing well so far this year, but simply don’t know what might happen in the remainder of 2019. There are plenty of pundits who are willing to make those predictions, based on a wide variety of indicators, but we have yet to identify anyone who can consistently make valuable predictions. We do listen closely to a handful of thoughtful economists, of course, and try to bring their insights together into a coherent picture – but our management of your portfolios is based on our long-term expectations, not any short-term projections.
What economic indicators do we watch? One indicator that lots of economists follow is the “yield curve”, and right now it’s “inverted”: it’s more expensive to borrow money for three months, even for two years, than for ten years, and that is normally a negative sign for the economy. There seem to be other unusual factors causing this inversion, including worries about global political stability and trade, so we’re not as concerned about it as we might be. And there are other indicators that are positive right now: for example, the “quality spread”, the difference in the interest rates paid on high-quality bonds (such as US Treasuries) and low-quality bonds (“junk bonds”), seems to imply that the US economy is currently quite healthy. Other indicators are “neutral”, somewhere in between the negative sign of the yield curve and the positive sign of the quality spread.
Like many economists, we believe that there will be a recession, and with it a serious bear market, eventually. We really don’t know when it’s coming, but we don’t think it will be in 2019 or 2020 – unless something unexpected, like a new war in the Middle East or significant escalations in the trade war with China, comes along and upsets every projection. In the short-term, then, we recommend that our clients stick close to their existing long-term investment plan, and not try to guess market highs and lows.
Investment Policy and Long-Term Expectations:
What can we say about the long-term prospects, then, if we can’t say much at all about the short-term? Every spring, when the world’s financial analysts have had a chance to compile and crunch all the numbers from the previous calendar year, we review the results of a handful of the analysts we trust the most. We review and compile those, trying again to create a coherent picture of the probable market returns for the next ten years or so, so that we can make long-term plans with our clients.
Again this year we find we have to lower our long-term expectations a bit, for all but our most conservative portfolios. While the short-term economic outlook is not bad, as discussed above, current views of the next decade include a probable recession and slow global growth, which cuts into the expected returns for stocks. While we could pursue higher expected returns by changing the allocations to different asset classes, the risks associated with such performance-chasing would not be prudent.
As a result, the expectations page of the Investment Policy Statements we prepare for our clients has been edited to look like this:
Our all-stock portfolio is expected to return about 6.3% per year, on average, over the next decade; in a really good year (+2 standard deviations), that portfolio could bring in as much as 37%, and in a really bad year (-3 standard deviations), it could lose nearly 40%.
If you have questions about how these changes impact your expectations for your long-term portfolio, want to discuss possible changes to your Investment Policy Statement because of recent changes in your life, or just can’t remember which asset allocation your accounts are assigned to – please let us know. We’re happy to talk about the theory behind our decisions, or the practical impact it might have on your life, whenever you have the time. Just contact us when you’re ready.