2018 First Quarter Outlook
My Investment Model has a high allocation to stocks with an increasing shift to a conservative rotation. Financial risk is low with improving corporate performance, steady economic growth, and moderate inflation. Medium-term risks are less slack in the economy, rising interest rates, and the unwinding of “quantitative easing.” Longer-term risks are high valuations.
Most people have inadequate savings for retirement. Unfortunately, lower investment returns in the future, compounded by pension and social security shortfalls and reforms, exacerbate this problem.
I have been a better saver than investor through most of my life. I became a good saver when I got married, had stable employment, and started contributing the maximum amount to company savings plans. I followed the sage advice of the time to invest in low-cost index funds and let it ride through good times and bad times because you can’t time the market.
Understanding secular markets is key to developing an investment model. Ed Easterling does an excellent job describing how stock market returns are impacted by market valuations and inflation in Unexpected Returns and Probable Outcomes. Secular bull and bear markets often last for more than 20 years and usually contain cyclical bull and bear markets. I believe that we are part way through a secular bear market that began with the bursting of the technology bubble.
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The conventional wisdom is that your stock allocation should be equal to 100 minus your age so that your allocation to stock declines as you near retirement. Average life expectancy is in the 80s so retirement savings may have to last more than 20 years making a portion of savings long-term investments, even for retirees. How much a retiree has invested in stocks is an individual situation that depends upon how much they have saved, whether they have a pension or other income, risk tolerance and experience in the markets among others.
I have been developing an investment model for me, as an individual investor nearing retirement. It is based in part on the books included in the appendix. My Investment Model is based on 22 years of monthly and quarterly data. Most of the data series that I use are available at the St. Louis Federal Reserve website.
Review of the Past 22 Years
Below is a chart showing the value of $100 invested in the S&P 500 in January 1995 with dividends reinvested. The annualized returns for the cyclical bull and bear markets are also shown. The return for the entire period is 9.6%, excluding the impact of taxes and expenses. By comparison, the return provided by Vanguard for an all-stock portfolio from 1926 to 2016 is 10.2%.
An investor would have done well to put money in the stock market in 1995 and ignore it through the tech and housing bubbles. Notice that the annualized returns for the bull markets ranged between 15 and 23 percent and that annualized bear returns are between -21 and -46 percent.
Valuations are one of the best metrics of long-term returns. Most valuation metrics indicate that the S&P 500 is about 25 percent above the average for the past 22 years, which is even higher compared to longer-term averages. A market correction of 25% will lower the annualized return to about 8% since 1995 while a correction of 50% will lower annualized returns to 6 to 7%. According to Investment Return Assumptions of Public Pension Funds, the majority of Pension Funds use a target return assumption of 7 to 8 percent while often not meeting this target. Pension funds have to have shorter-term investments with lower returns to meet obligations and must also pay expenses.
Rules of the Investment Model
The Investment Model maximizes return given a set of rules. The rules that I set up are for an individual investor nearing retirement with savings and a pension. The rules are:
- Maximum investment in stocks of 80%
- Minimum investment in stocks of 20%
- Maximum investment in cash and equivalents of 25%
- Minimum investment in cash and equivalents of 10%
- Maximum investment in inverse stock funds of 10%
- Maximum monthly drawdown of 7.5%
The Investment Model is intended to assist with reviewing investments once a month while making small changes and is not a short-term trading tool. A single indicator is created from a weighting of 30 main indicators. Four investment stages are created based on the direction and level of the indicator. They are intended to replicate average returns for asset classes. Each stage has a subset of allocations to stock styles, real estate investment trusts, oil, and gold. Each stage also has a subset of allocations to corporate, high yield, and bonds of different durations.
Investment Model Return
The allocations that optimize returns given the rules are shown below. The resulting value of $100 invested in 1995 for the Model (black) is compared to investing in the S&P 500 (tan). Taxes are not taken into account as most investments are assumed to be in tax-advantaged savings accounts. The Model is heavily influenced by the number and magnitude of market downturns. The Yale University endowment fund has one of the best 20 year annualized returns for institutional investors of 13.9%. Future conditions will be different and so will the returns. Then, of course, the model may not perform as well going forward.
The behavior of some of the main indicators is shown in the following graph. Individual indicators have a weight of +1 when strongly positive for investing and -1 when strongly negative. The graph is made of the indicators after they are weighted to create the Allocation Model. To the right are the most positive indicators including Risk, Leading, Labor, Coincident, Margin Debt and Euro Zone. To the left are the weakest indicators including Monetary, GDP, OECD, Income, Money Funds, Valuation, and Banking.
I added one indicator in 2017 for Money Funds, based on Retail and Institutional Money Funds and Money Market Funds. It shows when money is flowing into and out of money funds. It tends to lead market downturns as investors begin taking profits. The Money Funds Indicator is not positive for the first quarter of 2018 as it was for 2017.
Fisher Investments has a Tactical Asset Allocation model and says that a defensive strategy, if successfully implemented, is designed to avoid some of the negativity of a bear market. The Secret to a Perfect Asset Allocation describes a market allocation model based on bull, bear, and transitional markets. These and some of the books in the appendix describe the strategies that I am striving to achieve.
The raw index composited from the 30 Main Indicators is shown in the following chart as the dashed blue line. The solid blue line is the allocation to the stock market capped between 20% and 80%. The shaded areas are based on the value and direction of the indicator and indicate times where an investor may want to be aggressive or inverse the market. This is my attempt to break down economic expansions into periods of acceleration and deceleration. The red line is the percent of the 30 indicators that are negative. The expansion in 2017 has slowed down.
Impact of Tax Changes
Models are fallible. My Investment Model is complex enough to use close to a hundred indicators but takes only 30 minutes once a month to update. There are no indicators for Tax Reform and understanding has to be applied to models. For this timely topic, my last article on Financial Sense, nearly a year ago was a dry, detailed look at the potential impact of Tax Reform. I repeat part of the summary from that article. I believe that the large run-up of the markets in 2017 has already priced in the benefits of tax reform.
- The need to reform international tax codes is recognized by the OECD and WTO and is an evolving process. Corporate tax reform will be beneficial to “adjust” for the U.S. tax system being based on income and the most of the rest of the world relying more on consumption (VAT) taxes. Tax reform may increase revenues by reducing the incentives to seek tax havens.
- Reducing top tax rates and capital gains taxes will continue to benefit the wealthy more than the middle class, but will increase investment in the U.S. and reduce tax evasion (to havens).
- The current reforms and stimulus are likely to provide a temporary boost to the economy, but long-term growth of 4% is highly unlikely.
Review of Selected Indicators
Turning Point Indicator: The Turning Point Indicator uses 12 of the Main Indicators to more closely identify inflection points for the economy. As shown below, a major downturn is not anticipated in the near term.
Risk: The following Risk Indicator is a composite of the Chicago Fed Adjusted National Financial Conditions Index (ANFCI), the St. Louis Fed Financial Stress Index (STLFSI), the Kansas City Financial Stress Index (KCFSI), the CBOE S&P 100 Volatility Index: VXO (VXOCLS), and the Economic Policy Uncertainty Index for the United States (USEPUINDXM). Its level and direction indicate calm financial conditions over the next few months.
Technical Indicator (Don’t Fight the Tape): The Technical Indicator is a composite of a stock market relative strength indicator, 200-day moving average, percent off from 4-year high, a stock return to bond return ratio, and a simplified version of Martin Pring’s Cycle Stages. The direction and level are favorable to stocks.
Dieli Indicator: I adapted the concept of Dr. Robert F. Dieli’s “Mr. Model” and created an indicator. It is created from 20-year Treasury yields, the Federal Funds Rate, Consumer Price Index and unemployment rate. This indicator is trending toward the negative.
Corporate Health Indicator: The Corporate Health Indicator is a composite of gross value added, disposable income, operating surplus, real output, exports, and sales. The level and direction of the Corporate Health Indicator are favorable.
Leading Indicator: The Leading Indicator is a composite of the Conference Board’s Leading Indicator, Philadelphia Fed Leading Indicator, Chicago Fed National Activity Index, and State Leading Indicator developed from the Philadelphia Fed State Leading Indexes. The Leading Indicator is strong and improving.
Interest Indicator: The Interest Indicator is a composite of the BofA Merrill Lynch US Corp Master Total Return Index Value, the yield curve, TED Spread, and BofA Merrill Lynch US High Yield Option-Adjusted Spread. Its level is not positive for the investing environment but improving.
GDP Indicator: The GDP Indicator is based largely on the Output Gap (Real Potential GDP compared to Real GDP). It suggests that future growth may be accompanied by inflation and that the Fed is likely to raise interest rates. In Time-varying risk premiums and economic cycles, Thomas Raffinot makes the case “that asset prices and returns are not correlated with the business cycle… but are primarily caused by the economic cycles.”
Valuations Indicator: The Valuation Indicator is a composite of the stock market to GDP capitalization, Tobin Q Ratio, Cyclically Adjusted Price to Earnings Ratio, and Price to Earnings Ratio. This indicator is negative for the investment environment.
My Valuation Indicator is slightly negative based on the past 22 years of data. However, if you look at Nonfinancial Corporate Equities (market capitalization) divided by GDP, the valuation (blue line) is almost twice the average for the period. It is also more than twice as high as the global average (in 2015). Equity Valuations, Recessions and Stock Market Declines by Doug Short shows a table of valuations and stock market declines. When the stock market is overvalued by more than 20% prior to a recession, the stock market has historically fallen by around 50%. John Hussman prefers using market capitalization of U.S. nonfinancial equities, divided by the gross value-added of U.S. nonfinancial companies. He writes, “the prospect of negative 12-year returns is likely to be resolved in far fewer than 12 years.”
Monetary: Don’t Fight the Fed: I started building an investment model in 2010 and have learned the hard way, the meaning of Quantitative Easing. Over the years, I added a Monetary Policy Indicator. It is based on M1 and M2 money stock, the Federal Funds Rate, 1-Year Treasury Constant Maturity minus Federal Funds Rate, price index, and monetary base. I view unwinding of quantitative easing as a headwind. For a better understanding of the potential impact of unwinding quantitative easing, I refer to “The Greatest Bubble Ever: Why You Better Believe It,” Part 1 and Part 2 by David Stockman. To summarize, Mr. Stockman points out that “Quantitative Tightening” is taking place at a time when the federal deficit is compounded by the increase to finance tax cuts must be financed when US households are only saving 3% of disposable income. This, he expects to result in a “downward reset” of financial asset prices.
Pension and Savings Crises
Insufficient savings for retirement, lower future returns resulting from demographic changes, high valuations, and high debt, combined with underfunded pension funds and social security will result in difficult adjustments in the future. The following paragraphs and references describe the current situation and what many people can do to improve their retirements.
The State of American Retirement (2016) paints a bleak picture, “of increasingly inadequate savings and retirement income for successive generations of Americans”. Do a search on the internet for why people don’t save for retirement and you will find lots of reasons. In 5 Reasons Why People Don’t Save For Retirement, the author lists that saving for retirement is not a goal, fatalism, excessive optimism, lack of income or job stability, and life gets in the way. Articles on Money and Market Watch both make the point that we as savers don’t make the connection between our future goals or aspirations and our present self. The 10 Countries Where People Save the Most Money states that Americans save 5.8% of their disposable incomes while Austria, Australia, Portugal, Switzerland, Sweden, Germany, Belgium, Spain, France and Ireland all save more than 9%. Losing the discipline to save is detracting from our future.
Now do a search on how people can save more. How to Actually Save More Money simplifies increasing savings to three of the largest expenses: your home, car, and education. It has been my philosophy that students should go to a university that they can afford for the field that they choose so that they do not accumulate crippling debt before they even start their career. 54 Ways to Save Money provides useful ways to create a savings plan. 10 Reasons You Buy Things That You Don’t Need says that the average house size has more than doubled in the past 70 years and describes how to stop buying things that are not needed. In Saving vs. Spending: What Can $2,500 Get You?, Ryan Fause counsels younger investors by making the comparison that the $2,500 spent on a television now would be worth $45,000 in 40 years if compounded at 7.5% annually.
In Global Pension Crisis (2013), Richard A. Marin describes that pension funds are underfunded in the US by trillions of dollars due to longer life expectancies, higher medical costs and financial crises among other factors. There are efforts to counter these pension crises. In 2014, the federal Multiemployer Pension Reform Act was passed which allows trustees of multiemployer plans to reduce benefits to make the plans more solvent impacting more than a quarter million people. What happened after CalPERS Cut Pensions of Former Job Training Agency Employees describes the California Employees’ Retirement System cutting pensions for people who worked at LA Works because the agency hadn’t made payments on retirement benefits. Potential Social Security Reform includes that by 2034, the Social Security Administration projects that “beneficiaries will need to accept lower benefits unless changes are made today.”
My investment model shows that the economy is doing well entering 2018 but is no longer accelerating. The Model does not measure a high risk of a correction in the near term. I have concerns about an economy reaching its potential, low unemployment, and rising interest rates. Financing the federal deficit while tightening monetary policy is a concern. If investors do retreat from the market, high valuations will likely accelerate the pace.
I have always had the philosophy that I am responsible for my retirement. Pensions and social security only supplement savings. The starting point for a secure retirement is to make saving for retirement a priority. People can improve their probabilities of achieving secure retirement by setting goals, starting to save as soon as possible, building up to saving 15% of income, putting the savings in retirement accounts, maintaining an emergency fund, and having insurance to protect your loved ones in case something happens to you. Working longer continues to increase savings and defers withdrawing from savings. Most people should use a professional financial advisor.
I built my Investment model because it was a technical challenge and a hobby. It is an objective system that reduces the noise and emotions associated with investing and provides concrete direction. It is customized to my circumstances. My suspicion is that the model will start showing a declining trend over the next six months.
One of my New Year’s resolutions is to sit down with a cup of coffee one morning per month and listen to what the Investment Model is telling me and evaluate the path to take. In 2017, I was overly conservative and will start following the model more closely.
I am not an economist, investment advisor nor investment professional. This material is for informational purposes only and should not be construed as investment, legal or tax advice. Investors should do their own research or seek the advice of investment professionals.
Books and Articles about Retirement:
Retire Secure!: A Guide To Getting The Most Out Of What You've Got by James Lange.
10 Truths About America’s Entitlement Programs U. S. Chamber of Commerce
Articles about Saving More:
How to actually save more money USA Today
7 Ways to Trick Yourself into Saving More Money in 2015 Money
This Is Why Most People Don’t Save Money for Retirement Market Watch
54 Ways to Save Money America Saves$
The 10 Countries Where People Save the Most Money Fox News
10 Reasons You Buy Things That You Don’t Need Huff Post
23 Reasons Why You’ll Always Be Broke Money
Books about Investment Models:
Conquering the Divide by James B. Cornehlsen and Michael J. Carr
Nowcasting the Business Cycle by James Picerno
Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor by James Picerno
The Investor’s Guide to Active Asset Allocation by Martin Pring
The Age of Uncertainty by Francois Trahan and Katherine Krantz
Ahead of the Curve by Joseph H, Ellis
The Research Driven Investor by Timothy Hayes
Being Right or Making Money by Ned Davis.
DIY Financial Advisor: A Simple Solution to Build and Protect Your Wealth By Wesley R. Gray, Jack R. Vogel, David P. Foulke
The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation By A. Gary Shilling
Anatomy of The Bear By Russell Napier
Business Cycles: History, Theory and Investment Reality By Lars Tvede
Business Cycles: Durations, Dynamics and Forecasting By Francis X. Diebold and Glenn D. Rudebusch
Forecasting Financial and Economic Cycles by Michael P. Niemira and Philip A. Klein
Leading Economic Indicators: New Approaches and Forecasting Records By Kajal Lahiri (Editor) and Geoffrey H. Moore (Editor)
Data Smart by John W. Foreman
Business Statistics for Competitive Advantage with Excel 2010 by Cynthia Fraser
Fundamentals of Forecasting Using Excel by Kenneth Lawrence, Ronald Klimberg, and Sheila Lawrence
About Charles Bolin
Charles Bolin Archive
|02/01/2017||Slow Growth and "Making America Great Again"||story|
|11/29/2016||Stagnation and the OECD's Solution||story|
|11/23/2016||Stagnation and the Secular Bear Market||story|
|10/14/2016||Balance Sheet Recessions and the QE Trap||story|
|09/09/2016||Charles Bolin's September Investment Outlook||story|
|08/04/2016||Bolin August Investment Outlook||story|
|07/05/2016||July Market Outlook: Possible Change from Cautious to Bearish||story|
|05/25/2016||Charles Bolin's Detailed Investment Outlook - Market Topping, Economic Data in Decline||story|