Market Musings Blog

Last year’s US stock market was the definition of robust. Volatility was on the low side, and returns were high. Daily price movements were minor when the market sank, but high when the market rose. The S&P 500 corrected about 5.7% from mid May to late June – a decline that was markedly milder than the usual annual correction – only to surge to a new all time high less than two weeks later. Rarely is the stock market so satisfying.

This year, we are reminded just how rare last year was. In short order stocks are down 5%-7% depending on which index you prefer. Foreign stocks are off more. Volatility is rising: triple digit losses are back in the news and volume is surging.

The underpinning of this decline is uncertainty around the Fed’s gradual withdrawal from the bond market. Coincident with the Fed’s taper, China is showing signs of weakness (see our blog of January 4), emerging markets are having a rough go thanks to currency runs, and even some US data points are looking suspect. The confluence of these events is reminding investors that risk is increasing with the change in monetary policy. When risk increases, prices need to decline. The market is behaving as it should. At some point, prices will reach a level that accounts for the riskiness of the transition from lots of Fed support to less Fed support. That will be a buying opportunity.

On the other hand, interest rates were supposed to rise when the Fed tapered. “Everyone” says so. At least for now, this appears to be wrong. Interest rates are not up, they are down, and substantially, from the beginning of the year. In fact, the 30 year mortgage rate has ticked down, for the first time in months. Could it be that a Fed taper will not cause rates to rise?

One of our gripes about our own industry is high investment management fees and the fact that many consumers of investment services really have no idea what they are paying. One new client had two accounts under the same name at his old advisor’s shop. He told us that he didn’t really understand why the old manager wanted to split the account. We were worried that there was some estate planning reason for this split, but when we looked at his old statements we saw he was paying over 2% in investment management fees per year on one of those accounts. At once, we saw that he had been “sold” on a separately managed account, where he pays an overseer as well as a manager. Fees for these types of accounts can approach 3% per year.

Any time your manager uses mutual funds, you are very likely paying two fees: one to the manager, and one to the mutual fund. This can ramp fees into the stratosphere. Most investors don’t understand the hidden mutual fund fee is on top of the cash they pay out to the overseer. And if you pay commissions, ask for an annual commission summary. You might be shocked at the bottom line, and that won’t even reveal all your costs, because every trade costs money other than commission charges.

Here’s how high fees hurt: If you start with $100,000 and you pay a fee of 1% per year, and your account grows by 7% a year, you will have roughly $177,900 at the end of ten years. If you pay 2% per year, though, you’ll have only $160,700. That missing $17,000 would buy a lot of dinners out!

In the ultimate solution, one could eschew advice, buy index funds, and retain a lot more return – IF you know how to do the right things when you navigate through crashes like ’08-’09, and retirement withdrawal planning, and financial emergencies like replacing a roof or funding a grandchild’s surgery. If you can’t keep your portfolio constructed rationally through these events, it makes sense to pay for a little help. But more than 1% borders on unnecessary. If you’re paying that, better do some comparison shopping! And if you have a lot of money under management – several million – a flat fee should be on the table as an option. Flat fees can prevent you from paying ever more as the market rises which is not something your manager controls, after all.

While the US basks in a moment of diminished stress – political shenanigans have abated, the Eurozone isn’t threatening to vacate its currency, America’s economy is puttering along, markets are good, and all the current wars are old wars as opposed to new wars – China is quietly suffering. How much is hard to tell but signs include periodic interest rate spikes that affect loans between banks, slowing growth, and simultaneously rising rates on corporate bonds.

Over the years we in the West have read about property speculation and “empty cities” in China. Funding all this growth has been a priority so the government can show strong economic statistics and push immigration into cities but with the change in leadership recently, authorities are shifting course. Debts are too high and defaults at banks and other entities dangerously near. Government spending is being reduced and redirected and banks are being brought to heel. China would like to shift from investment in buildings and plants to investment in consumption, transportation, environmental clean up and efficiency projects. These spikes in rates are in one sense a measure of its progress.

With one of the world’s largest economies masterminding such a shift, our companies and markets stand to either benefit or suffer depending on product lines. China has long been a large consumer of heavy equipment, metals, building materials, energy, and gold. Looking forward, fewer excavation machines might be sold, while more robotics and medical equipment go out the door. But in the meantime, China must manage this transition, without igniting its own form of subprime crisis.

Inflation, which was supposed to be surging by now, is so low and still declining, that our thesis that QE will not end imminently and interest rates won’t pop up much from here is looking like it has legs. After the summer’s increase in rates, we weren’t looking very prescient. But now, articles are popping up in the Economist and the Wall Street Journal discussing the difficulties that low inflation present. The recent Economist article reminded us that Japan’s deflationary bout didn’t take hold until seven years after its real estate bust. And in fact, nearly every developed country is struggling with diminishing inflation. Only in Britain is inflation even close to the 2% preferred by central bankers, and there, it is 2.1%. In the US, we’re stuck somewhere between 0.7% and 1.2% depending on how you measure it. In Greece, prices are falling.

With a lot of production and employment slack in the world today (Spain’s unemployment rate is over 25%), forces propelling interest rates are simply missing. While short term interest rates need to be higher, we’re still not convinced that longer bonds will rise much in yield from here.