We spoke to a few clients about what they wanted from our newsletter. The feedback we received was to provide clarity, meaning and an overall education on how recent events could impact their portfolios. We will do our best to meet those expectations.
Long Term Thinking
Mitigating risk while seeking growth is a general goal for all of our clients. With this in mind, we construct portfolios for each client depending on their need for income and preference toward risk.
In most cases, a percentage of their portfolio is not needed within the next 7-15 years, and that portion is generally allocated to stocks. Not just for growth, but surprisingly for safety.
Since 1950, there has not been a 15-year period when stocks have had a negative return (S&P index). After a 10-year period the likelihood of having a negative return was 3%, after 5-years the likelihood was 8% and after 3-years it was 11%.
As you shorten the time frame, the likelihood of having a negative return increases with the worst 1-year return at -43.3% for the period ending February 2009 (see chart).
In the long run, averages emerge and short term volatility evens out with a long term average currently above 10%.
Unfortunately, in the short term, market fluctuations can be very uncomfortable. Therefore, matching clients to appropriate risk levels is an ongoing and highly valued responsibility. Only by setting proper expectations and planning ahead can we execute properly with less stress and more confidence should we find ourselves in a difficult market.
By us sharing data on long term averages we are not trying to communicate a guaranteed return, as past performance doesn’t indicate future results. We are sharing this information to communicate that events and markets cycles come and go also that we are keeping a close eye on the investments and their potential within client’s portfolios, more on this below…
Looking at Financials
As mentioned, mitigating risk is important and one of the ways we accomplish this is by investing in companies that are financially strong. Of the 40 companies we usually hold in a client’s account, 38 hold an “A” rating or higher. Of the 1700 companies tracked, a highly rated company is less likely to experience significant financial difficulty.
Companies are ranked by evaluating their balance sheet, cash flow, level of debt, net cash, business risk, level and direction of profits, and earned returns.
The remaining two companies that we invest in have a B++ rating, which were downgraded slightly due to their larger debt levels; both companies are being monitored, but are not a cause for concern at this time.
Monitoring a company’s financial strength becomes particularly important should we encounter a difficult market. Prior to investing in a stock, we need to gain a strong sense of confidence that they will be a good long term investment.
There are times when we need to maneuver and make decisions as new information surfaces. For example, prior to the knowledge that Johnson & Johnson used talcum powder in their products, we held the stock in several accounts.
Upon learning the news, we decided to sell our positions and reinvest the funds into companies that are not facing significant lawsuits and drains on their cash flow. There are plenty of great companies to own, and we don’t see a need to allocate resources toward a company that has large obstacles to overcome. Since the news release they have significantly lagged behind the broader market.
The unresolved trade tensions are the root of most economic challenges arising today; the impacts of the trade war will probably peak in 2021. We believe both sides are motivated to reach a resolution, but we are waiting patiently to see how events unfold.
In anticipation of slowing global growth, central banks around the world have lowered interest rates to encourage lending and spur investment; the Federal Reserve has followed suit.
By lowering interest rates, central banks are providing liquidity to a slowing global market. A general concern is that if the economy stumbles, The Fed will not have the usual 5% margin to drop rates. However, it would not make sense to increase rates domestically as the rest of the world is lowering them. As a result, they are exploring new methods of monetary policy to accommodate the United States’ ever changing financial landscape.
When investors encounter global uncertainty, they tend to flock to safer assets usually within the US market. As the largest economy in the world, the US is seen as a safe haven for funds because of its stability, large and reliable tax base, and abundant natural resources which established the dollar as the world’s reserve currency.
The US dollar’s influence has grown as the global economy has become more integrated: “50-80% of international trade is invoiced in dollars [most contracts are written in dollars because it is considered an easier negotiation process], 28 trillion dollar denominated debt [Treasuries and corporate debt] is held internationally and 70% of the world’s currencies are anchored, in varying degrees, to the dollar.”¹
As the demand for US assets (including stocks) increases, the dollar strengthens; bringing with it its own set of complications.
Being the world’s reserve currency allows the US to run a higher budget deficit, lowers the cost of borrowing, and strengthens our financial system by lifting asset prices. However, it hurts US exports and gives rise to persistent trade deficits. The stronger the dollar is, the harder it is for our exporters to compete internationally. Which could turn into an issue later on.
Our clients have been correctly allocated to US assets as international markets continued to struggle. Besides short stints of decent performance, international exposure has lagged behind domestic markets since 2011. We have no reason to think this will change anytime soon.
¹ Mercatus.org “The Challenges of Dollar Dominance”
Crandall Pierce & Company, Standard and Poor’s Corporation and ValueLine.com, Bloomberg.com, YCharts