The convergence of the twain

And as the smart ship grew

In stature, grace, and hue,
In shadowy silent distance grew the Iceberg too.

Thomas Hardy, The Convergence of the Twain (Lines on the loss of the Titanic)

 

Thomas Hardy’s poem makes sardonic note that, while the Titanic was taking form in Liverpool shipyards, so, too, was the iceberg that doomed it. And, while each bull market grows, so do the forces that will eventually cause it to stop.

What will cause the death of this bull market? No one really knows, and the nature of a bear market is that few see it coming. But if I were to put money on it, the most likely assassin would be the Federal Reserve, rather than disappointing Facebook earnings.

The Fed’s job is to keep the economy on a sustainable growth rate, which means that the economy should grow fast enough to keep unemployment low without inflation. (To the cognici, this is the non-accelerating inflation rate of employment, or NAIRU, which sounds like something out of the Mork and Mindy Show.) Just what NAIRU is is a matter of debate among economists. It’s enough to know it exists.

When the economy is sluggish, the Fed lowers short-term interest rates, which makes it cheaper for companies to borrow and invest. It allows people to refinance mortgages and other debts at a lower rates – essentially, putting money into their pockets.

When the economy is growing too fast and inflation is rising, the Fed raises short-term interest rates to slow the economy. When rates rise, it’s more expensive to borrow, which slows the housing market and makes companies more wary of borrowing.

While the Fed may say that it doesn’t want to cause a recession or slow down the stock market, rising interest rates often do both. A recession wipes out wage inflation: You can’t have wage inflation if people are getting laid off, and you can’t have a wage-price spiral without rising wages. Most stock investors know that higher rates can augur recession, and they tend to sell stocks as rates creep higher. And, on a technical note, stock analysts tend to reduce price targets when interest rates rise.

The most famous example of the Fed crushing stocks and the economy was in 1981, when the Fed hiked short-term interest rates to the highest in modern history: The three-month Treasury bill yielded 16.3% in May of that year, and a sharp recession followed. Inflation, as measured by the Consumer Price Index, fell from 9.79% in May 1981 to 2.36% by July 1983.

But most other bear markets have been preceded by rising rates: The 1987 market crash, for example, as well as the 2000-2002 tech wreck and the 2007 financial meltdown all had rising rates at their backs. While none of those rate hikes were as severe as in 1981 – and you can debate whether they were the proximate cause of the bear market – few bear markets start after a prolonged period of the Fed cutting rates.

What does all this mean? If you have ten or more years to reach your savings goals, not a thing. In fact, a bear market is a good thing if you’re young and contributing regularly to a stock fund in a retirement account. You get the chance to buy stocks cheap over a long period of time.

If you’re close to your goal, however, you should at least think about how much you have in stocks. The most logical way is to rebalance: If you set a goal of 60% stocks and 40% bonds, for example, you’re probably out of balance now. It wouldn’t hurt to sell enough stocks and buy enough bonds to get back to that 60% and 40% risk.

Tracking the MSM

Even if you hate the mainstream media, here’s an MSM you can learn from: The Main Street Meter, via the Leuthold Group.

The MSM is the level of consumer confidence, as measured by the University of Michigan Consumer Sentiment Index, divided the unemployment rate. And right now, the MSM index is pretty high – and it has been for a while. (You can see the charts and read the article here) Good news, right?

Not exactly. Jim Paulsen, Leuthold’s chief investment strategist, notes that when the MSM index is high, investors tend to be frisky – more motivated by greed than fear. More troubling, though, is that with low unemployment, other troubles start to emerge. Typically, low unemployment is a precursor to inflation and higher interest rates.

The MSM’s highest points since 1960 have been 1968, 2000 and now. While this doesn’t mean that the stock market is going to collapse tomorrow – or even over the next few years, it does mean that the outlook for the next five years or so isn’t terribly good.

A high MSM does indicate that it might be a good time to add inflation-sensitive investments, such as real estate and commodities, to your portfolio. Typical late-cycle stock sectors, such as energy, materials and industrials, might fare well also.

Mr. Paulsen cautions that the MSM is not a good short-term market predictor, something it shares with that other MSM. But for those with the long term in mind, it’s an indicator worth following.

 

Off balance?

Three years ago on this blog, I introduced the Amish Portfolio — essentially a bare-bones, low-cost portfolio for those who get a little buggy by complex investment recommendations. If you have a wood-burning computer to track it, all the better.

The portfolio consists of three funds:

* Vanguard Total World Stock Index fund (ticker: VTWSX). The beauty of this fund is that you don’t have to fret about how much to have in international stocks and how much to keep at home. It’s all in there, according to market capitalization: 56.5% North America, 21.5% Europe, 20.8% Asia, and 8.0% emerging markets. Cost for the investor shares: 0.19% a year, or $1.90 per $1,000 invested.

* Vanguard Total Bond Index fund (VBMFX). You get broad exposure most types of U.S. bonds. Current yield: 2.54%. Cost: 0.15%, or $1.50 per $1,000.

* Vanguard Prime Money Market (VMMXX). Hey, it’s a money fund. It yields 2.03% after its 0.16% expenses.

The suggestion for conservative investors: 20% Vanguard Total Bond, 20% Vanguard Prime Money Market and 60% Vanguard Total World stock. You can add to stocks (and reduce cash or bonds) depending on your personal risk profile.

A mix of stocks, bonds and money market funds is remarkably self-balancing: Despite the stock market’s runup, the conservative blend above is at 65% stocks, 18% bonds and 18% money market funds. It probably doesn’t need to be rebalanced now.

Had this been your portfolio for the past five years, however, you’d now be 76% in stocks — far more than your initial target. In this case, you’d want to sell enough from your stock fund and add to your money fund and bond fund to get to your original 60% stocks, 20% bonds, 20% money fund allocation.

Rebalancing too frequently means that you’ll be cutting off your gains too quickly. (In a taxable account, it means you could be triggering taxes, too). Using the 10% rule typically means occasional rebalancing, and often when one market — stocks or bonds — are a bit frothy. If you’ve been in the market for a while, and you have a set allocation to stocks, now might be the time to rebalance.

 

 

Why buy bonds?

Why do economists continue to give interest-rate forecasts, despite the fact that they’re generally awful at predicting interest rates? Probably because people ask them to. But if you’re thinking of investing in a bond fund now, it would help to have a forecast in mind – if only to give you an idea of the risks you’re incurring.

People ask economists to give interest rate forecast because so many things depend upon your assumption for rates, and that’s especially true for bonds. Bond prices fall when interest rates rise and they rise when interest rates fall.

Just how vulnerable is your fund to interest-rate changes? You can get a good idea by looking at the fund’s duration, which tells you how much a bond’s price will fall, given a rise in interest rates of one percentage point. Consider the Vanguard Total Bond Market Index Fund ETF (BND), the largest bond ETF, which is also a good proxy for, well, the total U.S. bond market.

The Vanguard ETF, for example, has a duration of 6.09 years, meaning a rise in rates of one percentage point would mean a principal loss of about 6.09%. That loss would be offset, somewhat, by the interest investors receive from the bonds. The ETF has a yield of 3.13%, according to Morningstar Direct. If you were to assume that rates will rise by a percentage point, your total return – price decline plus interest – would about a 3% loss.

Interest rates have been rising since July 2016, when the bellwether 10-year Treasury note hit an all-time low of 1.38%. It’s trading at 2.85% now. Since that date, Vanguard Total Bond Market Index Fund ETF has lost 1.75%, including reinvested interest. While interest payments have certainly offset most of the fund’s losses, it hasn’t been enough to eliminate them entirely. The past 12 months, the fund has lost 0.82%.

Army ants.

Here’s where the forecast comes in. If you were to assume that interest rates will rise a percentage point in the next year, you should brace yourself for roughly a 3% loss. That’s not a catastrophic loss – bond bear markets are like getting attacked by very mean ants – but you might consider a few other options.

One is a money market fund. Just as the 10-year T-note yield has been rising, so has the yield on money market funds. Vanguard Prime Money Market Fund Investor Shares (VMMXX) has a yield of 2.02% and – assuming the fund maintains its constant price of $1 per share – it has very little potential for a principal loss.

Another is a fund with a tolerable track record of managing interest-rate risk. (Typically, these funds are also deft with credit risk – buying bonds from shaky companies that are getting better). One is Dodge & Cox Income (DODIX). It has a duration of 4.2 years, a 3.02% yield, and an expense ratio of 0.43%.  The past two years, the fund has averaged a 2.94% gain – not much, but better than the average fund.

Bear in mind if bonds are a part of a long-term plan, you shouldn’t dump your bond funds because you’ve got a feeling rates will rise.  Over the long term, bonds have a great record in dampening the effects of stock downturns. But if you’re trying to figure out where to invest money now, a money fund or Dodge & Cox Income are two good places to start.

A blue chip by any other name

When it comes to mutual fund marketing, the glass is never half empty: It’s always full. This is why we don’t see funds with names like “The Occasional Outperformance Growth Fund” or “The Somewhat Erratic Income Fund.”

We do, however, have several funds with the words “blue chip” in them. Unfortunately, they may not have the blue-chip attributes you’re looking for.

First of all: What’s a blue-chip stock? The term “blue chip” comes from poker, where blue chips are traditionally the most valuable. “I think of it as a large-cap company that has been around for decades, pays an attractive yield and has an above-average record of raising earnings and dividends for an extended period of time,” said Sam Stovall, chief investment strategist of U.S. Equity Strategy at CFRA. It’s a fairly exalted status that few stocks earn, and fewer keep.  They’re the kind of stocks you’d imagine Uncle Pennybags from Monopoly would buy.

The term “blue chip” has become so popular that there are 15 stock funds with “blue chip” in the Morningstar database. Elizabeth Laprade, research analyst at  Adviser Investments, notes that three of the largest blue-chip funds – T. Rowe Price Blue Chip Growth ($54 billion), Fidelity Blue Chip Growth ($25 billion) and John Hancock Blue Chip Growth ($3 billion) – have between 122 and 429 stocks.

Whether there are 429 or even 122 blue-chip stocks is debatable, at best, and all three funds seem to stretch the definition. T. Rowe Price Blue Chip Growth, for example, has stakes in true blue-chip companies like Boeing and JPMorgan Chase. But its third-largest holding is Tencent Holdings, the Chinese internet advertising company. It also had stakes in Tesla, Monster Beverage and Norwegian Cruise Lines, which are probably not blue-chip companies, at least by Mr. Stovall’s definition.  All three funds own Alibaba.

Distressingly, all three funds have more volatility than the Standard & Poor’s 500 and lower dividend yields, too. This may be because all three are growth funds, and growth stocks often sneer at the notion of dividends. It may also be because of the funds’ expense ratios, which range from -0.78% for the John Hancock fund and O.69% for the Fidelity offering. Those aren’t excessive by large-company growth fund standards, but they do take a bite out of the funds’ dividend payouts.

Even worse is the funds’ maximum drawdown – the most the funds lost from peak to trough during downturns in the past five years. Here again, they didn’t beat the S&P 500, Ms. Laprade notes. “People need to be careful,” she said. “If they’re looking for blue-chip stocks, that may not be the case.”

 

In which matters become more serious

Because I was born during the Taft administration, I remember that 1987 was a very, very good year in the market, at least at first. And I remember an editor, who shall remain nameless, saying, excitedly, “Isn’t it amazing how well this market is doing in the face of rising interest rates?”

The Dow Jones industrial average had climbed 27.6% in the first six months of the year, and tacked on another 7% in July 1987. And, in fact, the yield on the 10-year Treasury note had risen from 7.08% to 8.62% from the first of the year to the end of July.

From there on out, however, interest rates rose steadily, topping 10% on October 16, 1987. And the stock market, like Wile E. Coyote walking off a cliff, suddenly noticed that interest rates were rising. From its peak of 2,722 on August 25, the Dow began to stumble — first slowly, and then more rapidly. On October 15, the Dow fell 2.4%. The next day, it fell 4.6%. The next trading day, it plunged 508 points, or 22.6%, a record one-day drop.

For the past 12 months, the yield on the 10-year T-note has been creeping higher, albeit at far lower levels than 1987. (It’s still hard for me to get too worked up over a 2.84% T-note yield.) And the stock market has been soaring higher. Last year was, in fact, a very good year, with the S&P rising 22%. Even after today’s 666-point carnage (a 2.54% drop) the Dow is still up 3.3% for the year.

It’s entirely likely that interest rates will continue to rise. To quote myself: “The average yield for the three-year T-bill since 1934 is 3.5%. If we want to get rid of the very highest and very lowest yields, we get a typical yield of 3.18% over that 83-year period.” We’re closer to the average 10-year yield than we were, but we’re still a ways off. And being at the average rate of interest isn’t usually a problem for the stock market.

What is a problem is that stocks are generally overvalued. Rising rates only make that worse: Bonds and bank CDs suddenly become more attractive than they were previously. Corporate borrowng becomes more expensive. And, if rates are indeed rising because of a strong economy, higher wages will weigh on future earnings. Events must unfold to perfection at this level of stock prices, relative to earnings. And, as Wile E. Coyote could tell you, things rarely unfold to perfection.

If you’re a long-term investor, you’ll probably do better than 2.84% a year the next decade if you’re in stocks. What you probably won’t get is high returns with low volatility. If the bull market has pushed your stock allocation significantly above your target, it’s time to rebalance your portfolio back to your target. Otherwise, hang on and hope for the best, and keep saving — which is, after all, the single most imporant determinant of how much money you have when you reach your goal.

 

 

 

 

Bitcoin: What could possibly go wrong?

Bitcoin prices reached a new high today of $2,700 per bitcoin. What could possibly go wrong?

It’s hard to know where to start, but the parabolic arc of the bitcoin chart is one place. Spikes like this rarely end well. Here’s today’s bitcoin:

Look familiar? Here’s the Nasdaq during its halcyon days.

Of course, there are other reasons to fret about the rapid rise in value of something that has no earnings or dividends, as many of the tech wreck’s biggest failures did. One is the increasing cost of mining bitcoins. To create a Bitcoin, you have to use massive computing power to solve mathematical puzzles. The process is fairly succinctly laid out in this useful story: 

“Bitcoins are mined by getting lots of computers around the world to try and solve the same mathematical puzzle. Every ten minutes or so, someone solves the puzzle and is rewarded with some bitcoins. Then, a new puzzle is generated and the whole thing starts over again.”

The difficulty of the new puzzle — and the electrical cost of finding the answer — depends on demand. Back in May 2015, the bitcoin network ran on about 343 megawats, or enough to power about a third of the homes in San Jose, Calif. in May 2015.  Another estimate put the cost of mining one bitcoin at the same rate as running an average home for 1.57 days. (Bitcoins are granted in blocks, rather than individually).

Back then, a bitcoin was worth about $650. You can find out the current cost of mining bitcoins here.

Aside from the rising costs of mining bitcoins, there’s the theft problem. The problem with untraceable currency is that, well, it’s untraceable. Once it’s gone, it’s pretty much gone. And like many things stored on computers, bitcoins are vulnerable to hacking, as the 2014 theft of $700 million in bitcoins from Mt. Gox demonstrated.

Why invest in bitcoin? I honestly can’t imagine. If you’re thinking that government-issued money is going to go away, it’s hard to imagine bitcoin transactions in the smoking rubble of civilization. (As a friend of mine noted, it would probably be better to have a few things to trade, like food or wine). And it’s hard to imagine that governments will long tolerate alternative currencies. And bitcoin certainly doesn’t seem to be immune to bubbles. I hope you are.

Update: That was fast. Bitcoin’s down 9% today. 

Media preview

Thanks to Business Insider for the two charts, and the smart reporting.