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.

 

 

 

 

Taking the stock market’s temperature

It’s a balmy 53 degrees here, which isn’t bad for January, but the Standard & Poor’s 500 is hotter than a fire ant’s furnace. As of Jan. 25, the blue-chip index has gained 6.16%, including dividends. How do you know when hot is too hot? You can get one hint from the aptly named Thermostat fund.

A rising stock market, in and of itself, is no reason to panic. Typically, a really good year is followed by at least an OK year. When the S&P 500 gained 26% in 2009, it followed up with a 15% gain in 2010. Similarly, the index gained 13.46% in 2014 after a 32.31% advance in 2013.

What matters is how stock prices measure up against corporate earnings. The basic measure is the price-to-earnings ratio, which simply divides a stock’s price by its previous 12 months’ earnings.

The lower the PE, the cheaper the stock is, relative to earnings. A $50 stock that earned $3 last year has a PE of 16.7. Changes in either price or earnings affects the PE ratio. If the stock’s price drops to $35, its PE is 11.7. If its earnings fall to $2 a share, its PE rises to 25.

It’s not infallible. PEs were high in early 2009 because earnings were so low. Some argue that it’s best to use earnings estimates, rather than past 12 months’ earnings, to measure PE. There’s some wisdom to this: The stock market looks forward, not back. On the other hand, earnings estimates are fiction, and historical PEs are a tad more fact-based. You can get both on Morningstar’s site.

All of which brings us to the Columbia Thermostat Fund (CTFAX), created by storied value investor Ralph Wanger. The Thermostat fund adds bonds to the portfolio as the market heats up, based on the market’s price vs. long-term earnings. When stocks become cheaper, it adds more to stocks and reduces its bond holdings. The fund also has rules to prevent big swings in its holdings.

What’s the fund’s current reading? It’s got just 7.31% of its portfolio in U.S. stocks, and 2.43% in international stocks. Even by the fund’s cautious nature, that’s pretty low. Here’s how the fund’s stock allocation has varied over the years:

Source: Columbia Threadneedle Investments

The fund’s return the past 10 years has been above its category —  conservative allocation, by Morningstar’s reckoning. Nevertheless, its absolute return hasn’t been particularly spectacular. The fund has gained an average 5.35% a year the past decade, in part because it has been so conservative during bull market years.

Nevertheless, the fund serves as a useful market barometer: It’s hard to argue that most stocks are cheap now. If you’re thinking of turning up the temperature in your portfolio, you might want to take another look at the thermometer.

The monster under the bed

Alfred E. Neuman

One of the fun things about being a personal finance writer is the number of “Dear idiot” letters you get. Stories about the Federal Reserve Bank tend to get them. (“You idiot! Don’t you know the Federal Reserve is evil?”). So do stories about taxes. (“You idiot! Don’t you know that Girl Scout cookies are deductible?”)*

Inflation is another source of contention, particularly if you note that inflation has been moderate, which it has been, whether you’re using the Consumer Price Index, the GDP Price Deflator, or even the Billion Prices Project. But your perception of inflation depends on what you spend the most on. If you have kids in college or if you rely on prescription drugs, your personal inflation rate is pretty high.

Those who grew up in the 1970s and early 1980s recall when a 5% inflation rate was considered moderate, as opposed to the most recent 2.2% rate. And they fear a resurgence of inflation, with good reason: It erodes the value of retirement savings and pensions.

The consumer price index has averaged a 1.7% annual gain the past decade, and actually dipped into deflation — a period of falling prices — during the Great Recession. And the forces of deflation are still all around us: The favored tactic of technological disruptors such as Amazon, Uber and others, is to drive prices down and drive competitors out of business. This was a favored tactic of the Gilded Age, aided even further by the gold standard, which tends to favor deflation over inflation. I go on at some length about the subject here.

The Federal Reserve traditionally raises interest rates to slow the economy and cool inflation, and it lowers rates to stimulate the economy and encourage inflaton. The Fed has already nudged short-term interest rates higher five times since 2015, but rates are still extraordinarily low by historical standards. Most think the Fed is acting not out of fear of inflation, but out of fear of not having any ammunition to fight the next recession, whenever that may be.

Tomorrow’s Consumer Price Index report hits the headlines at 8:30: The consensus forecast is for a 2.1% year-over-year change for 2017. Anthing higher, particularly for the core CPI (less food and energy) is likely to make for an upsetting day in the bond market, where yields have been creeping higher and prices lower. The iShares Core U.S. Aggregate Bond ETF (AGG), a useful proxy for the bond market’s total return, has already fallen 0.57% this year, according to Morningstar.

Right now, there’s a balance between inflationary forces — a strong economy and fiscal stimulus — and deflationary ones. In the normal course of events, the Fed tightens too much during inflationary periods, causing the economy to slow, earnings to fall, and stocks to tumble. So there’s reason to watch inflation warily.

Is it time to panic? Well, no. It never is. If you’re particularly concerned about inflation, you might consider a fund that invests in Treasury Inflation Protected Securities, whose price is keyed to changes in the CPI. The current yield on TIPS shows that Wall Street expects inflation to remain at 2% the next 30 years. If you think they’re wrong, then one good pick would be Vanguard Inflation-Protected Securities Fund Investor Shares(VIPSX).

It may well be that technological changes have redefined the upper bound of inflation in the economy. Tomorrow’s CPI print is no reason to go running from the room in terror. But it’s worth keeping an eye on the monster under the bed this year.

* They aren’t, if you eat them.