Lots of cash and animal spirits: What could possibly go wrong?

If you’ve ever been to a particularly raucous New Year’s party, you know that there’s a logical progression from the first awkward arrivals and introductions until you’re sleeping in a car full of raccoons and empty Cheetos bags.  And, at the time, each step makes wonderful sense.

Right now, the markets are at a spot where spirits are high and cash is flowing like liquor at your broker’s annual Christmas party. Let’s take a look at the animal spirits first.

University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

 University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

As you can see, consumer sentiment has been rising since the dark days of 2009; it now stands at 98.2 — the chart is lagged by a month. Sentiment is now higher than it was in January 2015 (98.1), and the highest since February 2004.

Soptimism-graphmall business confidence is also up post-recession, but it jumped markedly after the election, presumably on the hopes of lower taxes and regulation by the new administration.

And that confidence — plus the 12% gain by the Standard & Poor’s 500 stock index this year — has sparked optimism among investors. The American Association of Individual Investors sentiment survey now stands at 45.6% bullish, vs. its 38.5% historical average. Similarly, just 25.7%  of those surveyed said they were bearish, vs. a historical average of 30.5%. Bullish sentiment is at a five-week high, and its third-highest level of 2016.

At the same time, there’s plenty of money on the sidelines, and some of it appears to be returning to stock funds. In the last week of 2016, investors poured an estimated $118 million into U.S. stock funds. But that’s a piker compared to the previous week, when an estimated $18.6 billion flooded — more than the previous 24 months combined, according to the Investment Company Institute, the funds’ trade group.

As of the end of November, there was $2.7 trillion in money market mutual funds, earning approximately zilch. A roaring stock market provides a great deal of temptation for at least some of that money.  Stock funds had about 3.2% of their assets in cash, which is not particularly high, and that figure’s usefulness has been eclipsed somewhat recently.

Another potential source of cash: Companies in the S&P 500 have a record $1.5 trillion in cash cooling its heels on their balance sheets. They can use this for buying back stocks, paying dividends, or — and this is crazy talk — reinvesting in plants, equipment and their own employees.

The bad news is that the stock market is already expensive. The S&P 500 sells at about 24 times earnings, as opposed to a historical norm of about 17 times earnings. S&P predicts that earnings will rise through 2017, bringing down the PE ratio to about 18. Bear in mind that forecasts are notoriously unreliable, particularly when they’re about the future.

Bear in mind, too, that the Federal Reserve is likely to continue to raise interest rates, and at a faster pace if the economy grows faster than expected.

Right now, it looks like animal spirits and plenty of cash will keep the market party going, and that can be good, clean fun. Enjoy the ride. Just remember that market rallies always last longer than a sober person would think. But remember that many things must go right for the rally to continue. It’s probably a good time to readjust your portfolio back to your original goals. No one ever went broke taking a bit of profits.





Greetings from Lacunaville

SDSC_0368tarting in January, I’ve been writing full-time for InvestmentNews, doing a monthly column for Money magazine, and studying for the Certified Financial Planner mark. (This, apparently, is also a test of your prowess with a hand-held calculator). And I went to Africa.

The blog, as you may have noticed, has, um, languished. I’m hoping to revive it on a somewhat irregular basis, which, come to think of it, is pretty much its usual schedule.

I’ll be updating my links pages in the next week or so. In the meantime, here are some things to watch for today, as well as some things I’ve found interesting or peculiar.

This week, all eyes are on the Bureau of Labor Statistics’ employment situation report, out at 8:30 a.m. Friday. But the stock market seems to be resigning itself to an interest rate hike, probably in June or July. (A later hike would give the impression of a political motivation, and the Fed generally doesn’t like to do that). The current consensus estimate for new nonfarm jobs is 158,000, according to Bloomberg, with the unemployment rate falling to 5%. (And, yes, the total unemployment rate is still high, but it’s the nonfarm payrolls number that Wall Street watches.)

Wages also seem to be firming up, and it should be interesting to see if traditional summer employers, such as ice cream vendors and lawn mowers, have a hard time finding help this year. All of these would seem to give the green light to the Fed to raise rates.

Of course, we’d be talking about a lordly fed funds rate of 0.5% to 0.75% after a Fed hike, an increase that will be promptly reflected in your credit card bill and eventually in your money market mutual fund account. For those who still watch their money fund account, the average money fund now yields 0.10%, nearly triple its rate at the start of the year.

DSC_0353The stock market typically dislikes interest-rate hikes. Higher rates mean bonds become more competitive with stocks, and increase short-term borrowing rates. On the other hand, higher short-term rates mean that companies will earn somewhat more on their cash, and that savers will earn slightly more on their cash.

The old adage about Fed rate hikes — three steps and a stumble — meant that the stock market takes the first two hikes as a sign that the economy is improving, and rallies. At the third hike, stock investors realize the Fed wants the economy to slow, and stocks sell off. Bear in mind that the adage originated when a normal fed funds rate was 4% to 5%. It would take a stairway, not a few steps, to get us back to the traditional stumble level, assuming the Fed raises rates at a quarter-point a pop.

I’m an optimist, and think that rising earnings are a good thing — in fact, the one thing that the economy desperately needs for sustained growth. Most companies, despite their complaining, have nice profit margins, good balance sheets, and plenty of cash. They might even be surprised to learn that when their employees get raises, they spend more — and even on the products their employers sell.

DSC_0488The one caveat: Stocks aren’t cheap, at least by the price-to-earnings ratio of the Standard and Poor’s 500 stock index. The current PE, based on forward earnings estimates, is 17 — a tad feverish, although nothing like the levels during the technology bubble. Nevertheless, at these levels, it’s a bit like driving a bit too fast on old tires. If the market takes a rate hike really badly, investors could find that both bond and stocks slide off the road. And in that case, having a bit of cash in a money fund might be a good safeguard.


How the naive are faring

You could line up all the advisers from here to Albuquerque, and you still wouldn’t reach a conclusion as to the best diversified portfolio for your retirement savings.

Because of that, many investors simply use the 1/n portfolio — which is to say, they divide their money equally among all the options in their 401(k) plan. Among those who study these things, this is called the Naive Portfolio.

What would a Naive Portfolio look like? Most 401(k) plans are not exactly paragons of fund-picking: They often choose the largest funds. After all, those funds typically have decent long-term records and low expense ratios, and no one is going to get sued using those criteria.

Let’s compose a naive portfolio of the 10 largest mutual funds. It would look like this, ranked by size:

Tot. ret. Tot. ret.
Fund Ticker Category 2015 5 years
Vanguard Total Stock VTSMX Large blend 2.37% 13.98%
Vanguard 500 Index VFINX Large blend 2.89% 14.23%
Vanguard Total Intl Stock Idx VGTSX For. large blend -2.35% 3.30%
Vanguard Total Bond VBMFX Interm. bond 0.68% 2.86%
Growth Fund of Amer A AGTHX Large growth 6.98% 13.78%
Europacific Growth A AEPGX For. large growth 1.57% 5.49%
Vanguard Prime MM VMMXX Money market 0.03% 0.03%
Fidelity Cash Reserves FDRXX Money market 0.01% 0.01%
JPMorgan Prime MM VPMXX Money market 0.01% 0.01%
Fidelity Contrafund FCNTX Large growth 7.93% 13.87%
Average 2.01% 6.76%

Source: Morningstar.

So how did our naive investors do? At least this year, they have done pretty darn well. The average expense ratio in this portfolio is 0.35%, which, honestly, you can’t beat with a stick.

Furthermore, a 2% return is just a shade lower than what you would have gotten with a single investment in the Vanguard Total Stock Index fund. And you would have gotten that return with far less risk than a pure stock index fund, given that 30% was in money market funds and 10% in bonds.


Just how successful a naive investment would be over the long term is a more difficult calculation, which I’ll tackle in future posts. But the takeaway is that naive diversification is probably better than no diversification at all.




Cash is never trash

For nearly a year now, pundits have been describing the U.S. stock market as “the least dirty shirt in the closet,” “the least bad-looking market,” “squeakier than a bowl of mice.” Ok, they didn’t use the last one. But the general implication is stocks may be expensive, but hey — they’re not bonds and they sure aren’t cash.

cashYou may have noticed, however, that cash looks increasingly attractive this week. While you’re earning an average 0.02% a year on your money market fund, that’s generally better than losing 1% to 2% a day on your stock fund.

Think of it this way: The average large-company blend stock fund is down 4.26% the past month. If you had 30% of your portfolio in cash, and 70% in your basic large-company stock fund, you’d be down 2.98%. While no loss is good, smaller losses are always better than larger ones.

More importantly, you would have an easily accessible buying reserve for stocks that seem ridiculously cheap. Finding values is more than buying whatever’s on the new low list. But if you can find a good stock that’s selling at a 20% discount or more, then this is a good time to think about buying.

Just recently I posted a list of companies in the Standard & Poor’s 500 stock index that are selling for 20% or more below their 52-week highs. That list has only grown since then. As of yesterday, 141 stocks, or 28% of the S&P 500, were below their 52-week highs. Among the more interesting entries to the 20% discount club:

  • Asset managers. Franklin Resources is down nearly 30% from its 52-week high, and it has now been joined by Legg Mason and Genworth.
  • Luxury goods. Coach is now nearly 60% below its all-time high, and Fossil is 56.5% below its all-time high. Michael Kors is nearly half its 52-week high.
  • Railroads. Union Pacific, CSX, and Kansas City Southern are all at least 20% below their 52-week highs.

The two biggest areas that are getting clobbered are energy and technology stocks. The problems in energy are obvious: Oil is down more than 50% from its recent highs.

The problems in tech are not quite as clear, although the weakness in the Chinese market seems to be the easiest answer. But some tech stocks seem tempting at these levels: Intel sells for just 11.3 times expected earnings, and pays a 3.4% dividend, to boot. Applied Materials sells for 12.3 times expected earnings and yields 2.5%. And Sandisk sells for 12 times forward earnings and yields 2.3%. If you have the cash — and the tolerance for tech stocks — these might good places to nibble.

The Amish portfolio

One of the biggest arguments I hear for having a professionally managed account runs like this:

“Hey, it’s a big, complex world. You have so many investment choices: Emerging markets bond funds! Long/short funds! Bank loan funds!You need me to tell you what to invest in, because only I can figure out the right proportion of all these funds for you.”

What’s not usually mentioned, of course, is that much of this complexity is an invention of the financial services industry. No one ever went broke because they didn’t have 2.3% of their portfolio in a long/short fund. Did you miss the runup in REITs last year? Most managers did, too.

An Amish buggy in Lancaster, Pa.
An Amish buggy in Lancaster, Pa.

There are plenty of good reasons to hire professional financial help, but this big old complex world really isn’t one of them. In fact, there’s virtue in Amish-like simplicity. You can construct a low-cost, extremely diversified portfolio with three funds.

We’ll use Vanguard funds because they’re cheap. You could probably construct a similar portfolio with offerings from other companies, although you might not be able to match on cost. The portfolio:

* 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: 54.1% North America, 22.1% Europe, 14.2% Pacific, and 9.4% emerging markets. Cost for the investor shares: 0.27% a year, or $2.70 per $1,000 invested.

* Vanguard Total Bond Index fund (VBMFX). You get broad exposure most types of U.S. bonds. Current yield: 1.9%. Cost: 0.20%, or $2.00 per $1,000.

* Vanguard Prime Money Market. Hey, it’s a money fund. It yields 0.02% after its 0.2% expenses.

That’s it. A conservative mix would be 60% Total World Stock, 20% Prime Money Market and 20% Total Bond Index. You can adjust your stock portion up or down, depending on your risk tolerance. Rebalance whenever the stock portion is 10 percentage points higher or lower than your target.

If you want to add other funds to this basic portfolio, go right ahead. But as any Amish person would tell you, the more you tinker with it, more likely it is to be a little buggy.