Inflation continues to be an important factor shaping the market. In the aftermath of the 2008 financial crisis, investors were primarily concerned about the economy growing too slowly. In that environment, bonds tend to diversify the risk of holding more economically sensitive stocks. In an inflationary environment, bonds face pressure from the loss of purchasing power and stocks face pressure from the risk of higher interest rates and greater uncertainty. Concerns over inflation were a key catalyst for the recent decline.
The Bureau of Labor Statistics reported the Consumer Price Index (CPI), one measure of inflation, rose 0.5 percent in January. As you might expect, the cost of some items rose faster than others. For example, energy costs rose by 3.0 percent, while the cost of food was up 0.2 percent. In total, during the last 12 months, the all-items index rose 2.1 percent. When food and energy (the traditionally more volatile sectors) are excluded, the increase was 1.8 percent.
Barron’s reported, “Leaving aside the month-to-month squiggles, the real story is that inflation is closing in on the Fed’s 2 percent target…And even if January’s rise in the CPI was overstated, a real cyclical uptrend is under way…Deflation in the prices of consumer goods we like to buy is ending; the rate of increase in the cost of things we have to buy either is rising, as for food and energy, or remains high, as for services or rent.”
Higher prices are one side of the inflation coin; the other side is higher interest rates. Inflation is one of the data points the Federal Reserve considers when determining how well the economy is performing. Rising inflation signals a robust economy. That may encourage the Fed to raise rates more aggressively during 2018 to prevent the economy from overheating. The possibility of more concerted Fed tightening helped bump U.S. treasury rates higher last week.
Higher interest rates could become a positive force for income-oriented investors. For years, persistently low rates have caused some investors to accept higher risk than they might have otherwise. As interest rates move higher, there may be opportunities to reduce portfolio risk and still generate attractive levels of income.
Key points for the week
- U.S. stocks were positive every day last week.
- Markets will remain choppy as uncertainty has climbed.
- Inflation appears to be increasing, which may lead the Federal Reserve to raise rates faster than anticipated.
- Economic growth appears to be accelerating based partly on tax reform and deregulation.
- Domestic stock markets recovered approximately 50% of the loss from the all-time highs reached at the end of January. Most stocks indexes are now 3-5% below their all-time highs and near where they ended 2017.
Two Ideas Worth Thinking About When Markets are Moving.
In general, U.S. stock indices did quite well last year and the year before. While no one can invest directly in an index, recent returns make it easy to understand why U.S. stock markets have been popular with investors. Morningstar reported record amounts of money were invested in various types of U.S. stock investments during 2017. Whenever large numbers of investors are doing the same thing, a prudent course of action is to step back, take a breath, and evaluate the situation. Here are two questions that deserve some thought:
1. Is the price or return above average or below average?
Usually, being above average is considered a positive state of affairs. That’s not the case with investing. Mean Reversion Theory (MRT) suggests prices and returns eventually move back toward the average. In other words, when annual returns are above long-term averages, they’re likely to move lower. The reverse is true, too. When returns are below long-term averages, they may move higher.
Consider the S&P 500 Index. It returned 21.6 percent last year. The historic average annual total return for the Index over the last 89 years, from 1928 through 2017, was 11.7 percent. During the last 40 years, the average total return was 11.4 percent. Therefore, 2017 returns were well above average.
That doesn’t mean 2018 returns will be below average. It simply suggests investors may be buying high. In addition to prices and returns, MRT can also apply to interest rates and price-to-earnings ratios.
MRT is the bucket of cold water that can help restore sanity when investments trade well above (or well below) historic averages.
⦁ Are animal spirits informing investors’ opinions?
Animal spirits is a term some economists use to describe investor behavior. The blog Organization and Markets explained, “The new behavioral economics literature uses the term to refer to a range of behavior which falls outside what is normally understood as rational.”
In Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters, co-authors George Akerlof and Robert Shiller said animal spirits are often inspired by ‘new era’ stories that “purport to describe historic changes that will propel the economy into a brand-new era.”
You don’t have to think very hard to remember one of the greatest new era stories ever. The story was about the future of the Internet, and it led to the dot.com bubble. The storytellers weren’t wrong. The Internet was important new technology that ushered in a new era. However, investors were so inspired they got carried away and the world experienced one of the biggest stock market bubbles of all time.
Back to Basics
It’s not difficult to identify today’s new era stories, either. Peruse the research of any bank or investment house and you’ll find captivating tales about the potential of self-driving cars, facial recognition software, space exploration, life-extending medical innovations and of course cryptocurrencies/blockchain technology.
There is no shortage of investment opportunities with the potential to deliver attractive returns. In fact, there are so many it can be easy lose sight of basic investment principles.
When you find yourself inspired by the potential of new era stories, and you consider moving more of your savings (perhaps, all of it) out of investments that have been chosen specifically to help meet your financial goals, it’s time to remember the foundational principles of investing. These include:
⦁ Defining measurable and attainable financial goals. Typically, your goals should describe what your money should do for you. Every goal should be measurable so you know if you are saving enough. Additionally, every goal should have a time frame attached. For example, a goal might be:
- A retirement income of $5,000 each month for the rest of your life
- $100,000 in savings to put toward your child’s college tuition in 14 years
- Leaving a million dollars to each of your children or grandchildren
- Providing lifetime income for a child with special needs
- Being able to afford healthcare in retirement
⦁ Developing allocation strategies to reach your goals. Choosing an asset allocation strategy and diversifying investment holdings may help manage risk effectively. Typically, asset allocation strategies blend stocks, bonds, cash, and other investments to balance risk and potential reward.
⦁ Maintaining a long-term perspective. Animal spirits often inspire impulsive investment decisions. The kind that can undermine the success of any financial plan. When market gyrations tempt you to make significant changes to your portfolio, even though your financial goals remain the same, contact your financial advisor.
The basic principles of investing remain fairly constant. Human emotion, however, is quite variable. When emotion tries to jump into the front seat and drive your investment choices, apply the brakes by evaluating MRT and animal spirits.
If you would like to talk about markets or review your financial plan, give us a call.
We have shown the survey results from the American Institute of Individual Investors many times in the past. Sentiment is a secondary indicator we monitor to determine if fear or greed start to reach excessive levels. This indicator, like the Fear & Greed indicator we showed last week, are used as contrarian signals. When markets are elevated and bullishness is also high, risk is elevated. When markets are elevated and bullishness is low, then we likely have not reached the irrational exuberance or blow-off stage we see at the end of bull markets. No indicator is right 100% of the time and we utilize this as just one of the many tools we use.
What are we reading?
Below are some areas articles we paid particularly close attention to this week. We encourage our readers to follow the links.
U.S. Treasury Collects Record Taxes The U.S. Government received a record amount of tax revenue in January. Observers have pointed to the tax reform change as a possible reason.
IRS Rejecting 2017 Returns Without Health Care Information Reported.
The IRS has said it will not accept electronically filed 2017 tax returns that do not report on the taxpayer's compliance with the individual mandate provisions of the Affordable Care Act (ACA). The IRS did not reject such returns for 2016 after President Trump issued an executive order that directed federal agencies to waive, defer, or delay the implementation of ACA provisions that imposed penalties or fees. The Tax Cuts and Jobs Act reduces the amount of the penalty, or Shared Responsibility Payment (SRP), to zero for months beginning after 12/31/18, but for 2017, the IRS says that it won't consider an electronically filed tax return complete and accurate if the taxpayer does not report full-year coverage, claim an exemption, or report an SRP on the return. The IRS's statement can be found at www.irs.gov/tax-professionals/aca-information-center-for-tax-professionals.
RIDISULOUS? SILLY? STRANGE? SOME IDEAS MAY SEEM THAT WAY.
Albert Einstein is famous for having said, “If at first the idea is not absurd, then there is no hope for it.” In recent weeks, Fast Company has reported on some “world-changing ideas,” including:
⦁ Teaching happiness in school. The mandate of a school being built in India will be teaching children how to be happy. One of the co-founders said, “It’s our view that happiness – or emotional intelligence, or balance, or confidence, or self-esteem, or any other word for feeling good about ourselves and our place in the world – is the foundation on which great lives and great achievements are built.”
⦁ Cancelling student debt. “Collectively, [Americans] owe nearly $1.4 trillion on outstanding student loan debt. Research shows that this level of debt hurts the U.S. economy in a variety of ways, holding back everything from small business formation to new home buying, and even marriage and reproduction,” according to a February report from the Levy Economics Institute at Bard College.
The research estimates if the U.S. government purchased and cancelled student loan debt the U.S. economy would increase real gross domestic product – the value of all goods and services produced – by $861 billion to $1.083 trillion over 10 years. Also, the step could lead to the creation of more than a million new jobs every year.
⦁ Revitalizing Haiti with blockchain. The details are still being hammered out, but the Blockchain Cotton Project hopes to use distributed digital ledgers (blockchain) to manage supply chains, making it easier and less expensive to source organic cotton. One member of the project said, “We’re still figuring out how the farmers do the live reporting. But we hope it will replace the normal organic or fair-trade certification through a radical transparency approach.”
Story of the week
Olympian overslept after Netflix binge and still won gold
Olympic athletes are some of the most determined people in the world. They follow rigorous training schedules in the hopes of winning medals for their country. But U.S. slope snowboarder Red Gerard is so good, he figured, why bother? Gerard overslept the morning of his competition after binge-watching Netflix. He also lost his coat. But his roommate let him borrow his, and Gerard won gold for the U.S. anyway. USA! USA! USA!
Weekly Focus – Think About It
“The function of education is to teach one to think intensively and to think critically. Intelligence plus character – that is the goal of true education.”
~Martin Luther King, Jr., American Baptist minister and activist
"Decisions determine destiny."
~ George Patton, General U.S. Army
“Beginning today, treat everyone you meet as if they were going to be dead by midnight. Extend to them all the care and kindness and understanding you can muster, and do it with no thought of any reward. Your life will never be the same again."
"He who moves not forward goes backward."
~ Johann Wolfgang von Goethe, Poet
Links & Disclaimers
RJFS and SPC do not offer or provide legal or tax advice. Tax services and analysis are provided by the related firm, S&M through a separate engagement letter with clients. Portions of this newsletter were prepared by Carson Group Coaching. Carson Group Coaching is not affiliated with RJFS, SPC or S&M. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. This information is not intended as a solicitation of an offer to buy, hold or sell any security referred to herein. There is no assurance any of the trends mentioned will continue in the future. Any opinions are those of the author and not necessarily those of RJFS. Any expression of opinion is as of this date and are subject to change without notice.
Opinions expressed are not intended as investment advice or to predict future performance. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. Investing involves risk, including loss of principal. Consult your financial professional before making any investment decision. Stock investing involves risk including loss of principal. Diversification and asset allocation do not ensure a profit or guarantee against loss.
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