Time For A Risk Check?

It’s been a rocky start for 2016, continuing the choppiness that started in August. US stocks as measured by the CRSP US Total Market Index are down roughly 5% since the beginning of the year and almost 9% since the last market peak on June 22nd.

Given a US economy that is strong enough for the Federal Reserve to begin raising rates, one might logically wonder what happened to throw the stock markets into such disarray? In short, a bad bet by China, rapidly falling oil prices, and mounting expectations that stocks were due for a fall.

China, a relatively new and arguably inexperienced player on the global markets, last year began experiencing a slowdown in its economy likely more severe than they were letting on. Then in late November, for reasons economic historians will probably question for years, the International Monetary Fund (IMF) added the Chinese yuan to its elite basket of global reserve currencies, putting the Chinese yuan on the same footing as the US dollar, the Japanese yen and the British sterling.

In the words of Lingling Wei and Anjani Trivedi of the Wall Street Journal, such credibility for its currency, “Chinese officials believed, gave them the ability to shift priorities from bolstering the yuan in the eyes of the world to enlisting the yuan in the national effort to stimulate the slowing economy, according to interviews with more than a dozen Chinese officials and advisers to the central bank.”

“Steps they could have taken to increase the ease with which the rest of the world dealt in yuan were put on hold. Instead, the authorities have embarked on a perilous path of trying to gradually weaken the currency to help make China’s exports relatively cheaper in foreign markets, these people say.”

“The massive risk inherent in that strategy became painfully apparent this week, gathering momentum Thursday and hammering global markets from stocks to commodities. The reason: The People’s Bank of China’s efforts to steer the currency lower were pounced on by investors who sold in droves, effectively engaging the central bank in a titanic struggle over who gets to control how far and fast the yuan declines.”

According to Wei and Trivedi, traders and investors around the world were left with two possible interpretations of the Chinese central banks’ intentions – as a sign that China’s economy is slowing more precipitously than many expected, or as an indication that the Chinese leadership isn’t on top of how to deal with it. The last upset to global markets occurred in August with another mismanaged government stock-market rescue. Like it or not, markets are becoming more and more closely tied to one another.

Meanwhile, oil prices went into a power dive this week taking prices to $33.27 a barrel, a level not seen since 2004. While experts were concerned about going below $40 just days ago, the new threshold is now $30 with plenty of reasons to expect it to be breached, making $20 a distant possibility. China is the world’s second-largest consumer of oil. Producers in the US and Mideast continue to pump oil at rates far exceeding demand. And the deepening rift between Saudi Arabia and Iran give concern to their ability to manage production and to control prices.

Low oil prices are great for consumers and in the long run will be healthy for our economy. Consumers will have more discretionary income to spend when less money goes to gasoline and home heating and cooling. The cost of manufactured goods and of plastics falls. And municipalities spend less providing services and building roads.

But fast drops in oil prices and oil company revenues do not give managers time to adjust strategically. The energy sector represents over 14% of the US economy. A dramatic drop in jobs and investment could cause short-term damage to the overall economy, given the relative slowness of our overall economic growth.

Still, the jobs report today shows continued strength. Non-farm payrolls increased a seasonally adjusted 292,000 in December, according to the Labor Department. The unemployment rate remained at 5% last month, but hasn’t been below that mark since 2007. It’s likely the Fed will see this strength as sufficient to continue their new policy of gradually raising interest rates to end their unprecedented accommodative money policy.

Lastly, the markets were ripe for a fall. Since taking off on March 9, 2009 after the worst stock rout since the Great Depression, and ending with their latest peak June 22nd, stocks as measured by the CRSP Total US Stock Market, the S&P 500, and the Dow Jones Industrials were up 270%, 214%, and 177%, respectively. Since June 22nd however, they are down 9% as measured by the Total US Stock Index and 7.5% as measured by the Dow.

Odds of stocks losing money in any one year are 1 in 3.9. Statistically speaking at nearly seven years, we were overdue. But that’s just statistics. It’s not a prediction, and you know we don’t do those.

What we do, however, is build portfolios to withstand the severe storms that crop up every 3.9 years. So this is a good time to take a look at how they are doing. We don’t spend the thousands of dollars required to advertise our performance, so I will be using the indexes, rather than actual portfolio performance, in the following examples. They are gross returns too, so actual annual client returns would be lower by our fee and the cost of the portfolios – ranging from .8% to 1.3%. I use the Dow Jones Total US Market for comparison because the index we use was started after the earlier study date.

The point, not to be lost in all the numbers below, is that your portfolio results are not as bad as the TV news would lead you to imagine. While stocks have declined 9% since their June 2015 peak, our typical client portfolios have declined a more comfortable 1.2% to 6%. The extensive risk diversification of our large stock indexes serve to mitigate some of the volatility risk of stocks, but the most significant support has come from 7-10 year US Treasury Index. Since June of last year, the index is up just under 3% to buoy portfolios – this despite the Fed’s program to increase rates.


The number following the word “Beacon” in the chart above represents the index’s allocation to stocks. As the stock allocation declines, the Treasury and cash allocations rise commensurately. Our model portfolios very closely track these indexes (less fees and ETF expenses). There are three date periods included: The market trough in 2009 to it’s latest peak in June of last year, the June peak to now, and the trough to now.

The third column is very instructive because it shows how  returns of each of the portfolios (indexes) begin to tighten. The aggressive or all-stock falls considerably, while the more conservative falls more slowly, and may even rise during prolonged market declines. If the long term average for stocks is 11.5%, doesn’t it make more sense to be in a portfolio like the Beacon 45, 60, or 70 that offer similar returns with far less risk of six-month double digit drops as recently experienced by the 80, 90, or 100%. More to the point, we find that many of the prospective client portfolios we review behave more like the 80, 90, and 100’s. The go-go portfolios are fun when stocks are rising, but the piper demands a high payment in times like these. It pays in sleep and wealth to take no more risk than is absolutely required to meet your goals. That’s where we specialize.