There is no way to escape risk. It is a part of every day living. Crossing the street involves risk. So does leaving (or even remaining in) your home. Risk is a universal fact of life.
Being in the stock market is risky, but so is being out of the stock market. Much of the risk associated with not being in markets comes from the Federal Reserve’s willingness to create liquidity, unconscionable amounts of it. This liquidity reduces interest rates below the rate of inflation, meaning lower-risk returns are insufficient to protect against loss of purchasing power. To participate in “safe” fixed income investments is, today, a nearly certain way to increase your nominal wealth by decreasing your real (purchasing power) wealth.
Some Market History
The following chart shows the performance of the Dow-Jones since 2007:
DOW-JONES
The next chart shows the SPY, an ETF representing the S&P 500. SPY (the S&P) is a better indicator of the overall stock market than the Dow, despite the Dow’s popularity as a benchmark.
SPY
Data in both charts represent monthly data.
As seen above, the two indices are highly correlated.
Were you invested fully in SPY, your portfolio from the peak in 2007 to the trough in early 2009 would have decreased a devastating 55%. From January 1, 2007 to November 1, 2013, your portfolio would be up by 43%, even though you suffered the big drawdown in 2008 – 2009. The return is about 5.2% per year compounded. That return barely kept you ahead of purchasing power losses, as measured by the government. Whether it was enough to cover real inflation or pay for your ulcer repellant prescriptions during the period are issues beyond this discussion.
The Problem
There are few alternatives for income in the financial repression (holding down interest rates) imposed by the Fed. Those past working age are especially vulnerable to such conditions. At a time when collecting interest on savings was supposed to be the means of a happy retirement, there is no interest income. Risks are forced upon people that they should not be incurring. Even for those with large nest eggs, the systematic destruction of purchasing power for holding safe assets is unavoidable. One wag described conditions in today’s bond markets as “return-free risk.”
To step up risk by committing more than normally considered prudent to the higher risk stock market is to risk another 2008 event. Those believing that that was a once-in-a-lifetime event are either naive, young or weren’t paying attention in 2001 when the dot-com bust produced a similar decline.
The charts above are useful to better comprehend swings in the stock market. Are we at a period like January 2013 where returns proved to be both steady and unusually high? Or are we at a point like January 2008, where catastrophe lies directly ahead? These are the two extremes shown in the data. There are plenty of other points that, while not so dramatic, could be highly rewarding or painful. Mid 2011, for example, was a very bad time to enter/remain in markets.
Increasing Risk?
Wide swings appeared more frequently in the first decade of this new century. Arguably, this period was as bad as the 1930s as shown in this by returns-by-decade distribution chart:
For a more detailed discussion of this chart, see this article.
No Way To Avoid Risk
Two distinct risks are associated with today’s markets. One is the risk of losing money when you are invested and markets drop. The other risk is the opportunity cost of not being in markets when they rise.
In the current economic environment both risks have been exacerbated by the Federal Reserve. The enormous injections of liquidity have increased volatility. Furthermore, they increase the risk of being out of markets due to the risk of purchasing power loss.
Those who missed getting into the market after the 2008 bottom missed one of the great bull markets ever. The opportunity cost of missing that was enormous. On the other hand, those who were in the market at the beginning of 2008 and stayed in, got crushed by early 2009. Being wrong in either of these situations was harmful to your net worth and probably your mental health.
Asset Class Rankings
The major asset class rankings, as of November 1, are shown in the table below.
These reflect the same ranking algorithm used to rank ETFs on a monthly or intra-monthly basis. These rankings are not recommendations. They do reflect recent relative strength and weakness among major asset classes. As such, they may or may not be helpful to you in judging market sectors in terms of strengths and weaknesses.
[level-premium]
The standard equity components all rank above SHY, the cash equivalent. The two commodity-related funds continue to be unacceptable and rank at the bottom, a position they have owned for much of the year.
The rankings provide a green light for major asset classes. Remember, however, that these rankings are mechanical and backward-looking.
Both US and International markets have had good years. The US has been especially strong. Were the US rankings followed, returns would have been the equivalent of two-year’s normal returns in just ten-months. This performance reflects a lengthy up-trend in markets. The bar chart of SPY above shows 17 of the last 22 months as green bars, indicating that SPY only had five down months in this period. How much steam is left in this move before some kind of correction occurs?
I intend to reduce my exposure to current markets, probably to levels of 50 to 75% of normal. There is nothing in the rankings to suggest doing so. It is due to the growing gap between current levels and what seem justified by the economic fundamentals. But that has been true for some time and markets have continued to go higher.
Liquidity and exuberance do strange things. They don’t care about what you or I think. They will do what they will do.
ObamaCare
Increasing my concern regarding fundamentals is the disaster known as ObamaCare. The website “glitches” are inexcusable and a sign of massive incompetence. But the real impact of ObamaCare is just now becoming apparent to much of the public. It is showing up in sticker-shock and the millions losing their current insurance.
Consumer confidence and spending are likely to be adversely affected and seriously so. Higher premiums paid by individuals will cut their ability to spend on other items.
By the time the employer mandate kicks in, companies will have taken additional actions to avoid the rising costs associated with the program. These include further downward pressures on employment and employment hours. These effects will only hurt an already crippled economy.
The Conscience of a Keynesian
Those who believe in Keynesian economics (I do not) should be screaming to defer or cancel ObamaCare. It represents the opposite of a stimulus program. It decreases purchasing power, jobs and economic activity. It is not something that any Keynesian would support in slow or recessionary times.
The fact that Keynesians are not objecting to the implementation of ObamaCare in today’s economy is significant. It pits their brand of economics directly in conflict with their apparent desire for bigger government. That they abandon their principles in order to grow government is indicative of their real motives. Keynesian economics has always been a political rather than economic tool. When Keynesian economics conflicts with the politics of a situation, it is conveniently ignored. Bigger government apparently is more important than a good economy.
seems to me proof that they practice this brand of economics because it provides a vehicle to grow the size and power of government. When their form of “proper” economics clashes with their vision of government, their form of economics can be ignored.
For a Keynesian, it is difficult to imagine something dumber than launching ObamaCare in recessionary times.
[/level-premium]
