Has the Fed created a Madoff market?

We are now experiencing the fifth most powerful bull market in stocks since 1900. The Federal Reserve, through its quantitative easing program, has lowered interest rates to near zero, thereby forcing investors to search for income in nontraditional places. In response, dividend yielding stocks and high yield “junk” bonds have soared in price. If you review the trajectory of the S&P 500 over the past year, it appears that the market is advancing without any significant corrections.

The market continues to shrug off risks. Despite poor economic data, decelerating growth in China, still unresolved European debt woes, and increasing tensions between Russia and her neighbors, the market continues on its march upward. The only data the market seems to respond to are signals from the Federal Reserve that they may increase interest rates. For now, the stock market assumes that new Federal Reserve Chair Jerome Powell “has its back.” The dovish Powell appears to be an advocate of an accommodative policy through 2018.

Investors can become complacent believing that this pattern will last indefinitely. To wit, the flow of money into stock funds reached an all-time high in 2013-2017 as memories of the crisis of 2008 faded. The belief that market gains can be achieved consistently with no apparent risk of correction is not only naive, but dangerous. Investors in Bernie Madoff’s fund were likewise transfixed by the steady, impressive returns that seemed to move with no correlation to the financial markets. Sometime when things seem to be too good to be true…..
We only need to look back to the more recent examples of complacency and calls of “this time it’s different,” to remind ourselves of the dangers that can result from this mentality.

In the 2000 tech implosion, the market finally came to the reality that stocks with non-existent earnings and lofty prices were not necessarily a good buy. We were told that “earnings did not matter” and that this was “the new paradigm.”

In 2007, when everyone was buying second homes, flipping “spec” homes, and loading up on a McMansions they could not afford, the party line was that, “housing is an investment that never goes down in value.”  The financial crisis was created in part due to this mentality, and we are still feeling the painful repercussions.  In this article , Peter Schiff discusses the implications of the massive debt the US has incurred post 2008.  He states,

America is trying to borrow its way out of recession. We are creating debt now in order to push up prices and create the illusion of prosperity.

He opines further that:

 “The red flags contained in the national and global headlines that have come out thus far in 2014 should have spooked investors and economic forecasters. Instead the markets have barely noticed. It seems that the majority opinion on Wall Street and Washington is that we have entered an era of good fortune made possible by the benevolent hand of the Federal Reserve. Ben Bernanke and now Janet Yellen have apparently removed all the economic rough edges that would normally draw blood. As a result of this monetary “baby-proofing,” a strong economy is no longer considered necessary for rising stock and real estate prices.”

It is important for investors to remind themselves of the following:

Markets are cyclical

Corrections are normal consequence of business cycles:  We can’t predict when they will occur, but we should prepare mentally for their eventuality.

Market timing is extremely difficult.

Who would have predicted that in 2013 the S&P 500 would increase over 30%?  This occurred despite the debt ceiling and budget showdowns, sluggish economic growth, and other geopolitical events.  Few if any analysts, predicted this incredible performance, giving further credence to the notion that the so called “experts” are not particularly prescient.

Chasing performance can lead to pain

Investors have a tendency to pile into segments of the market that have recently performed well , buying more of the recent winners and eschewing the “dogs” that underperformed.  But short term performance is not indicative of longer term returns.  Overexposure to one asset class, say large-cap US stocks, will reduce your portfolios diversification, thereby increasing the overall volatility of your investment mix. Discipline in the form of rebalancing would be a better tactic. In this related article, Craig Israelsen discusses this behavioral tendency and how it can be avoided through proper diversification.

Looking at traditional measures of valuation, the current stock market is overvalued.  According to John Hussman, current valuations suggest that equities are poised to deliver paltry returns of roughly 2.3% before inflation over the next 10 years.  Even the Fed’s own Richard Fisher, president of the Federal Reserve Bank of Dallas, recently said he was concerned about “eye-popping levels” of some stock market metrics warning that the Fed must monitor the signs carefully to ensure bubbles were not forming.

In irrational times like this, it is important to maintain perspective; we don’t know exactly what the stock market will do in the short run.  We can’t control inflation, taxes, political turmoil, the weather, our health or major geopolitical events.  We must instead focus on the things we can control like the following:

Our emotions– It is essential that we have a portfolio of investments that we can stick with through thick and thin.

Review your investment policy statement that was prepared as part of you plan; and specifically; revisit the potential decline for your investments based on your target allocation to the stock market to see if it is still palatable

Rebalancing –After a large market advance, it is important to prune our winners and reinvest proceeds in losing asset classes.

Most recently, that would mean selling stocks and buying bonds. While this is counter to our  behavioral instincts, it is a powerful way to maximize long-range investment returns.

Costs–Given that future stock market returns are likely to be lower, costs becomes especially important.

Employing no-load, passive, low-cost funds and ETF’s will help maximize your gains.  The money you save due to low fees will compound for you over time.  This has an exponential effect on the growth of your portfolio.  Costs are reflected in your funds’  expense ratios.  Low cost investment advice helps to further reduce the overall cost of your investment management.

Diversification–resist the urge to follow performance and load up on yesterday’s star asset classes

Just because US stocks have been stellar performers doesn’t mean that this will continue. We never know in advance which portion of the portfolio will be the star performer. As this periodic table of asset class performance indicates, the stars of one year can easily turn to dogs the next. It is also important to remember that cash, CDs, and high-quality bonds, while they possess frustratingly low yields, are still an essential component of your portfolio, as they act as shock absorbers in periods of market turmoil.

Risk– if you’re planning to retire in the next five years or recent retiree, you may want to adjust your portfolio to position yourself more conservatively.

Recent studies suggest that minimizing your exposure to stocks, five years before and five years after retirement  and then increasing your stocks allocation slowly over time, may be a prudent way to maximize spending in retirement as well as avoid outliving your funds.

In summary, the market over the past few years may convince you that risk will be rewarded with little chance of loss. But remember, what goes up must go down, and invariably, a tipping point emerges that changes the course of the market.  History does repeat itself.  Be realistic and stick to a prudent plan so you are well equipped to weather any market storm.

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