Category: Economics & Investing

Investors are well aware that financial markets go up and down.  That is the essence of business and economic cycles.  What is difficult for individual investors to master is how to act in the face of market advances and declines.  Unfortunately, most people become very tolerant of risk and increase their exposure to the stock market when the market is advancing.  Similarly, they avoid risk and clip their exposure to stocks when markets are declining, or after a large correction.  It is human nature and “recency bias” that create this visceral response to market perturbations.  Recency bias occurs when investors believe that the most recent performance of their investment portfolios will continue indefinitely in the future.  It is just one factor that results in investors consistently underperforming the stock market.

Brad M. Barber  and Terrance Odean, in their 2011 study “The Behavior of Individual Investors,” conclude that individuals routinely underperform benchmarks through 1) selling winning investments and holding losing investments, 2) being heavy influenced by most recent past returns (repeating investment behavior that coincides with pleasure and avoiding behavior that is painful), and 3) holding undiversified portfolios.

Dalbar studies have also shown that most individual investors typically trail the market rate of return, and they typically do so by a fairly wide margin.

The message from Dalbar since its first study in 1994 is that investment results are more dependent on investor behavior than fund performance and that mutual fund investors who tend to buy and hold are more successful than those who attempt to time the market.

Investors who attempt to time the market are often acting irrationally out of fear of a potential loss. Stocks and investment funds happen to be the only assets that people buy less of when they become less expensive. Let’s think about buying food at the supermarket, if the price of steak rose considerably, you would be more inclined to reduce your purchase of steak or buy something else, but if the supermarket suddenly reduced the price of the steak by 30%, you would stock up. However, you do the opposite when it comes to stocks and other investments. The stock market can foster a gambling mentality. When you are on a roll you hate to stop, but that is exactly when you should cash some chips in.

So how does an investor counteract the tendency to time the market and invest based on most recent results? Rebalancing is great way to fight the effects of recency bias. Rebalancing to your target asset allocation is a mechanistic and unemotional way to fight these counterintuitive emotions. I sometimes get an odd look from my clients when I suggest that they rebalance after a market run-up. “Why would I want to do that, the market is hot?” might be a typical comment. But that is exactly why rebalancing is so important. It removes the emotions, market noise, and other extraneous factors, and reminds the investor of their original financial plan and goals.

The best value-added proposition a financial advisor provides is to set the target allocation and then monitor and adjust it based on the client’s personal goals and life events. The asset allocation is set within the investment policy statement and the portfolio is rebalanced yearly, or as needed, after large market advances or declines. The asset allocation is revisited periodically, at least every 3 years, and is adjusted in response to a client’s retirement goals, change in health or marital status, or market valuations.

Rebalancing in this way, will not only help the client attain rates of return closer to the respective benchmarks for his or her portfolio, it can actually be a source of additional return. In a recent article in Financial Planning magazine, “Portfolio Rebalancing: Get It Right,” Allan Roth underscores the incremental benefit of rebalancing. His analysis shows that “over the past 15 years, the portfolio that stuck to its allocation earned 1.54 percentage points more each year than the average portfolio that tried to time asset classes.”

Rebalancing is just one area where advisors add incremental return and why it is essential for our clients to commit to the annual review and rebalance exercise. Emotions can be hard to control, let your re-balancing take them out of the mix, so you can maximize your long range returns.

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Can We Still be Smart Investors?

Any other week would be a better one in which to write a financially-themed article. While this article will be in the November issue, the context from which I write is immediately following the announcement that the House of Representatives voted NO on the Bailout plan. We all know that this sent the stock market tumbling, causing many people to feel fear— perhaps the first real time in our generation’s adult life (except maybe some from the dot com bust but that was “fun money” before we had families!!).

While a revised Bailout Plan will likely pass and a few more banks may fall by the time this is published, the events of the past few weeks have made many people question whether or not they are handling their money the “smartest” way.

As a fee-based financial planner who does not manage portfolios, I cannot recommend individual stocks or funds to buy and sell. Nor do I think that will help the families with whom I work at this juncture. I can, however, help you take a macro-perspective on what is smart for you and your family.

“Smart” begins with the basics:

  1. What is your family’s vision and what are you creating?
  2. What is your relationship with money? How do you handle fluctuations? How anxious are you?
  3. What are your financial goals? When do you need the money?

VISION:

You’ve heard me say it time and time again if you read my column with regularity. What is the life you want to create for your family? What does it look like? How do you define success?

Are you living in a hillside cottage with a large yard or do you have an apartment with a home in Tahoe? Do you pick a new country to visit with your children every year? Do you want to settle into a community where you will root for the next 20+ years? Do your children walk to the locale public school or will they be attending a private school?

The vision you create for your family trickles down to the types of investments you make also called an investment vehicle (such as stocks, bonds, mutual funds). Before you can decide into which vehicle you will invest, you need to know for what you want the money.

YOUR MONEY PERSONALITY:

A fascinating area of financial planning is how people relate with money. This alone can fill pages upon pages of articles and keep me reading for weeks (I am endlessly intrigued by this topic). At the very fundamental level, you have to know what is commonly talked about in the financial planning world as your “risk tolerance.” I find that concept hard to grasp, so with my clients I like to hear more about what keeps them up at night. What makes them anxious?

Is it any negative movement in a 401k or is it not having enough money in cash in a savings account? Do they ride out the drops like the one on Sept 29th with grace and ease saying “it’ll come back” or “this is expected” or do they run for the bank and hide their money in their mattress? Everyone is different and understanding your level of anxiety with investment fluctuations is an imperative input factor to deciding how to invest.

YOUR FINANCIAL GOALS:

Taking your vision and translating it into financial goals is where I find the financial planning process helps the couples with whom I work the most. This makes the softer airy vision a dollars and cents reality. Smart investing requires that you know:

The amount the goal will cost
The Time horizon over which you are investing (that is, when do you need the money)?
The amount of money you are starting with for the goal
The amount you are contributing along the way

All of these factors will let you know what the return you need for your money will be. To say that another way, it will tell you how much you have to make each year on the investment to reach the goal. And different investment vehicles offer different possibilities for returns. Holding investments in cash will probably stay within a few % points, while stocks can jump all over the chart — in both directions. To get higher returns, you also will take on higher risk. The return you need combined with your personal tolerance for fluctuations will determine the investment vehicle.

For example:
If you already have $100,000 that you want to put toward a home down payment in one year, you only need a very conservative investment vehicle. Keeping that cash in a money market account would give you the best assurance that your money will be there when you want it.

I see many clients who come to me with next year’s house down payment in stocks or equity mutual funds. Perhaps that is how they built up the money or maybe they just like to participate in the market. In a week like the ones of late, however, a portfolio may drop 10%, making a $100,000 down payment now a $90,000 one. For the exceptionally daring individual, this may be okay, but as a financial planner, I advise people to match their investment vehicles with their time horizons.

If you want access to your money soon, keep it in a cash-equivalent vehicle. This way the market can jump all over the place and you can rest assured that you have what you need when you need it (caveat from the recent events: up to the FDIC insured limits of $100,000 – or more if you set up a certain kind of account designed to expand this limit) . The longer you have before you need the money, the more fluctuations you can likely tolerate. So while you may not be thrilled that your 401k invested in a mix of mutual funds, for example, has decreased, you will likely have more tolerance if you do not need the funds for another 30 years.

PARTNER FOR SUCCESS:

Granted there are those among us who will feel compelled to switch to other asset classes if ours are not performing just because of their personality and risk tolerance. Whether or not this is the smart way to go depends on your personal situation only. To help you handle the next bump, I encourage you to be prepared to act with knowledge and not emotion. The best way to do this is to partner with a financial professional who can help you ride out these rough times and stick with a “system” that works for your anxiety level and your goal achievement timeline. With a plan in place, you can approach the times when everyone else seems to panic with the desired calmness that comes with real knowledge of your own smart investing strategy.

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The economy appears to be making strides as it emerges from critical condition and enters into rehabilitative mode. Some positive signs include increasing bank lending, auto sales, and consumer confidence. Unemployment is also declining, especially for skilled labor. Both the US budget deficit and state budgets are improving. Corporate infrastructure such as plants, buildings, and equipment are overdue for upgrades, suggesting substantial future increases in capital expenditures.

Headwinds from the Euro debt crisis have subsided to a large extent, with credit spreads collapsing. In fact, spreads seem unusually tight given that Spanish bond yields are currently lower than US Treasury yields. This is quite unusual, and likely due to the European Central Bank’s announcement that they will engage in more aggressive monetary easing policies to halt disinflation and spur growth.

Japan and China are still muddling through their own economic malaise attempting to establish equilibrium. In short, the global financial landscape seems eerily quiet, especially given the growing geopolitical pressures. Increased tensions in the Ukraine, civil war in Iraq, and continued presidential scandals have failed to disrupt financial markets. The US stock market, in particular, is experiencing reduced volatility. We are now going on almost three years with no correction of 10% or more (since August of 2011).

The current situation reminds me of my garden. This year I made a vow to finally grow vegetables. I decided to start with something easy and small. I filled a cement container with soil and compost and planted two tomato plants. The plants grew tall quickly; and before I knew it, I had about 15 shiny green tomatoes. I was so excited that I started to plan my recipes, who I would share my bounty with, and what I was going to add to my garden next year. Then one day when I went to check my plants; I found a shriveled up tomato and one that had brown rot on the bottom. Uh, oh. I researched the disease online and now realize that I may not be able to save my tomatoes. I am taking steps to reduce the risk of further rot, but I am concerned that I may be fighting a losing battle.

I may lose a lot of my tomatoes, or I may be able to minimize the losses and still have plenty of tomatoes for weeks to come. The same may hold true about the financial landscape. Although the economy is starting to improve, the stock market seems to have gotten a bit ahead of itself. The market appears frothy, with little room for future growth, but a correction may come in days, months, or maybe years.

Why are stocks and investors so complacent?

The Fed Reserve’s policy of printing money has resulted in a massive increase to their balance sheet from $800B in 2007 to over $4.5T today.

This massive flood of money into the system has drastically devalued the dollar and has forced investors to put their cash in riskier investments. This has been the main reason for the overly ebullient markets since the Great Recession of 2008. In this zero interest rate world, desperate retirees and savers are reaching for yield in risky areas of the market in order to get more return on their money. This has resulted in overvalued fundamentals. Valuations are rich for US equities using metrics that have traditionally been highly correlated to market performance.

Using the CAPE (Cyclically adjusted PE) ratio developed by Robert Shiller from Yale University, the market may be signaling that US stocks are possibly overvalued by 50%, as the ratio is approximately 51% above its average (arithmetic mean) of 16.5.

Of course, valuations can’t be used as market timing techniques, as markets can stay overvalued or undervalued for long periods of time. But at these levels, it does suggest that loading up on equities, especially if you are a new or soon to be retiree, may not be a good long-term move.

According to John Hussman, “The median price/revenue multiple for S&P 500 constituents is now significantly higher than at the 2000 market peak.” He is currently forecasting weak returns over the next decade with negative returns for period of 7 years or less.

Similarly, James Montier from GMO expects that large U.S. stocks will have a return of -1.6% a year for the next seven years.

Mebane Faber in a recent conference suggested that not only US stocks, but particularly dividend stocks are severely overvalued. He also warned that “home bias” skews our portfolios in favor of our own country’s stocks. Right now international markets, especially certain emerging market countries, have better valuations.

The point is that shocks occur when you least expect it. They are often caused by some triggering exogenous factor and are met with disbelief, which in turn leads to unpredictable human behavior.

We need to prepare for inevitable corrections as they are part and parcel of business cycles.

Since this rally is particularly long in the tooth and has created severe overvaluations, it may be a time to mentally and financially prepare for a market setback. While I do not espouse market timing, I do think it is prudent to reduce exposure by 10-20% in the event of extended markets, impending retirements, or in the event that you have reached or surpassed your target financial goals.

Times like these also underscore the importance of re-balancing your portfolio. Re-balancing is the best way to keep yourself unemotional, since you invest based on your target allocation as opposed to market noise. This is why I always urge my client’s to be faithful regarding their annual reviews.

When you re-balance or take some actions to reduce risk, you not only enhance your awareness of your financial well being, but you feel more in control of your situation. When it comes to investments, we can’t control the economy or the direction that the markets will turn, but we can and should control the things that we can, such as reducing costs, planning to avoid tax spikes, and maintaining an exposure to the stock market that is consistent with our risk profile and market valuations.

In order to reduce the risk of losing more tomatoes to disease, I bought some gypsum and added it to the soil in my tomato plant container. I don’t know if it will work, but I at least feel better that I did all that I could to help prevent the spread of the disease. I hope to have an abundant garden this summer, but only time will tell.

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The Federal Reserve is tapering their bond-buying program, but interest rates remain low. In fact, since the beginning of this year, the ten year Treasury note has declined from roughly 3% to 2.54% (5-21-14).

Retirees and savers are frustrated. Since 2008 CD rates have plummeted. Since emergency cash reserves and money that you will be spending in the next 2-3 years should be kept in a cash or cash equivalent account, what is the best way to maximize your yield?

The highest yields for cash can be found at online banks and credit unions such as GE Capital, Ally, ING, etc. The reason these rates are significantly higher than local banks is that these companies do not have to pay for infrastructure (bank buildings) or labor (tellers). Transactions and customer interaction is done primarily online. Since most online savings accounts are yielding more than three times the rate of local banks, the extra inconvenience of setting up an online account is generally worth it. For example, most local banks are offering yields on their savings accounts of up to 0.2%. As of 5-21-14, you could find an online savings accounts yielding 0.95%. If you had $100,000 in savings, switching to an online savings account would put an extra $750 in your pocket. Before you open a savings account online make sure to check if they have any restrictions on monthly transactions and make sure the bank has safe ratings.

Longer term cash needs-CDs and bond funds

Certificates of deposit (CDs) may be a good savings vehicle for the balance of your emergency reserve or additional cash needs over the next 2 to 4 years. In this extremely low-interest rate environment, it may not make sense to purchase long-term CDS unless they have a low early withdrawal penalty. Although we can never know for certain where rates will end up in the future, chances are more likely that rates will be higher than they are today. Current 2 year CD rates are averaging around 1.25%, 3-year rates are 1.4%, and 4 year are 1.7%. If you lock in a 4 year CD at 1.7% and rates rise to 2% in the next year, you won’t be happy. Consider putting the cash you need for the next 2-3 years in a savings account with the balance of your necessary reserves in a 3 year CD. Alternatively, you could ladder any reserves needed in year 2 and 3 in CDs, but the small yield differential and prospect of raising rates may not make that extra work worthwhile.

For those investors who are still not happy with the interest rates on CDs and online savings accounts, another place to invest would be short to intermediate-term bond funds; however, bond funds have drawbacks. They are not FDIC insured, and the investment will experience a loss in principal when interest rates rise. If you want to use bond funds, choose high-quality funds with no more than a 4-year duration.

Higher yields can be found with longer term or lower quality bond funds, but these funds tend to act like stocks when markets drop. For now, CDs seem to be preferable to the bond funds as many of the shorter term higher-quality funds have lower yields than CDs.

A big caveat is that investors in the highest tax brackets may want to skew more of their reserves into municipal bond funds since a 3.8% surcharge is assessed in addition to their applicable tax rate on all interest and dividends they receive from taxable bond funds, CDs, and savings accounts. A limited term or intermediate term tax-exempt bond fund may be desired, in addition to some FDIC insured savings.

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Housing data released recently suggests that challenges to the housing industry still remain almost six years after prices plunged precipitating the Great Recession. New home sales in March collapsed 14.5% month-over-month to their lowest since July 2013. Pending home sales in February fell for the eighth time in eight months. Prices in most areas of the country are still well below their 2005-6 highs as diminished demand is putting the brakes on the housing recovery. Clearly significant challenges still remain that affect housing demand. Why is housing faring so poorly this far into the economic “recovery?”

Household formation has declined due to the weak recovery.

Many young adults are unable to find employment after college or high school.   A lack of quality jobs is causing some college grads to continue their schooling and or postpone marriage, thus delaying their first home purchase.  In fact, according to the NY Times, the number of households increased an average of 1.35 million a year in 2001 to 2006, compared to 569 thousand a year from 2007 to 2013.

Tough economic conditions have resulted in many families living under the same roof and made it hard for first time homebuyers to save for a down payment.

A record 13.6% of Americans aged 25-34 are living with their parents, (an increase of over 30% compared to the year 2000).  The lingering recession has also affected Baby Boomer living arrangements.  For the seven years through 2012, the number of Californians aged 50 to 64 who live in their parents’ homes swelled 67.6% to about 194,000, according to the UCLA Center for Health Policy Research and the Insight Center for Community Economic Development.

Many individuals cannot get a loan either due to poor credit or conservative bank lending standards.

Many business owners are wary of purchasing a home due to uncertainty regarding the economy and the Affordable Healthcare Act.

Baby Boomers are downsizing and or moving to multifamily housing.

In fact, much of the recent growth in housing has been due to strong performance in this sector.  Out of work Boomers and young adults unable to find employment are causing the US to increasingly become a renters’ society.

With prices still below the 2005-6 peaks homeowners are loathe to put their homes up for sale.

Perhaps, the American public is finally learning a valuable lesson about real estate. Your personal residence is not an investment in the traditional sense, as it does not throw off income and over the long term it has a poor rate of return that rarely beats inflation. In fact, the average annual price increase for U.S. homes from 1900 to 2012 was only 0.1%/year after inflation.

Due to extraordinary performance in the late ’90s and early to mid ’00s, many home buyers were lulled into thinking that their home was a piggy bank, an investment that was sure to go up indefinitely and that would never decline in value. This misinformed thinking resulted in homeowners (and investment bankers alike) allocating far too much of their assets to housing. An increasing proportion of household income was diverted to mortgages and other home expenses in lieu of investing in their retirement or college education. This resulted in a distortion of investment dollars and ultimately a bubble in home prices, which collapsed leading to the Great Recession. Our hot love affair with housing ended as most do, and now we are paying the price. The Federal Reserve has kept interest rates low to bring the magic back, to little avail.

Americans need to stop focusing on maximizing square footage; and instead, focus on more productive, higher return investments. For some perspective, according to the Milken Institute, middle class households in eleven Asian nations spend 16% on housing and transportation whereas the average middle class American homeowner spends roughly 50% of income on housing and transportation. Clearly, our priorities are out of alignment. We are putting a lot of eggs in one basket at the expense of saving for other goals like, retirement, college education, and healthcare costs.

In order for society to allocate investment dollars to productive endeavors that enhance economic growth, we need to rethink our love affair with real estate.

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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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