“Slow but steady wins the race.” Aesop
The US expansion continues to limp ahead. Like a plow horse, the domestic economy keeps putting one foot ahead of the other. It won’t win any races, but it’s not going to stop and die either. The good news is that by the end of June the US economy will have delivered three years of uninterrupted GDP growth. However, the bad news is that the growth rate during that time has only been 2.40%, and current quarter growth is forecast at a slower yet 2.20%. This is the slowest recovery on record since 1950. Since that year overall economic growth – including both recessions and expansions – has averaged 3.00%.
We should note that the “Core PPI” (Producer Price Index) has increased by 2.70% over the past year. Inflation is not dead.
European elections and the ongoing debt crisis, along with slower emerging markets, have shaken global stock markets. These renewed fears exist despite growing US consumer confidence and impressive domestic earnings. Perhaps this is the “cleanest dirty shirt” scenario, but many folks are starting to believe that US assets might be the world’s financial gems. The Dow Jones Industrial Average fell 1.67% last week for this year’s largest weekly decline. In a flight to safety trade, 10-year US Treasury bonds are now yielding less than 1.80%, the lowest rate since 1941. In comparison, equity dividend rates look attractive. Today, well over 40% of the S&P 500 index stocks yield more than a 10-year Treasury.
"Offense draws fans, but defense wins games." Butch Farris
In an effort to sharply reduce risk, many investor portfolios are now misaligned with their returns objectives. Out of fear they have reduced their investment risk profile, but have increased the risk of missing their investment return objectives. Nobel Laureate behavioral psychologist Daniel Kahneman calls this risk aversion “prospect theory.” In this situation, an investor becomes much more distressed by a potential $10,000 loss than by a potential gain of $10,000.
As we return some of the first quarter’s heady gains, defense is critically important. The cruel math to portfolio declines is that it takes huge gains to recover significant losses. In technical terms, there is a nonlinear relationship between losses and gains. Essentially, as a loss increases, even larger subsequent gains are required to restore the loss. For example, let’s assume you invested $100 in a stock that declines by to $75. You’ve lost $25, or 25% of your principal. Unfortunately, to get back to $100 you need to regain your $25, which on your remaining $75 investment requires a 33% gain (25/75 = 33%). Ouch!
Volatility and risk are real, but so are your long-term objectives. Your investments need to be aligned with your financial goals. I believe that the patient contrarian will be rewarded, and that a willingness to accept reasonable volatility with a diversified portfolio should generate attractive returns over the next few years.