The Patience Principle

Global markets are providing investors a rough ride at the moment, as the focus turns to China’s economic outlook. But while falling markets can be worrisome, maintaining a longer-term perspective makes the volatility easier to handle.

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Will the US growth continue?



The American economy has finally found some solid footing for growth after 6 years of questionable economic stimulus.  The combination of perpetually low interest rates and a wide open money spigot from the Federal Reserve has finally produced positive economic growth.  While the economic growth of the rest of the world is temporarily stagnating, the US equity markets have flourished.  Much of this has previously been due to the abundance of investible funds looking for a place to go.  The US remains the safe money alternative for most of these funds.  Yet 2015 brings a new set of opportunities and challenges.  Oil has plummeted in price.  This positive event could bolster the outlook for the US as cheap gas leads to additional consumer spending.  One side effect is the instability this causes for several international countries whose economy and potential existence depends on oil, notably Iran, Venezuela and Russia.  This offers the potential for conflict in several areas of the world and could be a destabilizing factor in any resurgence of world economic growth.  Another situation will be the ability of the newly elected, Republican dominated Congress to work with the President to maintain and expand the current economic growth.

As noted previously, the US equity markets had another banner year. They were again led by large cap US stocks.  This is a continuation of the trend from 2013 where investors bought large US stocks to get some dividend yield with the potential for growth instead of CD’s with limited return.  This was aided by companies buying back their stocks instead of investing in plant and equipment, due mainly to anti-business government regulation and economic uncertainty.  The large cap US markets outperformed the mid and small cap stocks by almost 10% this year.  Again, evidence of the movement of money into what is presently perceived as the safest available worldwide.

The international markets were docile for the most part. Growth in China slowed so prognosticators and investors took this to mean the rest of the world was slowing. We still believe the long term prospects overseas are excellent as the demand for goods and services to the newly minted middle class people will only increase.  Cheaper energy prices will aid in the process.  While we cannot predict the exact timing, the prospects of US equities already high price/earnings ratios extending further are dwindling.

Interest rates have been at historic lows for 6 years. They have failed to promote the type of economic stimulus one might expect for a number of reasons. The Federal Reserve has ended the “quantitative easing” folly and begun talking of the need to raise rates in 2015.  A return to more normal rates should be good for many investors.  Those needing better fixed income returns would be aided.  It might also bring a better equilibrium to the equity markets, already trading at higher than normal earnings multiples.

We can only hope that the results of the elections will bring legislation that will help the economy.  Trade agreements overseas, tax reform and restraining business disincentives from past government regulatory rules will be on the agenda of the new Congress.  Those who believe government can regulate a country into a better economy have obviously not availed themselves of any statistics of what does and does not work to improve economic conditions.  We do know what works, we just need leaders to use that knowledge and forget politics – our brand of wishful thinking.

We appreciate all of our clients and hope to meet with each of you early in 2015 to look at results and plan for this year.  If you have any questions, please call us.  Thank you for a great 2014.


Larry Miller

Larry Miller

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Heat of the Fire

Investors can prepare for future market volatility by revisiting their experience from past market declines. Brad Steiman discusses the value of conducting a “financial fire drill” and offers portfolio illustrations to help set client expectations.

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The unusual continues…as usual

The movement of the Dow and S&P stock indexes would lead one to believe the economy is doing great one day then collapsing the next.  We have seen volatility in this particular area of the equity markets like never before.  Any good news on the economy leads to a down day.  The reverse is true for any bad news.  The motivation for the seemingly contradictory movements resides in the future course the Federal Reserve will take on interest rates.  If the economy is performing poorly, the investment world believes the Fed will keep interest rates low for a longer period of time.  The opposite occurs on good economic news.  While the bond buying plan known as “quantitative easing” ends in October, the outlook remains for low short term interest rates well into 2015.

The equity markets have fallen in line with our thoughts going back over a year.  The large cap US stocks have done very well.  This can be seen by looking at the P/E ratios for the S&P index.  The norm for this index is a price/earnings multiple of approximately 15.  The current ratio is near 25.  We believe this is because of investors need for return going back to early 2013 when CD rates were, and still remain, quite low.  The small investor decided to look for 2 – 3% dividend return with the potential for growth versus any purely interest bearing holding.  This is reinforced by the fact that the rest of the US equity market is relatively flat this year.  The divergence between large cap US stocks, up nearly 10%, and mid to small cap stocks, which are near zero this year, is quite unusual.  We have been selling portions of client large cap positions and moving to smaller cap indexes as this disparity should eventually close.

One other area of movement has been in the emerging market indexes.  We made a move to balance out our equity exposure to a more equal level between domestic and international several years ago.  This was due to the fact that 60% of the world economy occurs outside the US.  We also moved a little more aggressively toward the emerging markets for long term investment growth.  This is currently paying off as the emerging markets have gained nearly 10% this year.  While domestic growth has increased, many emerging market economies are growing at 2 – 3 times our growth.

The interest rate picture remains murky.  Chairwoman Yellen is continuing to push for low short term rates as her perception is that the domestic economy is still on shaky ground.  We have seen a slight uptick in the longer term rates but nothing that will pull investors away from dividend stocks.  We remain relatively short in interest bearing maturities, looking for reasonable yield until the rates move higher.  While most of us see inflation on a daily basis, the tools used by the Fed and the government to report real inflation are manipulated or excluded, as in food and energy, so that their definition produces a lower figure.  This is the justification for maintaining low rates.  With that being said, we would also point out that, in the history of the Federal Reserve, they have never tightened credit either too soon or on time.  We believe history will probably be repeated.  In addition, they have stated that their new method of tightening, whenever it occurs, is new and totally untested.  With six years of the great Keynesian monetary expansion experiment and an untested control mechanism for the future, it is difficult to have a great deal of confidence in their ability to produce stable and sustainable growth.

We have mid-term elections coming soon.  Regardless of political persuasion, everyone should be urged to vote.  This is our individual expression of how we believe the US should be governed.  It is a privilege not accorded throughout the world and part of a great democracy.  We appreciate your business, are here to help every client meet their financial goals and are available to assist with any questions you may have.


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Larry Miller

Third Quarter 2014

Q3 2014 Q2 2014 Q1 2014 Q4 2013
S&P 500 1.13% 5.23% 1.81% 10.51%
MSCI EAFE -5.88% 4.09% 0.66% 5.71%
Barclay’s US Agg Int Term Bond 0.03% 1.62% 1.20% -0.14%

Rate Expectations

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Interest rates around the world are at historic lows. They can only go in one direction from here, right? And aren’t rising interest rates bad for bond investors? The truth might surprise you.

Central banks in developed economies have injected extraordinary stimulus into the system since the recession arising from the global financial crisis five years ago.

The stimulus has come from these steep reductions in official interest rates and from more unconventional measures aimed at holding down long-term interest rates.

In 2013, markets became unsettled when the US Federal Reserve signaled it was contemplating a timetable for reducing its stimulus—the so-called “taper.” The central bank later changed its mind, and markets cheered the news.

In the meantime, many investors are asking what will happen to their portfolios when central banks do decide to start restoring rates to more normal levels.

The market values of bonds rise or fall depending on investors’ views about the outlook for inflation and interest rates, their perceptions about the creditworthiness of individual issuers, and their general appetite for risk.

The yield on a bond is the inverse of its price. So if the price falls, it means investors are demanding an additional return, or yield, on that bond to compensate for the risk of holding it to maturity. This sensitivity to interest rate change is called term risk.

So if interest rates can only go up from current levels, why hold bonds? There are a few points to make in response.

First, it is very hard to forecast interest rates with any consistency. Standard & Poor’s regular scorecard shows most traditional forecast-based managers fail to outpace bond benchmarks over periods of five years or more.

Second, there is nothing to say that rates will return to normal very quickly. In the case of Japan, benchmark lending rates have been at or close to zero for the best part of 15 years. We have already seen many large bond fund managers make badly timed calls on when the cycle
will turn.

Third, bonds perform differently from stocks. So regardless of what is happening with the rate cycle, there is a diversification benefit in holding bonds in your portfolio. Diversification is a way of managing risk and helping to target a smoother ride.

Fourth, if you look at history, there is no guarantee in any case that longer-term bonds will underperform shorter-term bonds when interest rates are rising.

We carried out a case study of four periods of rising rates from the past 30 years. To meet the test, the rate increases had to be spread out over 12 months or more and cumulative increase had to be at least 1.5 percentage points.

The four periods were December 1976–March 1980 (when rates skyrocketed by 15.25 percentage points), September 1992–June 1995 (3 points), November 1998–December 2000 (1.75 points) and June 2003–August 2007 (4.25 points).

The chart below looks at the performance of US government bonds during those four periods. We use standard indices: the Barclays Intermediate (1–10-year maturity, in blue) and the Barclays Long (10–30-year maturity, in green).

What’s notable in the chart is that in two of these four periods of rising interest rates long-term bonds did better than shorter-to-intermediate-term bonds. In the other two periods (1998–2000 and 1976–1980), longer-term bonds underperformed.

This may seem counterintuitive, but it can be explained by the fact that long-term bond holders, whose biggest concern is inflation, can be comforted by a central bank moving aggressively and pre-emptively against this threat by raising official rates.

Also note that seven of these eight bars show positive returns, which contradicts the view that bonds always deliver negative returns in periods of rising interest rates. The exception in this study is the late 1970s, when the longest-term bonds (10–30 years) suffered during a period of very sharp increases in rates.

So, the first lesson is that an increase in official lending rates set by central banks is not always replicated across bonds of all maturities. Indeed, in some cases, as we have seen, longer-term bonds have outperformed in rising rate environments.

The second lesson is that bonds can play an important role in your portfolio whatever the stage of the interest rate cycle. How much term (or credit) risk you take with bonds will depend on your own risk appetite and investment goals.

Trying to forecast interest rates is not a sustainable way of investing in bonds. But there is plenty of information in today’s prices on which to base a strategy. In the meantime, you can help temper risk by diversifying across different types of bonds, different maturities, and different countries.

Ultimately, the reasons for investing in bonds should be driven by your own needs, not by everybody else’s expectations.

Diversification does not eliminate the risk of market loss.

Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Simplicity & Sophistication

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Complexity in investing often comes with a lack of transparency. The highly engineered and multilayered financial derivatives that contributed to the global financial crisis five years ago are a case in point.

For many investors, these products were problematic because their complexity was such that it was very difficult to understand how they were designed, how they were priced, and whether the proposed payoffs were right for their own needs.

Of course, there is an incentive for many players in the financial services industry and media to make investing seem complicated. For some investment banks, for instance, complexity provided a cover for overpricing.

In contrast, there are far fewer mysteries about the underlying stocks and bonds traded each day on public capital markets, where prices are constantly in flux due to news and the ebb and flow of supply and demand.

The virtue of these highly competitive markets for most investors is that prices quickly incorporate new information and provide rich information on risk and return. From these millions of securities, diverse portfolios can be built around known dimensions of return according to the appetites and needs of each individual.

The competitive nature of public capital markets, the efficiency of pricing, and the difficulty of getting an edge are what underpin the “efficient markets hypothesis” of Prof. Eugene Fama, who was recently awarded the Nobel Prize in economics.

Essentially, the practical takeaway from Fama’s work is that you are better off letting the market work for you rather than beating yourself up adopting complex, expensive, and ultimately futile strategies to “beat” the market.

Writing in the Financial Times on the Nobel, economist and columnist Tim Harford said Fama had helped millions of people by showing them the futility of picking stocks, finding value-adding managers, or timing the market to their advantage.

“If more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns,” Harford wrote. 1

In the Sydney Morning Herald, journalist and economist Peter Martin said the world owes a great debt to Fama, who “demonstrated rigorously that if the supermarket crowd is big enough or if there are enough cars on the highway, you will get no advantage from changing lanes. Anyone who could have been helped will have already helped themselves.” 2

This might be a counterintuitive idea to many people. After all, in other areas of our lives, like business, the secret to success is to study hard, compete aggressively, and constantly look for an edge over our competitors.

One of the other two academics with whom Fama shared the Nobel–Robert Shiller–takes the view that markets can be irrational and subject to human error. He is frequently cited as a philosophical opponent of Fama.

In practical terms, though, both men agree that it is very, very difficult for the average investor to get rich in the markets by trading on publicly available information. Most people trade too much or underestimate the unpredictability of prices. 3

For example, many investors bought into supposedly sophisticated trading strategies during the financial crisis that left them on the sidelines in the subsequent rebound, which has driven prices in many markets to multiyear or record highs.

The simpler approach is to adhere to three core principles: Markets reflect the aggregate expectations of investors about risk and return, diversification helps reduce uncertainty, and you can add value by structuring a portfolio focused on known market premiums. For the individual investor, the essential add-ons to this are staying disciplined and keeping a lid on fees and costs.

Yes, these are simple ideas, but to quote another philosopher (Leonardo da Vinci), simplicity is the ultimate sophistication.

  1. Tim Harford, “Why the Efficient Markets Hypothesis Merited a Nobel,” Financial Times, Oct. 14, 2013.
  2. Peter Martin, “Pitfalls of Looking for Life in the Fast Lane,” Sydney Morning Herald, Oct. 16, 2013.
  3. Robert Shiller, “Sharing Nobel Honors, and Agreeing to Disagree,” New York Times, Oct. 26, 2013.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.