How We Got Here
The end of March brought the end of the first quarter of 2018 and along with that, a whole lot of nothing from the markets. The market run up in January was led by the “melt up,” of investors chasing returns buying stocks based on recent performance versus fundamentals. The market peaked on January 26th, days before the President’s address to the nation and the proverbial victory lap Trump was going to take regarding the US economy. Then February hit…
When looking back since the election, it is clear that the market rally has been quite surprising. Coming off a double-digit year like 2017, it seemed stocks were fairly priced as we discussed in our last newsletter. However, behavioral finance has a way of keeping a good thing going and overshooting on the downside as well as the upside. As such, the markets went from up over 6% by the end of January to negative across the board come March 31st. The DOW ended down 1.76% and the S&P followed suit ending down .76% while the international markets ended down 1.53%.
Like the groundhog, Punxsutawney Phil who saw his shadow, we are getting our fair share of an extended winter from the markets. From Tariff talks to financial engineering both have added to the increase in volatility. The ramifications of the two will make its way through the markets for many months and arguably years to come.
Tariff (Taxes)… A Game of Chicken
We all remember the scene in Rebel Without a Cause where James Dean is playing the game of chicken. Fortunately for James Dean, his jacket did not get stuck on the door handle and he jumped out of the car before it barreled off the cliff. Well, that’s the situation the US is in with China regarding tariff talks. The US is in one car and China is in the other, both racing towards the cliff.
Tariffs act like a tax because the cost of the tariff is ultimately passed onto consumers. In economic terms, this creates a deadweight loss where consumer surplus and producer surplus are both diminished and the fair market price of the good is artificially inflated. From a strategy standpoint, tariffs make no sense. It does not make sense to impose a tax on consumers months after cutting taxes via the Tax Cuts and Jobs Act. This policy change is counterproductive for our economy, to say the least.
What’s of particular concern is the unique economic relationship we have with China. This unique relationship is symbiotic as one cannot exist without the other. China does not purchase US debt because it is a great investment, it purchases the debt because the US debt market is the only market in the world capable of absorbing so much capital. By making these purchases it enables the continued trade deficit in the US. The Chinese economy depends on exports and the US economy depends on consumption. To enable our consumption, we need someone to purchase our debt. Both economies need each other, thus creating a feedback loop that is becoming more imbalanced. Escalating tariffs would be bad for both economies and an all-out trade war would be mutually assured economic destruction. As such, we are exercising caution and watching the portfolios carefully as this could have a negative impact on both stock and bond prices.
Financial Engineering
To understand the definition of financial engineering, it’s best to take a look back over the past decade and ask ourselves, “how did the Great Recession of 2008 happen?” The simple answer: financial engineering. Investopedia defines financial engineering as, “The use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from the fields of computer science, statistics, economics, and applied mathematics to address current financial issues as well as to devise new and innovative financial products.” The use of computer science, statistics, economics, and applied mathematics to finance is not the problem with financial engineering, the new and innovative financial products are the issue.
When President Nixon ended the convertibility of the US dollar to gold in 1971, it effectively ended the Bretton Woods system established at the end of World War II. The Bretton Woods system was designed to maintain a steady exchange system between the United States, Canada, Western Europe, Australia, and Japan by tying its currencies to the US dollar and gold. Under this system, it prevented rapid monetary expansion due to the limited amount of gold available. The end of Bretton Woods marked the end of US economic hegemony. Since 1971, the supply of money has exploded, creating untold wealth for many across the globe, and marked the beginning of the globalized economy.
With the growth of money supply, financial engineering became part of the economic growth. Recent financial engineering innovations include computerized trading, expansion of individual investors through online trading, debt securitization, and more recently cryptocurrency. Computerized trading led to the Black Monday in 1987. The expansion of individual investors through online trading lead to the 2000 dot.com bust. Debt securitization led to the Great Recession of 2008. Not all financial innovations lead to an economic crisis but one can argue all recent economic crises were driven by financial engineering. We will have to wait and see how the cryptocurrency innovation plays out. Of course, this is a cherry-picked list to illustrate a point, but we are keeping a close eye on these new and innovative ways to invest and are monitoring the potential collateral effects or unintended consequences on our economy.
Portfolio Benchmark Updates
To more accurately gauge and understand the performance of your investments, we have determined it was best to update the benchmarks we have utilized over the past several years. Previously, the benchmarks comprised of worldwide equities, worldwide bonds, and cash. In 2017, the Archvest benchmarks greatly diverged from the actual realized risk and return profile of your actual investments. Furthermore, we noticed an anomaly; the conservative benchmark realized substantially higher risk than the aggressive benchmark. While this can be true in certain circumstances, recent market conditions do not fully explain this anomaly, thus we’re updating the benchmarks to measure your portfolios better.
Our new simplified benchmarks will be using just two indices: MSCI All Country World Wide Equities, and Bloomberg Barclays US Aggregate Bonds. Here’s the comparison between the new and old benchmarks:
|
New Benchmarks |
MSCI ACWI Equities | Bloomberg Barclays US Aggregate Bonds | Bloomberg Barclays Worldwide Bonds | Cash (90-day T-bill) |
| Conservative | 40% | 60% | 0% | 0% |
| Moderate | 60% | 40% | 0% | 0% |
| Aggressive | 80% | 20% | 0% | 0% |
|
Old Benchmarks |
MSCI ACWI Equities | Bloomberg Barclays US Aggregate Bonds | Bloomberg Barclays Worldwide Bonds | Cash (90-day T-bill) |
| Conservative | 40% | 0% | 59% | 1% |
| Moderate | 60% | 0% | 39% | 1% |
| Aggressive | 80% | 0% | 19% | 1% |
Statistically, these new benchmarks have a higher correlation when compared to the portfolios, meaning that the new benchmark data does a better job explaining the realized risk and return of your portfolios versus the old benchmarks. Thus, starting this quarterly report, we will report based on the new benchmark data. Please feel free to reach out to us if you have any questions regarding this change.
As always, we appreciate the confidence you have placed in us to work alongside you regarding your planning needs. Be sure to follow us on Facebook, LinkedIn and Twitter as well as our RSS feed to stay up to date on what we’re reading and thinking.
Eric Lai and John Wenzel
Eric Lai & John Wenzel | Archvest Wealth Advisors