AdviceIQ

The Equity Trap

Given the rough time the stock market has had lately, does it make sense to overweight your portfolio with equities? No.

The August market slump was tough for financial advisors and investment managers who advised clients to keep a heavy allocation of stocks in their portfolios.

Advisors who advocated stock-heavy portfolios should be able to answer clients’ questions about why they are so optimistic that share prices will continue to increase.

Investors, likewise, should ask why they are following that advice.  Investors need to be accountable for their future.  If their advisors are wrong, they will pay the price, not their advisors.

Given the state of the world economy – and stock markets throughout the world – many questions need to be answered.  Here are some of them:

Where is future growth going to come from? Don’t look to China, which may claim to be growing at 7% this year, but few believe it. Don’t look to the U.S., where baby boomers are retiring and millions of people in all age groups have stopped looking for work.

Maybe Japan, which seemingly is following its lost decade with another lost decade, will serve as the new model for the rest of the world.  Today, growth is a quarter when the economy doesn’t shrink.

Is it OK for markets to move higher on weak economic news because of central bank stimulus? In a free market economy, markets should rise when the economy is strong and lower when it is weak.

Central bank interference – aka stimulus – has resulted in the opposite.  The result is like Bizarro world from Superman comics, where down is up, up is down, hello means goodbye and goodbye means hello.

The Federal Reserve’s bond-buying program resulted in a drop in interest rates, which caused bond yields to drop.  The drop in yields drove investors into the stock market, as there was no place else to put their money and earn a significant return.  The more money investors put into the market, the higher stock prices soared.

Unfortunately, though, for stock prices to keep rising, the Fed had to keep interest rates near zero.  Any hint of rising rates, which would cause yields to rise, has caused stock prices to tumble.

When rates are at zero or close to it in most developed countries, what tools will central banks use to boost the economy? The answer is none. They don’t have any tools left.  If monetary policy eased any further, it would be asleep. Mario Draghi, president of the European Central Bank, may disagree (he moved to get banks to charge customers for their deposits), but there is no interest rate less than zero.

No one’s even talking about “macroprudential supervision” anymore, where the Fed oversees financial institutions so they don’t go haywire.  Or “forward guidance,” either, when the Fed seeks to influence behavior through telling what it will do, for that matter. These were the other tools the Fed and other central bankers tried to use to stimulate the economy, but they were more talk than tools.

So what will governments do next to stimulate their economies?  Devalue their currencies, of course.  That will make exports more attractive to other countries – until those countries also devalue their currencies. At that point, the multiple devaluations will cancel each other out.

We should add that raising interest rates would make the underlying currency stronger. The U.S. dollar having has strengthened considerably since the Federal Reserve stopped its quantitative easing (bond buying) in October 2014. Will the Fed now make it even stronger relative to the world’s other currencies by raising interest rates now?

What country is in the best position to devalue and who do you think is going to win the currency wars? China has a heck of a head start, having devalued its currency nearly 2% in August, as Wenning Advice previously noted.

Another sign that China is in devaluation mode has been its continuing accumulation of gold.  Quoting Song Xin, president of the China Gold Association, general manager of the China National Gold Group Corp. and party secretary, we reported that China is seeking to accumulate 8,500 tons in official gold reserves, an amount that would exceed the gold reserves of the U.S.

Maybe it’s because the U.S. Treasury holds our gold, but the Fed hasn’t seen any need to accumulate gold.  After all, do we really need to back our currency?  The gold standard is so 1960s.

Debt levels are at extraordinary levels; what impact will that have on economic growth? The federal debt now exceeds $18 trillion. Annual interest on today’s debt comes to more than half a trillion dollars ($525 billion) even at today’s interest rates.

This year’s federal budget is $3.8 trillion. Let’s say you’re a Keynesian and believe government spending stimulates the economy.  About 14% of the budget is going toward servicing debt and provides no stimulation whatsoever.

When interest rates increase, that percentage could easily double or triple.  What affect on economic growth will we see when a third or more of the federal budget is used just to service the existing debt?  Either the federal government will have to be slashed or taxes will have to increase, which would mean less discretionary income and less consumer spending.  We’ll all be poorer, which will result in fewer tax revenues, which will result in even more government debt.

When that happens, the 2% growth we’re been experiencing since the recovery began will seem like the golden age.

Why are so many companies reporting non-GAAP earnings? GAAP, which stands for generally accepted accounting principles, ensures uniformity in how companies report their financial performance. Non-GAAP earnings are “adjusted” earnings that take one-time events into consideration, such as acquisitions of companies, sales of subsidiaries, restructurings or asset write-downs.

GAAP, some say, has a downward bias effect on corporate earnings, while non-GAAP (also known as pro forma) accounting has the opposite result.

In other words, if a large number of companies are reporting non-GAAP earnings, the overall profit picture is probably not as good as (or maybe “even worse than” is a better way of saying this) it appears.

Are so many companies reporting non-GAAP earnings today because they have legitimate adjustments – or are they trying to make their profits look higher than they really are?

Is it safe to be in risky assets when economies all over the globe are imploding? This question answers itself. Of course, maybe the Fed will begin a fourth round of quantitative easing and cause bad economic news to continue boosting the market.

What stage of the economic cycle are we in? We’re always either in a recession or we’re pre-recession – i.e., in a recovery, but this recovery in particular has never felt like one.

The current recovery dates back to July 2009 and, given its length, Forbes says it is likely to end soon.  Of course, the Forbes article cited dates back to October 2012. If you’re an optimist or a Keynesian, you may be saying: Wow, this is one long recovery we’re seeing.  No reason it can’t go on forever.  If you’re a realist, you’re saying: Wow, this is one long recovery we’re seeing.  No way it can go on much longer.

As Zerohedge noted, only 20% of expansions have lasted as long as the current one.

Even the Fed can’t eliminate business cycles. Neither can the Chinese government.  In the past, China didn’t have business cycles, because, like every communist country, it was in a state of permanent recession. Now that it’s adopted its own form of pseudo-capitalism, cycles will no longer be confined to the streets of Beijing.  China will be sharing our pain – until the next recovery.

Is your retirement plan dependent on the actions of central bankers? If so, what happens when they lose control? We’ll answer this question with a question: Do you think the Fed’s quantitative easing program (QE1, QE2 and Q3) worked? Did Japan’s version of QE work?

Central banks have collectively lowered rates 600 times since 2008 to stimulate economic growth. If this hasn’t worked yet, it’s never going to work.

Follow AdviceIQ on Twitter at @adviceiq.

Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass. 

AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.

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