U.S. stocks continue to trend higher, indicating investor optimism about economic growth, while a flattening yield curve has tended to herald a weakening economy—the truth may be somewhere in between. Beneath the surface, risky corporate debt is conjuring images of The Big Short. Meanwhile, jittery investors are reading market reports, examining economic analysis, and racking their brains for answers to the burning question; “where is the market going?” A piece of wisdom from an unlikely sea creature may teach them to belay their fears. And, speaking of wisdom, have you ever puzzled over the best way to teach responsible financial habits? We offer some insight as to why this is such an important topic and what you can do about it.

The Bulls Aren’t Running in a Herd

Stock and bond investors appear to have very different opinions on domestic growth potential. Even though earnings estimates have been lowered, investor sentiment is in the “extreme optimism” zone for the stock market. Proponents of this optimism may point to the 50-year low of jobless claims, a 3.8% unemployment rate, and a rebound of job growth indicators such as payroll gains as supporting evidence for their bullish position.

Bond investors have a different story to tell. Keep in mind that bond investors typically have a longer-term investment horizon in mind and therefore tend to spook easily. No China-U.S. trade deal, the possibility of a border shutdown, Brexit, retaliatory tariffs, and other geopolitical issues still linger. To overlay these with weakening business indicators such as retail sales, durable goods orders, and a drop in the non-manufacturing (services) index makes for some fidgety bond investors.

It is certainly a coin flip as to who is right, but it is interesting that each camp seems to continue becoming more entrenched in their own viewpoint. As bullish stock investors continue deploying capital, bond investors are making the opposite bet. The yield curve has flattened substantially, even inverting for a short period, as the 10-year Treasury yield was below the 3-month T-bill yield[1]. In other words, there were more investors who believed the best decision was to keep their assets locked in at a low rate of return (approximately 2.6% annually) for the next decade than there were who would rather have the cash to invest. This tells us that there is a large swath of investors whose confidence in future economic growth is not particularly strong.

While interesting, these revelations from the past quarter are nothing new. The perma-bulls and the perma-bears are locked in an eternal struggle. This is the noise surrounding the inherent game theory of markets—every transaction has a buyer and a seller. The difference in opinions, by definition, is what makes markets work.

Looking one layer deeper, there are a few items to pay attention to over the next few years, specifically as it pertains to capital structure. Less and less corporations are raising funds by issuing stock. Some choose to de-list their stock and take the company private, but many now choose to never go public in the first place—the pace of annual IPOs (initial public offerings) has been cut by 50% since 1997[2]. This is also not a precipitous change, but rather a slowly downward-marching trend.

So, how are corporations raising capital? It’s not a trick question; debt has been in vogue with interest rates at historical lows for the past decade. Lending standards have loosened since the Great Recession. Recently, regulators are pointing to the ballooning of the leveraged loan market as a potential crack in the façade. In 2016, this market was approximately $875 million and has grown to $1.2 trillion as of the end of 2018, a 37% increase[3].

What exactly is a leveraged loan? Here is an example from the Financial Times

“With 18.7 million followers and a roster of fans that includes the Kardashians and Naomi Campbell, the Instagram page of beauty company Anastasia Beverly Hills offers crafty demonstrations of how to use its products to get the perfect eyebrows and lips. In one image, a model has a tiny heart carved into her manicured eyebrow.

The successful social media account is more than a marketing tool, however, for the cosmetics business owned by Romanian-born billionaire Anastasia Soare. It was also listed as one of the company’s “general intangible” assets in documents for a $650 million loan to fund a partial buyout by private equity firm TPG Capital, according to people familiar with the deal.”

If the tech stock craze of the dot-com boom was a display of irrational exuberance, then Instagram-account-as-loan-collateral is a display of downright stupidity. As lending standards continue to loosen, leveraged loan providers are extending more and more credit to lowly rated, more indebted companies. If growth slows, already risky loans are more likely to go into default.

True to form, Wall Street is compounding the problem. Collateralized loan obligations, or “CLOs,” are a package of these risky corporate loans, passed off as supposedly “safe” investments. Jerome Powell, Janet Yellen, and other central bankers are comparing this to the subprime mortgage crisis[4].

$1.2 trillion is not a tiny slice of the market and CLOs have made these loans mainstream. An uptick in corporate bankruptcies, which is a greater risk if there is more debt on the balance sheet, could potentially cause a domino effect. History repeats itself.

The Perfect Investor and The Perfect Fool

Making investment decisions based on accurately timing the highs and lows in financial markets is a fool’s errand. While of course there is skill, experience, and knowledge involved, this type of strategy essentially hinges on the power of prediction. Most weather forecasters, for example, make accurate predictions during relative calm. Even if 9 out of 10 forecasts are correct, weather forecasters are generally not trusted, as they are the most incorrect at the most inopportune times. The Seinfeld episode of Jerry wearing his suede coat in the rain comes to mind.

If skill, experience, and knowledge are taken out of the prediction equation, what is left is mere chance. This is like the weather forecaster on live TV throwing darts at a board with various potential forecasts. Or, like an Octopus placing your sports bets for you; from Albert Bridge Capital in the U.K. –

“Paul the Octopus was eight for eight [picking match winners in the 2010 World Cup], and briefly became the most celebrated marine invertebrate in the world, much to the chagrin of the equally clueless, albeit confident and determined, SpongeBob SquarePants.

Paul was metaphorically flipping coins and got lucky eight times in a row. The odds against doing so were 256-1. Impressive indeed! However, with two billion octopuses swimming in the oceans, there were eight million other eight-tentacled freaks out there just as good as Paul.  They just didn’t get any publicity.”

In a world of hot stock tips, Twitter pundits, and armchair investors, the average person might feel lost. Based on his performance, would you trust Paul the Octopus with your 401(k) balance? Probably not, but his track record speaks for itself. So, how much do skill, experience, and knowledge matter?

Let’s assume that an average investor uses broad diversification as their chief investment strategy and chooses to ignore market timing and stock picking. Let’s also assume, for argument’s sake, that this investor contributes $1,000 per year into an S&P 500 index fund for the next 30 years.

There are two extremes for this exercise: the $1,000 is invested at the low point of the market every year, or the $1,000 is invested at the high point every year. The most likely outcome is somewhere in between—there is a 1 in 124 septuagintillion (yes, we had to look that up) chance of being the perfect investor or the perfect fool. Using data from 1989-2018, it is possible to quantify these extremes –

Invest $1,000/year The Perfect Fool

(always buys at the high)

The Perfect Investor

(always buys at the low)

Ending balance in 30 years $121,822 $155,769

The perfect investor enjoyed an annual portfolio return of 9.71%, while the perfect fool had a return of 8.39%[5]. This same concept proves the same over almost every different 30-year market cycle, dating all the way back to 1939. A recent study has shown that the return of the average stock investor over 30 years is 4%[6]. In other words, investors (broadly) would be better off turning off the news, ignoring their emotions, and employing the coin flip strategy of Paul the Octopus.

Today, the case for broad diversification is the strongest it’s been in a long while. Global stock market correlation has slid to 20-year lows[7]. The opportunity set is also shrinking, as there is evidence that close to 100% of all stock returns over the past 25 years occur outside of market trading hours[8].

Luckily, with some discipline, investors can still maximize their returns without just flipping coins. Using mutual funds will ensure that all returns of the market are captured. Choosing multiple different funds to invest in a global, balanced portfolio will reduce overall risk. And, perhaps most importantly, using dollar-cost averaging will take advantage of the highs and lows of the market.

Investors don’t need to catch a wave—the tide rises all ships. Sometimes, less is more.

A Method to the Madness

Take a minute to reflect on how you got to where you are today. Who influenced your decision-making? What shaped your views on money? How would you assess your financial literacy?

This topic has been getting more attention lately for good reason. Managing money is not becoming any simpler, yet only 16.4% of U.S. students are required to take a personal finance course to graduate high school[9]. Many people are looking for advice on how to impart good money habits upon their young kids, teens, or even adult children. Whether you are a parent or not, there are a few methods to help leave a legacy of strong financial values.

Method 1: Walk the walk. The phrase “do as I say, not as I do” is your enemy. For instance, you might want to teach your kids the life skills of thoughtful choices, delayed gratification, and generosity. You could label three separate jars emergency, vacation, and charity (or some other form of saving, spending, and giving). A good strategy, but the lesson comes in implementing the strategy—you must be disciplined and stick to it. As Duke University’s Dr. Kelly Crace put it, “if I followed you around for 3 weeks, I could tell you exactly what your top 5 values are.” Teach by example.

Method 2: Accept mistakes. And, better yet, learn from mistakes. Have you ever made a budget, with the best of intentions, and splurged on an unnecessary purchase a month later? If you are a human and are reading this, then the answer is yes. Self-discipline comes from the experience of consequence. Most importantly, don’t be ashamed of the consequence. Talk openly about how you have learned from financial mistakes, encourage discussion about the experiences of others, or comment on family traditions which implicate money. Progress is a process.

Method 3: Celebrate independence. This one sounds easy but is far from it, as money can lead to toxic emotions. Pride—expecting your kids to share your interests and dreams. Envy—keeping up with the “Joneses.” Greed is another obvious one, and the list goes on. Money can be an amplifier of negatives, but it works the same way for positives. Remember that the definition of success, wealth, and happiness are all deeply personal and everyone’s path will be different. It is important to embrace these differences, so the experiences of others can enrich our own understanding. We’re in this together.

We hope you enjoyed our comments. If you have any questions, please do not hesitate to contact us. We welcome the opportunity to discuss our thoughts in greater detail. Thank you for your continued confidence in Planning Capital Management.

[1] Schwab Market Perspective, “Stocks vs. Bonds…Who’s Right?”, Charles Schwab, April 12 2019

[2] Frank Partnoy, “The Death of the IPO”, The Atlantic, November 2018

[3] Joe Rennison and Coly Smith, “The Debt Machine”, The Financial Times, January 21 2019

[4] William D. Cohan, “Wall Street’s Love Affair with Risky Repackaged Debt”, The New York Times, March 18 2019

[5] Drew Dickson, “The Futility of Market Timing”, Albert Bridge Capital, January 29 2019

[6] James Picerno, “Investor Returns vs. Market Returns: The Failure Endures”, Seeking Alpha, September 21 2017

[7] Jeffrey Kleintop, “Diversification: Finally Back After 20 Years”, Schwab Insights, April 15 2019

[8] Drew Dickson, “Groundhog Day and Overnight Returns”, Albert Bridge Capital, April 9 2019

[9] Jeff Desjardins, “Most U.S. H.S. Students Never Take a Personal Finance Class”, Visual Capitalist, October 2 2017