There is a perception that if news isn’t worth acting on, then it must be useless or a waste of time. And there are a lot of advisors (I’ve been one of them) that have stated on more than one occasion that retirees might be better off if they turned off the news. While I still generally believe that to be true due to our proclivity to act, it is a belief that has been actively evolving over the years. Let me explain.
The last time that you got on an airplane, the flight attendants went through a presentation before takeoff. You know the one. I’ll bet that you and just about everyone around you ignored it. Maybe even with headphones on. But if there was an emergency during the flight, you would likely be wishing that you had paid more attention. When an emergency comes along, it would be smart to have prepared for this emergency before the emergency occurs, not as it’s occurring.
Retirees are particularly exposed to making big investment mistakes in response to headlines for two reasons.
- Retirees are so often exposed to the daily grind of the news.
- Their entire life savings is on the line and as a result may be the most tempted to act on scary headlines or more accurately stated, react.
Reacting to the financial media, rather than sticking with your plan is very often a mistake. To successfully manage your retirement savings, you must accept that bubbles are part of the investing landscape. They always have been and they always will be. They can show up in haste and pop even more quickly.
If the night watchman on the Titanic had seen the iceberg early enough to miss it, James Cameron probably would have never made a movie about it. In much the same way, if you acknowledge the doomsday scenarios that exist, there is at least a chance that you can prepare yourself and your financial plan for whatever the market throws at you. Consider this a quarterly “lifeboat drill” for your retirement plan as I intend to update this piece on a quarterly basis as we move forward.
My goal for this recurring piece on “bubbles” is twofold. One is that I know my readers are constantly being bombarded by what the great financial writer Nick Murray calls the “apocalypse du jour” and therefore want investors to know what’s going on in the world accompanied by a dose of additional (helpful) perspective. Secondly, it will “require” me to seek out dissenting opinions, which will help me see the other side of the market arguments on a consistent basis. In other words, I am seeking out the “bears”.
For what it’s worth, throughout this article I am being liberal with the use of the term “bubble” as bubbles in a general sense are defined by prices increasing significantly above the fundamental value of the asset class often in a short time – much like what happened last year with cryptocurrencies. But because fundamental evaluation is not a precise science, bubbles by their very nature are rather subjective. As such, most of the predictions below aren’t necessarily bubbles in the classic sense, but a casting call for the more common risks being touted as possible catalysts for the next big market downturn.
I should include a disclaimer that any of my beliefs on the following bubble predictions are neither endorsements of or rebuttals to those predictions. They are simply my observations of the predicted bubbles with some corresponding commentary. No one, including myself, knows what the future holds. Period. Hard stop. There is simply no way to know.
That being said, here’s my first run at what will be a quarterly affair. Below are what I’m finding to be the most prominent predictions for current financial bubbles with links to support.
Four Current Bubble Predictions:
1. The Market is Overvalued
The most popular assessment of the market’s valuation (particularly of those that believe the market is overvalued) is the Cyclically Adjusted Price-Earnings Ratio or CAPE Ratio as it’s commonly called. This ratio was developed by the American Nobel Laureate and economist Robert Shiller.
As I write this, the CAPE Ratio stands just over 32. This data point is commonly followed by the fact that there have been only two times in the last century where it has been at this level or higher which were September 1929 which was immediately followed by the Great Depression and in the late 90s which was followed by the Tech Crash. The primary reason to include these two factoids is that it is somehow predictive that this will be the case again.
In fact, in this article, Robert Shiller himself not-surprisingly believes that stocks look overvalued based on his metric but also offers some perspective. When asked if the CAPE means that a bear market is imminent, he responds,
Such episodes are difficult to anticipate, and the next one may still be a long way off…
…this analysis should serve as a warning against complacency.
I can appreciate his candor on the topic as well as his advice. It should serve as a warning against complacency. But please note that he did NOT say that you should go sell everything. These types of markets can go on for years.
Commentary: There is no shortage of people that quote the CAPE Ratio as a reason to sell. I won’t bother writing a long diatribe about this one because the folks at AQR already did. It Ain’t What You Don’t Know That Gets You Into Trouble. Be prepared for some serious reading if you decide to delve into their detailed paper on Long Horizon Predictability. Long story short, we have too small of a sample size for this indicator to be overly predictive.
Vanguard also wrote a great piece on the predictive power (or lack thereof) of various metrics. The conclusion states,
We’ve shown that forecasting stock returns is a difficult endeavor, and essentially impossible in the short term. Even over longer time horizons, many metrics and rough “rules of thumb” commonly assumed to have predictive ability have had little or no power in explaining the long-run equity return over inflation.
Additionally, while qualitative in nature, bull markets don’t generally end with the amount of pessimism that we continue to see around this issue. I’m not saying it can’t, I’m just saying it usually doesn’t. Additionally, looking at another measure of market valuation, forward-looking price-earnings, it currently stands at approximately 17 for the S&P 500 which is right in line with the historical average. This is primarily due to the higher earnings of the reporting companies.
The continued low-interest-rate environment may also leave investors with few alternatives if they are seeking inflation-beating returns.
Planning Thoughts: Making changes to your investment portfolio due to a single data point probably isn’t the best strategy. I do, however, think it’s wise to assume a lower expected future return in your projections. While some may consider this a potential cause or catalyst for a significant market pullback, I prefer to look at this data as a reason to review future return expectations for clients within their personal retirement plans. When building a retirement plan (or any financial plan for that matter), it is important to use conservative assumptions rather than aggressive assumptions. Because of that fact, over the past few years, I’ve been reducing client’s forward-looking assumed returns within their plans and will continue to use these conservative figures until something changes.
My thought is that if I’m wrong about lower future returns, then my clients would end up with more money than anticipated. The flip side is also true though in that if I am assuming returns that end up being higher than what is actually achieved, then my clients would have less money than previously planned. I’d much rather the former happen than the latter, so I’ll keep using conservative estimates and adjust along the way.
2. Trump Versus the World
President Trump seems to be at the forefront of every headline since his election in 2016. Every tweet seems to lead the nightly news. The “apocalypse du jour” ranges from the short-term and long-term impacts of tariffs that may or may not lead to a trade war to general geopolitical risk and concerns.
There is almost too much to write here on this topic, and don’t feel I’d be adding anything to this conversation due to the politically charged nature of the topic.
Commentary: I will, however, offer a few planning thoughts here. If there is one thing that most everyone can agree on, it is that President Trump is relatively unpredictable. Regardless, there is no way to know how anything that the President does will impact the market. There are some consensus thoughts, but we’ve witnessed President Trump change course a few times on various issues. Additionally, so-called trade wars have been going on for decades. Marketwatch actually just put out a great piece based on an infographic from Visual Capitalist showing these trade wars through time. Their conclusion was this,
But perhaps the most interesting fact highlighted by Visual Capitalist’s chart is that the cost of trade has steadily been dropping, making it cheaper to buy and sell with other countries, suggesting that no matter the threats and tariffs, global trade is likely to continue growing.
As for the politically charged nature of this market uncertainty, I have two thoughts:
For the Trump Bears: The reason that making decisions based on political leanings is foolish is simply that there are far too many variables at play in the stock market for the outcome to be dependent on the actions of any one person, including the President. There are millions of investors and institutions that are making different decisions based on different relative variables. Given that fact, there is just too much going on for there to be much, if any, predictive value to anything that comes out of the White House.
For the Trump Bulls: If you are a big believer in the bull market under Trump, it would probably be worth knowing that every single president since Hoover has seen severe corrections or bear markets on their watch, so it’s at least likely that we’ll see one with Trump in office. What will lead to it? I’m not callous enough to guess and I don’t think anyone else should be either.
Regardless of which side of the fence you fall on, the good news is that successful investing takes a long-term view ranging decades, not a few months or years.
3. Higher Deficits and the National Debt
This one is particularly popular among retirees and those getting close to retirement. Here is an article by the Fiscal Times about the “3 Big Risks the US Faces as Debt Levels Soar“. This is a recurring theme in both long-term and short-term headlines and is a topic that I hear quite often from the investors that I chat with. Since most of my readers are at or nearing retirement, it’s likely that you either share this concern or have heard about it pretty regularly over the past few years as the debt level has increased.
But the truth is that this has been a concern for decades. For a history of the debt phenomenon, see this article from The Atlantic titled, “The Long Story of the U.S. Debt, from 1790 to 2011, in 1 Little Chart“.
While I can understand the concerns because it just doesn’t seem quite right for the government to have so much debt, the U.S. Government does not work like our household budgets might. See the commentary.
Commentary: Perhaps the best resource offering rebuttal to this perspective comes from that of Cullen Roche from Pragmatic Capitalism. Mr. Roche spends his hours educating the public on what matters and what doesn’t matter when it comes to government spending and the federal debt.
Planning Thoughts: As I state regularly, my opinion is always to control what we can control. The future repercussions of the federal debt debate are unknown. While I tend to side with Mr. Roche’s assessment and believe this concern to be a bit overblown, there are no known facts of the future.
Though, as I stated above, it is of note that the federal debt has been a popular magazine cover topic for decades and thus far, the market has continued to push forward with remarkably consistent long-term returns. I’m not saying that’s how it will be forever, I’m just saying that the markets and the economy have kept moving forward despite the national debt.
4. Inverted Yield Curve
Many investors don’t even realize that you can lose money in bonds. In the simplest terms, as interest rates rise, the value of existing bonds are likely to fall. This is one market call that could have legs as far as the markets go. My friend Justin Castelli put together a good video primer on the “Inverted Yield Curve” and what it means if you are interested.
The interest rate spread is still very tight between the 2-year and 10-year Treasury, currently sitting at 0.38. This is often a cause for concern as far as recessions go. LPL has a lot of great research on the topic and notes that,
Inverted yield curves have a perfect history of predicting economic recessions over the past 50 years, with nine of the past nine inversions followed by an eventual recession.
Keyword here being “eventual.” I’m not purposely being harsh on LPL here, but that’s like saying that based on my personal history of waking up, it is usually followed by getting hungry at some point. I mean, based on the history of the market, don’t most intelligent investors expect that market pullbacks and recessions will occur eventually? Bull markets can’t go on forever. Is the inverted yield curve the cause, or a comfortable coincidence of the word eventual. They go on,
Here’s the catch: the yield curve isn’t inverted, and we’ve seen periods with a relatively flat yield curve that have lasted years before a recession (the mid-to-late 1990s for instance).
The question on everyone’s mind is, “If the yield curve does invert, when should we expect a recession to occur?” Even they acknowledge that this inverted yield curve isn’t overly predictive from a timing perspective. That said, here is a chart showing how the yield curve has been evolving recently.
Source: Yahoo Finance & Factset
Commentary: I don’t have a lot to say on this. Despite my relatively cynical comments above, the data is nonetheless compelling that this could become an issue. Time will tell.
Planning Thoughts: What might you do about this? With yield curves flattening, you may consider keeping your bond positions on the high-quality, short end of the spectrum, if for no other reason, opportunity cost. If you decide to tie your money up in long-term bond positions to squeak out a little extra return, you could be opening yourself up to the value of your positions falling while giving up the opportunity to invest elsewhere. Likewise, if you decide to go lower quality (to increase your rate), you could be opening yourself up to default risk if the economy stumbles.
Therefore, as a general rule in our current interest rate environment, I am of the opinion that bonds should not be used as a significant return vehicle for clients but as a safe harbor or buoy during tough market times. By sticking with shorter duration and higher quality bonds, you expose yourself to less interest rate risk as well as less price fluctuation. That is the combination that I am generally seeking when the market does turn south again.
This is certainly not an exhaustive list, but the primary ones that popped up for me when actively searching for bubble predictions. We know that one of the defining factors of bubbles is the inability to predict the cause or timing of it. That said, we still view it as a wise strategy to consistently look for things that could upend the markets. We certainly make no predictions as to what will happen and therefore believe in controlling the variables that we can control. This would include the allocation of assets between stocks and bonds, adjusting your fixed income portfolio to be less susceptible to changes in interest rates, using conservative assumptions in your planning and keeping historical perspective when things do eventually go south.
My goal is simply to keep my clients and readers from “being surprised”. It would be valuable to stress test your plan by conducting these types of “lifeboat drills”. Imagine how you’ll react if one of these comes to pass and adjust your plan accordingly.
Given your retirement plan, how prepared are you to deal with a 20%, 30% or 40% decline in the stock market? Do you have an income strategy that would allow you to comfortably deal with that possibility for one year? Three years? Eight years? If you don’t feel confident in how you might handle a situation like that, you might consider talking to a qualified retirement planner to get your plan on track.
A goals-based plan requires being checked and adjusted on a regular basis to be sure you are still on track. It also requires emotional fortitude and patience that can only come about through education and a plan that accounts for the ups and downs of the market. Don’t try to shoot the moon with your portfolio. Instead, seek a portfolio strategy that increases the probability of reaching your goals with the fewest frictions possible.
Lastly, if you have other ideas of bubbles that you believe I should have included in this list, catch up with me on Twitter or send me an email at firstname.lastname@example.org.
Additional Recommended Reading:
Financial News Doesn’t Rhyme, But It Does Repeat Itself – by Ben Carlson
57 Points – 2018 Market in Review by Michael Batnick
Thanks for reading!
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