Gil’s Musings

Market Volatility is Back!

Ok, now people are getting jumpy. The market being down more than 1,000 points in one day gets people’s attention. That’s happened twice in a week.

Many people are asking whether they should pare back their stock holdings. We generally avoid switching gears too much for several reasons I will describe below. I do agree that equities are at the high end of their valuation range after a decade of decent returns. Several clients also thought that was the case 4000 Dow points ago when I talked them in off the ledge. Clearly that was premature, and I believe remains so today. But let’s discuss perspective. Many indices have just recently eclipsed their 1999 highs (i.e.NASDAQ 100; symbol QQQ) taking 17+ years to recover. The Dow Jones 30 traded at 11,130 on 12/30/1999. It was still at that same level in 4Q 2011, twelve years later. That’s because two 50% drops applied in the meantime; a feat only seen four times in history. Many say 50% drops are now common, which surely contribute to investor jumpiness. I believe in reversion to the mean, and it’s unlikely I will see such abrupt losses again in my lifetime. Let’s also be reminded that while parallels to 1999 levels are seen in the media, they never seem to acknowledge that current “prices” are much lower since we have 17 years of compounded earnings suppressing the P/E today vs then. Many companies earn twice the dollars per share today as compared to 17 years ago. If the index number is the same, you are getting twice the amount of value per dollar spent because earnings per share is what you are getting when you buy a stock. If earnings are twice and the “price” is the same, you get twice the value or half the P/E. Pundits see things absolutely by quoting today’s index level vs 1999 index terms (5000 level NASDAQ index) rather than quoting relatively (price vs earnings; P/E), which I find more rational.

The market is surely euphoric about having a businessman running the White House. I was stunned that he got the tax package passed, and it’s no wonder stocks have leapt. This is the biggest tax cut in US history, with Reagan’s 1981 & 1986 versions being larger only when combined. Stocks in the 1980’s and 1990’s had two of their best decades ever. That’s not a coincidence. It is however based on another interesting phenomenon that does not exist today; 12% (and declining) interest rates. Declining interest rates surely had a large effect on driving investors out of bonds and into stocks; a phase that seems nearly polar opposite to today. With the ten-year treasury at 2.8% today and seemingly headed higher, the backdrop of declining rates is likely long gone. The reversal of this decades-long trend is what has stock investors jittery for three reasons: higher borrowing costs sap company profitability, higher bond yields motivate stock holders to switch horses thus creating selling pressure in stocks, and memories of 1987 when interest rates quickly ratcheted higher and scalded stocks, albeit briefly.


Goldman Sachs says rising rates don’t pose a threat to business profitability until borrowing rates are higher than the cost/value of production increases. They say the magic number on interest rates that begin to get scary is 5%, but 4% on a different metric. But remember also, only a fraction of a company’s debt comes due each year (about 10%). So rising rates take some time to negatively affect a company’s earnings since most have longer term debt at fixed terms. A 10yr Treasury yield that high (4-5%) could pose a threat of a recession by suppressing business’ access to cheap credit. While interest rates are trending higher, positioning for that at 2.8% today seems premature to me.

Then there’s taxes. Earned income tax rates have come down, and so have estate taxes with increased exemption amounts. Not so for capital gains taxes. Selling stocks with 60% or 150% gains must be invested in a far better vehicle since the seller might only have 68% of their capital remaining after the tax. This is particularly important as we age, and just a reminder, the step-up-in-basis rule survived the estate tax negotiations. Many readers have read my blogposts on the significant role of deferring taxation in generating long term wealth. Remember that holding a stock with a gain is not taxable. It’s only taxable when you sell. Holding the profit at death by not selling is never taxable since tax on gain is exempt at death (step-up rule). Selling stocks to position more conservatively only because of a lofty market might result in optional taxation, not merely premature taxation. Each sale wipes that slate clean, giving an incentive to stay put as long as possible, especially until death if possible. This is why each position needs the characteristic of possibly holding forever, a well-known maxim of Warren Buffett. Sell rarely! Links to two Segment tax/gain blogposts I wrote can be found here: Don’t just do something, stand there and The Cost of Realizing Gains Too Soon.

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I’m not suggesting that stocks are poised for spectacular returns, nor are they doomed. I’m simply not prepared to offer a decent swap candidate; especially after taxes are considered. Additionally, the normal place to hide from stock volatility is the bond market. With the 10-year Treasury at 2.8%, that implies a P/E of 36x. That’s roughly twice the “price” of the SP500 P/E at 18-20 (depending on who you ask). If anything is expensive, it’s bonds. Most bonds also generate interest which is taxable every year and taxable at the maximum bracket (except muni bonds). Real estate is another place to hide, but real estate is less liquid than stocks, and has property tax and admin costs to bear. Higher interest rates make future development less practical, potentially hobbling the value of land. There are many reasons to like land, but it surely is not immune to rising rates, suffering from many of the same implications causing stocks to dislike higher rates.

One last point. What if I came to you in October of 2007 and told you that the second most severe recession and second largest market crash in history were about to commence, and you had but one chance to make a swap, would you take it? Treasury bonds were a fantastic choice to sidestep the decade commencing just before the financial crisis. Ten-year Treasury bonds would have mostly immunized you from that horrific near-60% loss and paid 5% interest annually to boot through 2017. Yet, ten years later stocks have actually provided a better return by 25% more. That’s before you consider the capital gains tax you would have likely paid to exit your stocks and before you consider the income tax on bond interest is at least twice as high as the tax on stock dividends and gains. You would also be carrying another ten years of stock compounding and inching toward a tax-free step up. In the end, stocks have likely provided more than 2x return advantage all things considered, while even including a 60% loss along the way. Those are compelling reasons to stay put. Patience pays!

Segment is generally standing pat with its positions currently. We might have a change of heart if interest rates accelerate and we risk likely then-lower stock prices accordingly. But the trend in rates could shift between now and then, making a move now a near certainty to cost taxes and retarding of compounded gain, without the certainty of declining share prices to warrant that move. We are confident stock prices will recover from any setback, as they have proven time and time again.

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