Risk & Reward
Thirteen months after the spectacular failure of Lehman Brothers and the subsequent financial carnage, investors know more about investment risks than they ever cared to know. The trade offs between risks and rewards (the opportunities afforded to those with the prudence, patience, and perseverance) are never crystal clear but seldom totally obscure. Having just navigated through the most turbulent investment markets in modern times, all of us have reassessed our risk tolerances and many of us have stress tested our portfolios. We should all be better prepared to meet the future vagaries of the financial markets.
After declining by 53% from its peak in October 12, 2007 to its low on March 6, 2009, the stock market (as measured by the Dow Jones Industrial Average index) rallied 47% though September 30th as investors re-entered the markets some had fled in disarray. Equity valuations remain, as always, debatable (are they rich or cheap?) and interest rates, while up from their lows, remain very low. At least the economy is on the mend. Q2 GDP was recently revised up to an annualized 0.7 percent decrease from a previously estimated 1.0 percent decrease. Inventories were revised lower – a possible positive for increased production in the second half of 2009. Third quarter, 2009 GDP growth likely was positive and we believe 4Q09 should also be, albeit less robust sans the Q3 cash for clunkers stimulus. The stock market rebound may tell us that valuations may have been too low last spring and that the recession has likely ended. But higher unemployment rates will be with us for a while before moderating as demand resumes, possibly by mid 2010.
Real Estate – the most recent S&P/Case-Shiller® home price index released on September 29th, reported its third straight monthly gain. While the US residential home market remains weak, the worst may be over with home affordability indicators at all time highs and mortgage rates at low levels.
Investors and their advisors are faced with daily decisions of how much risk to take in protecting past gains and pursuing future rewards. Some observers argue that near term market moves are mere “noise”; distractions amidst buy and hold long term investing. The downdraft in account valuations certainly felt worse than that. Current CD and money market rates provide little risk but almost no reward (in fact CDs may expose depositors to a silent risk of losing buying power if inflation turns up). Investors generally correctly perceive stocks as being riskier than bonds, but intermediate and long term bonds at these low interest rates are vulnerable to losing value if interest rate and inflation rise. We believe that investors should generally favor shorter term maturity bonds ahead of longer term issues.
Stocks valuations, as measured by the average P/E (price to earnings ratio) of the S&P 500 Index, have averaged 17.6 times over the last 29 years (since 1/1/80-9/30/09). They are currently at an estimated 19.9 times. On this basis some would say they are on the expensive side of historical ranges (the high over this period was 31.0 times in 2001). However, while the “P” (price) in this ratio is unambiguous, the “E” (earnings) is only an average of estimate – and estimates are always subject to revision, never more so than during times of economic transitions. If this recovery is real, many companies’ earnings estimates will be revised up, some meaningfully, rendering a forward P/E lower than the currently estimated one. In other words, stocks prices may be reasonable to cheap at current levels.
Bond prices, usually less risky than stocks, still have risks. As we discussed earlier they are vulnerable to rising interest rates once the Federal Reserve starts to raise official rates to combat inflation and/or withdraw some of the excess liquidity it has created. The ten year US Treasury note (2 ¾% due 2/15/19 at a price of $95.484) had a yield of just 3.31% at September 30th and a duration (or price sensitivity to interest rate changes) of 8.27 years. Duration (pardon the jargon) is the percent change in a bond’s price relative to the change in interest rates. In other words, if interest rates rise 1% over the next twelve months, the price of the 10 year UST bond will decline approximately 6.6%. An investor owning this security would lose over 3% pretax in this scenario over the course of 1 year; more if interest rates spike higher. Risk adverse investors may want to remain on the short end of the maturity spectrum to reduce this risk.
Commodities – (petroleum, agricultural products, and metals) are sensitive to global economic growth. Typically priced in US dollars, they are also used to “play” a weaker dollar. Should the US dollar weaken against major foreign currencies, commodity prices would be expected to rise in price. The actual prices will largely be driven by global supply and demand for the underlying commodities.
As always we will endeavor to track, measure, and balance risk vs. reward hoping that Q4 is as rewarding as Q3 was but on guard for the risks underlying markets. Our goal is to try to deliver competitive returns with below average risk, thus being effective stewards of your money. Thank you for your continued trust in Regency Wealth Management.
Mark D. Reitsma, CFP® Andrew M. Aran, CFA