Illumination Wealth January 2014: Is It Possible to Predict the Future?

Happy 2014!

We hope you had an excellent holiday season and that it carries over into an even better 2014.  As they say, today is your first (or second) blank page of a 365 page book. Make sure your write a good one.

2013 brought more success than we could have ever imagined. Being a part of your life’s journey and sharing in your experiences is the success and has been more rewarding than one can put to words.

In this year alone, we had clients and friends get married, “officially” retire, have children (and grandchildren), start their own businesses, see their kids off to their first year of college, purchase their dream home, get promoted and/or took on a new job, travel to incredible places and become completely debt free amongst others. We hope all of you had a successful year land-marked by your own personal and professional milestones.

It has truly been an amazing experience and we look forward to continuing our journey with you.

Here’s what we cover for you in the beginning of 2014:

· The Market Scoreboard for December 2013

· Illuminating Insights:  Is It Possible To Predict the Future?

· Readings of Illumination: Curated Articles for Your Financial Enlightenment

Market Scoreboard

Here is the market scoreboard for December 2013:

Notes: S&P 500, MSCI World Index ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: www.stockcharts.com. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.

What can we say, 2013 was an extraordinary year in many respects. U.S. stocks continued their ascent at a very healthy pace and foreign developed markets such as Europe and Japan finished higher in a close second to the U.S. Outside of stocks, there was little in the way of positive performance. Emerging market stocks declined over 5% on the year and diverged greatly from their U.S. counterparts (which is quite the aberration across history). Commodities declined in excess of 10% as did long-term U.S. treasury bonds. A year like this makes portfolio diversification look bad.  It can be tempting to think that because a year like this in the U.S. stocks you no longer need diversification. Until the day comes when you are able to predict the markets, you are in for one wild ride if you dismiss it.

Diversification is a valuable risk management too, but only when done correctly. Your goal when diversifying should be to add independent and sometimes opposing sources of return. This can lower risk and possibly increase overall return when combined with the other investment methods. As a U.S. investor, diversification, in this sense, would have had you invested in non-related markets such as bonds, real estate, commodities, gold, foreign and emerging market stocks and TIPS amongst others. As you think about constructing your portfolio, diversification should go well beyond equities and should be focused on the amount of risk that is appropriate for you (and no more than what is needed) that is in line with achieving your financial life goals.

We encourage you to read over our next section which has an even more detailed review of 2013 and outlook for the year ahead.

Illumination Insights: Is It Possible To Predict The Future?

“A man only learns in two ways, one by reading, and the other by association with smarter people” – Will Rogers

The New Year always brings about a shmorgashborg of predictions. We too, are quite often asked: “what will the stock market do in the year ahead?” No matter what the media or any financial guru says about the future, they truly don’t know and neither do we.

As we have pontificated in the past, it is significantly more useful to have a plan and a process that will lead to good outcomes over long periods of time. We don’t believe one should ever invest (or gamble) based on a rumor, hot stock tip, future prediction, or expectation that the market will just go up.

Paying attention to predictions makes it much harder to follow your plan. It’s easy to get swept up in predictions as they often make us feel like we actually have control over something that in reality is quite random and uncertain. Despite that, it’s useful to learn from ourselves and others which is why we want to feature a great article on both of these subjects from Jason Hsu of Research Affiliates, a global investment manager with $158 Billion in assets under management.

The Challenges of Year End Forecasting

Christmas will soon be upon us. Many of us in the investment business have just completed annual performance reviews and informed our staff of compensation decisions that are charged with practical and symbolic significance. These are bittersweet times. No doubt we all have talented people who have put in great effort but met with bad luck and worse results. Clearly, there is no lack of the opposite as well. Ah, the million dollar question in management and a topic for yet another B-school case study: “Do you reward application or outcome? Input or output?” The aftertaste in our mouth may be the eggnog, but perhaps it is the smack of our better judgment and the trace of our choice to pay big incentives for what we know was partly the product of chance. In any event, we concede that the ritual of celebrating good fortune is best observed in this time of festivity. You might have been a big winner. You might be the lucky one next year. Have some eggnog.

And there is an inescapable irony. In our quiet introspection, as we look back on this past year, we, the investment officers and research analysts of the world, are smarting from the same thing. It’s been a tough year for anyone who hasn’t boldly overweighed U.S. equities in the face of inevitable tapering, continual political dysfunction, and the uncertainty surrounding public policy. It’s been a bad year for anyone who has prudentially diversified away from a concentrated equity allocation.

Nearly everything else has performed abysmally.

But let’s not dwell on the unpleasantness. Let’s take credit for what we got right. Let’s bemoan the irrationality of the market for the calls that we got wrong. And let’s look ahead to the coming market environment. A humorist said, “An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”¹

Forecast the Market?

Forecasting the future would merely be psychical posturing if there were no evidence for its feasibility. Fortunately, this year the Nobel Prize Foundation honored two economists who both produced works suggesting that index dividend yields and cyclically adjusted P/E ratios (CAPEs), among other aggregate variables, can predict future equity market returns. While Eugene Fama and Bob Shiller virtually anchor the opposite sides of the market efficiency debate, Shiller’s 1987 and 1988 research papers with John Campbell (1988a, b) and Fama’s paper with Ken French (1989) conclude that market valuation ratios forecast five-year returns with satisfactory accuracy. High dividend yields and low CAPEs tend to predict above-average future returns; conversely, low yields and high CAPEs signal below-average returns.

While our two Nobel Laureates may disagree on why investors might plow money into the stock market when valuation levels are already high, they do agree that high CAPEs and low dividend yields are symptomatic of investors’ higher-than-average demand for equities; this willingness to bid up prices must, at some point, result in a lower-than-average future return. The CAPE (or the Shiller CAPE, as it is often called) spectacularly forecasted the carnage of the 2000 tech bust and the 2008 Global Financial Crisis. Of course, the same indicator has often predicted bear markets many quarters ahead of any appreciable decline.

So what did the Shiller CAPE of 21 for the S&P 500 Index tell us in January 2013? Given that it had a recent trend of 22 and a long-term average of 16.5, U.S. equities appeared to be neutral to extremely overvalue. The U.S. equity market’s return of nearly 30% in 2013 has pushed the Shiller CAPE toward 25; this appears decidedly expensive relative to recent and long-term levels. For emerging market (EM) equities, the Shiller CAPE stood at 15 at the start of 2013 versus its recent trend of 20.5 and long-term average of 16; EM equities thus appeared attractive to exceptionally cheap. Their –1% performance in 2013 has been one of the big disappointments for global equity investors who expected a recovery in economic growth after the great U.S. recession.

What ought we to make of the Shiller CAPE’s 2013 performance and its implied 2014 prediction? Contrary to CAPE-based expectations, U.S. equities outperformed EM equities by roughly 33%. Do we shrug off this perverse outcome as a fluke, an outlier? Should we double down for 2014 by further rebalancing away from U.S. equities toward EM stocks? It certainly feels dangerous to jump on the U.S. equity bandwagon after the 2013 rally.

Shiller CAPE Controversy

Of course, a discussion about the efficacy of the Shiller CAPE would be incomplete without considering the much ballyhooed disagreement between Professor Jeremy Siegel and Bob Shiller, himself, on the right way to compute the measure. The gist of Siegel’s argument is that backing out abnormal corporate earnings write-downs would make the Shiller CAPE look more compelling for U.S. equities. In reality, the controversy is groundless. Siegel wanted to rationalize the Shiller CAPE model’s underwhelming 2013 performance by recalibrating the model inputs so as to generate a buy signal for U.S. equities, retroactive to year end 2012. Siegel is Shiller’s dear friend and loyal champion; one might perhaps infer that he wanted the Shiller CAPE to work more than did Shiller himself.

Curiously, applying the same calibration method, we are likely to get a significantly more attractive buy signal for EM equities. This would, again, prompt a massive overweighting of EM equities at the expense of U.S. equities for much of 2014. Whether one sides with Professor Siegel or Professor Shiller, it does seem that, at the current Shiller CAPE, both would prefer EM equities over U.S. equities.

Bitter Medicine

While we are on the subject of Nobel Laureates in finance, it is worth remembering the crowning insight of Professor Harry Markowitz, who won the prize in 1990: diversification is the ultimate free lunch in investing. Clearly, 2013 was not the year for Nobel-worthy investment ideas. This year was most unkind to diversification. The free lunch was nothing short of bitter. Excluding equities, most asset classes had near zero to negative returns for the year, as Table 1 illustrates.

Does 2013 tell us that diversification is no longer operative? I would hope that investors do not reject sound investment principles on the basis of outlier experiences.

Fixed Income Crushed

It was probably no surprise that fixed income performed poorly. Nominal yields have been low; naturally, therefore, realized returns were also low. What was noteworthy was the divergence in performance between TIPS and nominal Treasury bonds. The negative yields registered by TIPS were a consequence of investors’ overreaction to the inflation risk engendered by massive quantitative easing. The substantial underperformance of TIPS relative to conventional Treasuries was the expected mean-reversion in inflation expectations, or the breakeven inflation. Alas, it marks a small victory for us contrarian value investors for 2013!

Concluding Thoughts

All eyes are now on the policy leaning of the Yellen regime.

The Federal Reserve announced that, starting in January 2014, its monthly bond purchases would be lower by $10 billion. Tapering is officially under way. However, the announcement also stated, “The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative….” The full economic and market impact of bringing quantitative easing to a close remains to be seen.²

According to a 2013 market outlook survey recently released by CFA Institute, 71% of all respondents now believe that equities will be the best performing asset class for 2014; this compares with 54% at the end of 2012. Respondents are also most optimistic about the U.S. stock market and most pessimistic about Brazil. These views reflect the familiar extrapolation of past returns and momentum in sentiments. Whether the survey has any forecasting power is difficult to assess and is, in any case, beside the point. The U.S. equity market can certainly rally another 20% in 2014. That is entirely within the realm of possibility, even if the Shiller CAPE predicts it to be improbable. What is, however, forecastable with a great degree of assurance is that if the U.S. equity bull market continues into the first half of 2014, many investors will pour more cash into equities and fire managers who have underweighted U.S. stocks. When all is said and done, this decision is likely to prove extraordinarily costly.³

Endnotes

¹ The quote is attributed to the great American humorist Evan Esar.

² See Hsu (2013).

³ Goyal and Wahal (2008) find that the wealth lost by investors from the practice of firing and hiring managers on the basis of recent performance far exceeds the average net-of-cost underperformance of active management.  The same finding has also been demonstrated in a number of Towers Watson research reports.

References

Campbell, John Y., and Robert J. Shiller. 1988a. “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors.” Review of Financial Studies, vol. 1, no. 3 (July):195–228.

_________. 1988b. “Stock Prices, Earnings, and Expected Dividends.” Journal of Finance, vol. 43, no. 3 (July):661–676.

CFA Institute. 2013. “Global Market Sentiment Survey 2014.”

Fama, Eugene F., and Kenneth R. French. 1989. “Business Conditions and Expected Returns on Stocks and Bonds.”Journal of Financial Economics, vol. 25, no. 1 (November):23–49.

Goyal, Amit, and Sunil Wahal. 2008. “The Selection and Termination of Investment Management Firms by Plan Sponsors.”Journal of Finance, vol. 63, no. 4 (August):1805–1847.

Readings of Illumination

Here’s our monthly compilation of interesting articles and videos designed to keep you informed and engaged in the areas of personal finance, the economy and life. We hope you enjoy this month’s edition. Please send us your thoughts on this month’s articles and suggestions for future posts.

Personal Finances

Success: A Peek at To-Do Lists of the Wealthy

The New York Times: For Top Earners, a Bigger Tax Bite This Year

Investment News: Nobel Laureate: Everyone should have a financial adviser

The New York Times: Emotion Has Its Place in Financial Planning

Economy & Business

Eventual Millionaire: Kickstart 2014: Insider Growth Evaluation Webinar

Dan Khabie: Big Idea 2014: The Next Big Idea Is Already Here

Life

Darren Hardy: Is Success in Your DNA?

Success: Get a Life

Great TED Talks & Videos

Paul Piff: Does money make you mean?

“In the end, it’s not the years in your life that count; it’s the life in those years.” – Abraham Lincoln

In 2014, how will you make your life dreams become reality? We know that IWM Wealth Plan can help. With our professionally designed Wealth Plan, you’ll see: how close (or far) you are to financial freedom…how to grow your savings and cash flow…how to purchase your dream house…how to pay for your children (or grandchildren’s) education.

If there is anything that we can do to help, please contact our office and we can set up a time to talk.

All the Best,

Matt & The Illumination Wealth Team

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The opinions and forecasts expressed are those of Matt Rinkey, President of Illumination Wealth Management (IWM) and may not actually come to pass. Mr. Rinkey’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security or Illumination Wealth services. No part of this material is intended as an investment recommendation. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any of IWM’s services. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that investment objectives outlined will actually come to pass. Investors should consult an Investment Professional before investing in any investment program. Neither Mr. Rinkey or Illumination Wealth nor any of their employees shall have any liability for any loss sustained by anyone who has relied on the information contained herein. Entities including, but not limited to IWM, its officers, directors, employees, customers and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. The analysis contained is based on both technical and fundamental research. Although the information contain is derived from sources which are believed to be reliable, they cannot be guaranteed. Past performance is never a guarantee of future results.