Featured in Forbes on June 29, 2017

Nearly 105 years ago, on April 15, 1912, the famed Titanic ship sank into the Atlantic Ocean after a fateful collision with an iceberg. Several theories have been proposed as to how the ship—which was an engineering marvel at the time—was brought down on its maiden voyage. A recent documentary entitled, "Titanic: The New Evidence1," explores the premise that the iceberg may not have been the sole cause of the Titanic's sinking after all. New evidence and research presented in the documentary focuses on reports of a coal fire which may have started in one of the ship's bunkers before the ship left the harbor. This slow-burning coal fire likely caused the ship's hull to weaken considerably, leaving it susceptible to any type of impact. As it turns out, the crew’s standard procedure for a coal fire would have been to dig out the burning coal and place it into the steam engine boiler, which may have explained the ship's higher speed when making impact with the iceberg. If there was in fact a fire onboard before the ship left, could the entire accident have been prevented had the crew taken further precautionary steps?

Whether or not this new evidence is credible (we may never know the true cause of the disaster), there are some important parallels to the investing world and how we as investors react to both internal and external factors. In a news-heavy world, with constant flows of oftentimes conflicting ideas, it is easy to be consumed by the proverbial sea of information instead of minding one's own ship. Daily market information can certainly test an investor’s willpower. Some commentary will stir-up unease about the future while others will encourage you to pursue the latest investment trend. 

 

Looking back at history, there are plenty of ominous headlines we can learn from. One notable example is the August 13, 1979 cover of BusinessWeek, which made a rather dire prediction: “The Death of Equities." When this cover appeared in BusinessWeek, stocks had underperformed short-term treasury bills for nearly a decade and any nominal returns were almost entirely wiped out by high inflation, which topped 13% per year in 1979. Basically, the entire decade was a complete headache both for stock and bond investors. Shortly after this BusinessWeek issue hit newsstands, the stock market began a major rally—and during the 1980's and 1990's, the S&P 500 produced annualized returns of over 17% (with dividends reinvested) while inflation returned to more normal levels.

 

Another example is the infamous Black Monday (October 19th, 1987) when the Dow Jones Industrial Average experienced its largest one-day percentage drop of all time, falling nearly 23%. The Brooklyn Daily Eagle published this seemingly catastrophic cover, invoking fear amongst investors. Would you have guessed that the stock market (as measured by the S&P 500) would end the year 1987 up over 5%, and then go on to notch positive returns in 10 of the next 11 years?

More recently, in January of 2010, The Economist magazine published the cover at left, claiming assets were overvalued and that a bubble had surely formed. From the time this cover was published in January 2010 to January 2017, the S&P 500 index returned over 130% with dividends reinvested.

There are dozens of examples of dire predictions which never quite materialized, creating unnecessary panic in the process. As economist John Kenneth Galbraith once stated: "There are two kinds of forecasters: those who don't know, and those who don't know they don't know."

We don't take instructions from the market; instead, we construct portfolios withstand a myriad of economic situations. Although we never gamble on making market predictions, we do stay apprised of the prevailing economic environment and have noted the following conditions. 

  • Record highs in domestic markets. U.S stock indices have continued to inch higher, with the Dow, S&P 500, and NASDAQ indices all hitting fresh new highs this year. While the U.S. stock market has been the ‘cleanest shirt in the hamper’ for some time now, other world markets have not fared so well. We continue to stress the importance of maintaining portfolios which have exposure to both domestic and international markets. 

  • Low interest rates linger. Interest rates are still near historic lows—but how quickly they may rise is unknown. The Federal Reserve has maintained that interest rate hikes will be coming this year, but will occur gradually and with caution. If the Fed does raise short-term rates, and overall interest rates move higher, bonds will likely take a modest hit in the near-term. The good news is—as bonds mature, the proceeds will be reinvested at the higher prevailing rates. 

  • Political unease continues. Within your own office, family, or group of friends, there is undoubtedly some difference in opinion regarding politics. However bitter the political discourse has been over the last several months, it is important to remember that policies and laws are implemented in a relatively organized fashion and it is quite rare for legislation to move through the halls of Congress quickly. In other words, there is a good amount of noise in politics, and (for better or for worse) there is relatively little action taken. In fact, recent studies have shown that less than 5% of proposed bills actually move on to become laws. 

  • Tax reform may be on its way. Speaking of laws, we do expect some version of tax reform in the near future. But as we outlined in our last quarterly letter, the specifics will not be known until they are signed into law. It would be premature to make decisions today with cemented expectations for what is yet to come. After all, there has not been a simplification or major overhaul of the U.S. tax code since the Tax Reform Act of 1986.

Instead of obsessing over these macroeconomic factors beyond their control, we urge clients to focus on what can be controlled: 

Portfolio diversification.

By definition, a diversified portfolio should always have something that is not working. As mentioned earlier, international markets (as measured by the MSCI ACWI ex-USA index) have underperformed the U.S. stock market over the last four years. However, over the last 20 years (1997-2016), performance has been about even, with the U.S. outperforming international in 11 of the 20 years and international markets outperforming the U.S. in 9 of the 20 years. If investors were to allocate capital only to domestic markets, they would miss out on investing in roughly half of the global economy.  

Maintaining an appropriate level of risk.

It may be tempting to purchase what has recently done well and sell what has not. In other words, buy more stocks because stocks have been moving upward and sell bonds as their performance has been somewhat lackluster. This can lead to a portfolio that is out-of-whack and inappropriate for your long term goals. Don't let market noise dictate how much risk you are willing to accept for the long run. Disciplined rebalancing can also help reduce overall portfolio risk. 

Minimizing income taxes.

Although we do not know what tax changes will be implemented in 2017 (if any), we do take a tactical approach to minimizing income taxes in our clients’ investment portfolios. For taxable accounts, we utilize tax loss harvesting (recognizing losses for tax purposes, while maintaining the stated portfolio objectives) and asset location (strategically placing certain assets in taxable and tax-deferred accounts) to help improve after-tax returns. 

As famed investor Howard Marks once stated:

"Investing concerns exactly one thing: dealing with the future—yet it's clearly impossible to know anything about the future. You can't predict, you can only prepare."

We believe being prepared is the best remedy in a world of great uncertainty. We cannot control what happens in the economy or in politics, but we can certainly be prepared to encounter and adapt to a myriad of market environments.

1The complete documentary reference above can be found at: http://www.channel4.com/programmes/titanic-the-new-evidence