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Third Quarter 2015 Investment Report

Chicken Little or Zeus?

Last month the market fell out of the sky. It caused quite a stir. Or not. It all depended on who was watching, and from what vantage point.

Chicken Little freaked out.   She scurried about in the dirt, with clouds of dust swirling around her. She could barely make out Jim Cramer’s image on CNBC’s beloved Mad Money. All the noisy bells and buzzers and rifle shots and shrieking crowds didn’t allow her to really hear much of what he was saying. But she knew it must be bad. When the market was down 10%, Chicken Little decided there was no more hope, and sold her equity positions. This is what really bothered her:

chart 3Q15 1

Zeus, on the other hand, wasn’t paying much attention to the commotion. From Mt. Olympus, things on Earth tended to look fairly small and unimportant. He viewed his investments from a distance, literally.   Zeus is clearly a long term investor. In fact, he actually looked forward to major market dislocations, when he could become a buyer, while mere mortals were flailing around and fearfully selling. Here is what Zeus paid attention to:

The above two charts go well beyond looking at daily, weekly or monthly securities’ price fluctuations. Rather, they track the yearly earnings and dividends of the S&P 500 over several decades. Dividends are paid out of earnings, and earnings show the health of a company. Stock prices are formed by humans, using human reasoning, which often incorporates emotion into the equation. But earnings and dividends are not based on emotions. They are actual, factual, “hard” numbers.  

From an emotionless distance, it is easy to see that over the long term, the trend in both earnings and dividends of large US stocks is clearly increasing. Yes, there is an occasional dip. Both dividends and earnings can take a step or two back during recessionary times. But as one can see, both dividend and earnings have always bounced after corrections and made new, higher highs. That’s why Zeus likes to buy at times when stock prices have retreated. He believes that earnings and dividends, as well as the more fickle stock prices, will move back up over time.

There is very good reason to invest like Zeus rather than Chicken Little. See the empirical data below. The chart shows what happens after various stock markets (US Large Caps, International Large Caps and Emerging Markets) have had 5% and 10% declines:

 

The data in these charts show us several important facts:

  1. 5% and 10% pullbacks are rather commonplace, and occur much more frequently than investors have experienced during the last few years of low volatility.

  2. The average magnitude of declines reaching 5% and10% have been about 50% more than those figures.

  3. After reaching the bottom of the decline, the market return for the next 1 year, on average, has historically been very generous to those who have either held through the correction or bought after the pullback had occurred.

These are the reasons your DHGWA advisor hasn’t given you a panicky phone call and recommended the wholesale selling of your equity asset classes. Statistics show that although there are never any guarantees in investing, selling into a meaningful pullback is seldom an intelligent reaction. Rather, with patience and potentially some rebalancing, there are often meaningful returns to be enjoyed by those who take a longer term perspective.

Most investors are neither mindless birds nor deities, but possess potential traits of each. Like Chicken Little, they can get caught up in the “sky is falling” mentality. Like Zeus, we have access to vast historical market data and can benefit from this perspective. Investors have a life expectancy somewhere between a chicken’s 42 day cycle from egg hatching to processing plant, and Zeus’s immortality. Hopefully, their investment decisions will take a long term perspective, and they’ll act more like a demigod, and less like a dumb cluck.    

Housekeeping

Our ADV2 Brochure, filed with the Security Exchange Commission, was updated on August 25, 2015.  Since the date of our last update, there have been no material changes to our business practices of which you would need to be made aware.  As ever, a copy of the most recent ADV2 may be obtained for free by contacting Kate Anderson at 828-236-5801.  The brochure is also available on our website, www.dhgwa.com.

Third Quarter 2015 Asset Class Returns

The third quarter of 2015 was the ugliest in several years. But it was not unexpected, and may actually be healthy for long term investors. As you can see, virtually all equity asset classes experienced high single or double digit negative returns. Only US Real Estate and bonds eked out small positive gains.

There were many reasons for this market weakness. As discussed over the last few reports, the valuations of the US equity markets had crept up to above average. Also, in August, China experienced a vicious sell-off following an extremely frothy bull run earlier in the year. The global markets lamented the fact that China’s development was actually coming back down to earth, with many doubting its self-proclaimed target of a “mere” 7+% growth. The fear is that China’s slowing economy may have a similar effect on many other global markets.   In addition, Yellen and the gang at the Federal Reserve got cold feet in their September meeting and surprised some investors when they did not definitively announce an increase in rates or a definite future date for this event.

Add to this the fact that there is still uneasiness in the marketplace as to what exactly will happen when higher rates finally do occur. The main concern with all these items is whether the US economy will be able to continue its admittedly tepid positive growth, or will China’s slowdown, or rising interest rates, or the strong US dollar slow down the healthiest economy in the developed world (although that is not saying much). What’s worse, as this report goes to print, surprisingly weak US employment numbers have been announced. Some are believing this is a sign of economic weakness and fear it will affect the Fed’s decision to increase rates and push that decision well into next year.

But there is some positivity in these events. First, with the current correction, market valuations are back in the “average” territory, which gives Bears little reason to believe this measurement alone can do meaningful damage to the market. There is much fear already priced into the market, and any “good” news may result in a positive market reaction.   In addition, few long term bear markets have occurred in the past without some element of higher inflation and a need for limiting inflationary growth. Inflation is certainly is not a concern in the US nor anywhere else on the globe at this time. Thanks to the energy sector collapse and the strong US dollar, it may be at least a year or two before inflation causes any real problems.

Market corrections are an expected part of the investment process. It is their pain that gives them their long term performance advantage. This is due to the direct relationship between the risk and reward of all asset classes. We control this equity risk by allocating only as much as is necessary to accomplish certain return requirements in your portfolio. If corrections in the equity markets are great enough, we can take advantage of this by rebalancing your portfolio. This is accomplished by taking capital from income asset classes and buying more equity asset classes, which balances your portfolio back to its originally desired risk and reward levels.   This process allows us to sell high (income) and buy low (equities), all without ever having to attempt to time the markets.

By the end of the year, we should know whether this market adjustment is a shorter term pullback in a long term bull market, or the beginning of a longer term correction that will take more time to unfold. Either way, your portfolio is being managed in a manner that has led to long term positive results in every type of market scenario over the past several decades of fluctuating market cycles.

You will receive our next report in 2016! In the meantime, all of us at DHG Wealth Advisors wish you the happiest of holiday seasons and hope you are able to spend them with the ones you love.

Sincerely,

Frederick F. Kramer IV, JD

Chief Investment Officer