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Does This Count as Market Timing?

A reader writes in, asking:

“I am new to really paying attention to investing. Most sources seem to agree that market timing is a bad idea. But then I also have read a lot about buying I Bonds or TIPS because they have high interest rates right now. Why isn’t that market timing? Does market timing only involve stocks?”

“Does _____ count as market timing?” is one of the most common types of investing questions I’ve received over the years writing this blog. The answer, in my opinion, is that it doesn’t matter whether or not an investment strategy “counts as market timing.” All that matters is whether or not it’s a good idea.

Some people will apply the market timing label to any strategy that has anything to do with interest rates or market valuations, thereby declaring all such strategies taboo, despite the fact that there’s a huge variation as to:

  1. The level of risk involved and
  2. The probability of success.

To illustrate what I mean, let’s take a look at a few example strategies, any of which could be described as market timing, depending on who you ask.

Strategy 1: Moving Between Cash and Stocks Everyday

Bob has determined that he cannot afford very much risk, but he still needs high returns to meet his goals. So he decides to move his entire portfolio between 100% cash and 100% stocks from day to day in an attempt to catch the best days in the market and miss the worst ones.

Bob’s strategy relies entirely on predicting what the stock market will do over very short periods, which is pretty much impossible. And if Bob fails, he could experience losses that he cannot afford. This type of market timing is clearly not a good idea.

Strategy 2: Shifting Your Bond Maturities

At a time when interest rates are far below their historical averages, Steve shifts his bond allocation from intermediate-term bonds to short-term bonds. Steve’s thought process is that interest rates are likely to come back up in the near future, and he doesn’t want to experience the larger loss in value that would occur with bonds with longer duration. He plans to wait for rates to come back up, then switch back to intermediate-term bonds.

Steve’s strategy is essentially a guess that interest rates will soon go up. Predicting where interest rates will go in the near future is about as hard as predicting where the stock market will go in the near future. (So this is not, for example, a strategy that I would be interested in using myself.) But a key difference between this strategy and Bob’s strategy above is that if Steve is wrong (and interest rates do not rise any time soon), it’s probably not a disaster for Steve. He just misses out on the slightly-higher returns that he could have gotten by holding longer-term bonds.

Strategy 3: Moving from Stocks to Bonds (Permanently)

Laura is planning to retire in the near future. At the time Laura is making the decision, the last couple of years in the stock market have been good and TIPS yields are high. Laura decides to shift a significant portion of her portfolio out of stocks and into a TIPS ladder.

Laura’s strategy is based on recent market performance and current interest rates, but it doesn’t rely on any prediction at all. It’s simply a decision that current rates are good enough to carry her through retirement with very little risk.

The Point of “Don’t Try to Time the Market”

Because of the taboo we’ve placed on anything that could be described as market timing, investors are sometimes afraid to use all the available information when making their decisions. I do not think this is a good thing.

The point of the “don’t try to time the market” message is simply that new investors need to learn that it’s impossible to predict a) where the stock market is going next or b) where interest rates (and therefore bond prices) are going next.

But it can be OK to make financial decisions based on current interest rates or market values, as long as you don’t have to successfully predict where the stock market or interest rates are going next in order for the decision to make sense.

How to Invest with a Looming Recession

A reader writes in, asking:

“I had a question that might work well for an upcoming blog post. Deutsche Bank recently forecasted an upcoming recession, and I was curious what your suggestion would be regarding how to invest a bonus with a potentially looming recession.”

It’s important to make a distinction between the stock market and recessions. For a few reasons, a recession happening over a particular period does not necessarily mean that the stock market would perform poorly over that period.

Firstly, the stock market is concerned with how much profit businesses earn. Recessions are determined by changes in production. (Specifically, a recession is usually defined as a decline in GDP over two consecutive quarters.) Production and profitability are linked, but production changing by a certain percentage definitely doesn’t mean that profitability will change in the same direction by the same percentage.

Second, GDP is concerned with a broader group of entities. The stock market is the market for publicly-traded corporations. So by definition it’s only concerned with publicly-traded corporations. In contrast, GDP includes production by privately-held businesses as well as by government entities.

Finally, the most important distinction, for our purposes, is that the price of a stock is essentially a prediction. It’s a function of how much the market collectively expects that company to earn. (Specifically, it’s the present value of the expected future cash flows from that company.)

So if the market has recently decided that publicly-traded corporations are, collectively, about to become less profitable (which could well be the case in a recession), that doesn’t mean that the market is probably about to go down. It means the market has probably just gone down. (And indeed, it has. As of this writing, the stock market is down about 14% year-to-date.)

In finance-speak, we say that the probability of a recession has already been “priced in” (i.e., it’s already reflected in the current price of stocks).

To reiterate this important point: the current prices of stocks are, themselves, predictions. So to make a prediction about what the stock market will do next is to make a prediction about a prediction. (i.e., will people’s predictions about corporate profitability become worse or better in the near future?).

And that’s really darned hard. Stock prices generally already account for all of the information that you or I are likely to know.

So How Should We Invest?

Moving in and out of stocks (or in and out of certain sub-categories of stocks) usually doesn’t make sense, because of how hard this guessing game is. That’s why it usually makes sense to just pick an asset allocation and stick with it, rather than trying to adjust your allocation based on events in the news.

Conversely, it definitely can make sense to change your asset allocation when your life circumstances change. For example, for a young person who sells a business for a very large sum, the allocation that might now make sense could be very different than the allocation that made sense a few months ago.

It’s possible that such a concept would apply with a bonus, if the bonus is a life-changing amount of money. But most of the time that’s not the case. Most of the time a bonus doesn’t constitute a major change in life circumstances and therefore does not require a change to the overall portfolio asset allocation.

Changes to the fixed-income side of a portfolio can make sense though, as economic circumstances change. That’s because current interest rates do give us some actionable information. That is, the interest rate on a given fixed-income investment is a decent predictor of its rate of return (and it’s obviously a very good predictor, if you plan to hold to maturity). So shifting between fixed-income options as the available interest rates change is not crazy.

For example, for years Allan Roth has written about using CDs rather than individual bonds or bond funds when CDs offer an interest rate that is as good (or sometimes even better), with less risk than bonds. Similarly, many people have been buying I-Bonds lately, because of how their yields compare to most other fixed-income options.

So, how should we invest if a recession is looming? About the same way we invest the rest of the time. It doesn’t usually make sense to make portfolio changes based on economic news, though changes within the fixed-income part of the portfolio can make sense, as the fixed-income option with the highest interest rate for a given level of risk can change over time.

A Basic Financial Planning Checklist

A realization that has only very slowly occurred to me, over 15 years in the world of financial planning, is that the most common financial planning mistake that I see people make is not so much a particular bad decision, but rather completely ignoring certain parts of financial planning.

In many cases, that shows up in the form of focusing too much on the investing part of the picture, while having some other critical financial planning need that is going unaddressed.

And that’s not terribly surprising. Investing involves thinking about upside — how your assets will grow (and how they could grow, if you make a high-risk bet and get lucky). That can be fun.

In contrast, many critical financial planning tasks involve thinking about downside. (What if you become disabled or die earlier than anticipated?) That’s less fun.

In addition, a lot of critical financial planning tasks look suspiciously like work.

What follows is just a brief checklist of financial planning topics, all of which should probably be addressed before spending much time thinking about exactly what is the correct allocation to international bonds or whether index funds are preferable to ETFs.

Insurance planning:

  • Do you have health insurance? (And if it’s open enrollment season, have you checked to see whether there’s a different plan that might be a better fit for your household?)
  • If anybody is financially dependent upon you, do you have sufficient life insurance? (Alternatively, have you canceled any coverage that is no longer necessary?)
  • If you are still working, do you have sufficient disability insurance? (And does the policy check all the necessary boxes? For instance, is it “own occupation” if such is important in your case?)
  • Do you have sufficient homeowners/renters insurance?
  • Do you have sufficient liability coverage on your auto policy?
  • Do you have an umbrella policy?

Cash flow planning:

  • Do you know how much you spend each month (or over the course of a year)?
  • Do you have a sufficient emergency fund? (Of note: a retirement portfolio can often serve as an emergency fund, once it is of sufficient size.)
  • Are you saving enough each month to meet your goals? (Or if retired, are you confident that the amount you are spending per year is sustainable?)

Estate planning:

  • Have you checked the beneficiaries (including contingent beneficiaries) of your retirement accounts and life insurance policies recently?
  • Do you have a will in place?
  • Do you have a durable power of attorney for finances?
  • Do you have a healthcare power of attorney?
  • When was the last time the above documents were updated?
  • Have you considered whether a trust of any sort would help you to achieve any postmortem goals for your assets?

Tax planning:

  • Are you confident that you are contributing to (or withdrawing from) the right types of accounts each year? (For example, should you be making Roth contributions instead of tax-deferred contributions?)
  • Have you considered whether Roth conversions would be useful now or in the near-term future? (Most often, this is helpful during years of retirement prior to RMDs and prior to Social Security.)
  • Do you know whether you are in or near the phaseout ranges (or other thresholds) for any tax credits or other significant tax provisions?

Basic investment planning:

  • Is your portfolio reasonably diversified, as opposed to having a large portion allocated to one stock (e.g., an employer or former employer)?
  • Is the basic allocation (i.e., the stock/fixed-income allocation) roughly appropriate for your risk tolerance?
  • Are you using funds with reasonably low expense ratios?

Basic retirement planning:

  • Do you have a plan for when you intend to retire? (And have you thought through the potential ramifications of being forced into retirement somewhat earlier than the intended date, due to illness, job loss, etc.?)
  • If nearing age 62 (or 60 if you’re a widow/widower), do you have a plan for when you will claim Social Security benefits?

In my opinion, most people should just be using a very simple portfolio (e.g., a basic three-fund portfolio or even a simple all-in-one fund if the portfolio is entirely in retirement accounts) until they’ve taken care of the above items. Using a basic portfolio frees up time and mental energy to focus on other things that matter quite a bit more.

And even for people who have taken care of these other financial planning to-do items, there’s still no need to spend time thinking about particularly advanced asset allocation questions. In nearly all cases, it’s perfectly fine to stick with the three-fund portfolio (or, again, a low-cost all-in-one fund if your portfolio does not include taxable accounts).

To be clear, the above list is not absolutely-super-duper-all-inclusive. For some people there will be additional points in one category or another that should be addressed. Also, the order of priority will vary from one person to another. For example, if you’re unmarried and have no kids, estate planning would be a lower priority than it would be for somebody with children. And estate planning would be an especially high priority for a married couple who each have children from a prior marriage.

Will a Total Bond Fund Keep Up With Inflation?

In reply to the previous article about fixed-income options in a low-yield environment, a reader wrote in with the following question:

“Would Vanguard’s Total Bond Market fund (or the equivalent) be expected to match inflation over time?”

For a bond (or bond fund), the best estimate for its expected return is its yield. Right now, the SEC yield for Vanguard Total Bond Market Index Fund is 1.19% You can find this on either the “Overview” or “Price & Performance” tab on the fund’s page on the Vanguard site.

But there are two important points of note here.

First point of note: that’s the expected return over the fund’s average duration. We can click over to the “Portfolio & Management” tab to find the fund’s average duration: 6.5 years. So what we’re seeing here is that the fund’s expected return over the next 6.5 years is 1.19%.

For periods shorter or longer than 6.5 years, there’s a greater degree of uncertainty about what the actual return will be.

For shorter periods, 1.19% is still probably the best expected return estimate, but the actual return is going to be primarily affected by price movements (i.e., whether the bonds’ prices move up or down as a result of interest rate changes). See any of the following articles for a discussion of how bond prices respond to changes in interest rates:

For longer periods, 1.19% is (again) likely the best guess, but we (again) have a lower degree of certainty. In this case, a major cause of the uncertainty is that, as we look at longer and longer periods, we simply don’t know what bonds are going to be in the fund’s portfolio. For example, imagine that we were concerned with the expected return over the next 20 years. Given the fund’s average effective maturity of 8.5 years, most of the bonds currently held by the fund will have matured before the 20-year period is even halfway over. In other words, the return earned by the fund over the next 20 years will be hugely affected by the yields on bonds that it hasn’t even bought yet — and which haven’t even been issued yet. And since those bonds don’t even exist yet, we have absolutely no way to know what their yields will be.

Second point of note: because this is a nominal bond fund, the 1.19% figure is a nominal yield (i.e., before inflation) and therefore a nominal expected return.

A good way to get a rough estimate of the market’s expectation for inflation over a given period is to find the difference in yields between TIPS and nominal Treasury bond for the period in question. For example, since our expected return is for a 6.5-year period, we could look at the yields for 7-year TIPS and 7-year Treasuries. Right now, the yield on 7-year TIPS is -1.10%, and the yield on 7-year Treasuries is 0.55%. That’s a difference of 1.65%, which tells us that the market is expecting inflation of roughly 1.65% over the next seven years.

So, in summary, with an expected nominal return of 1.19% over the next 6.5 years and expected inflation of roughly 1.65% over the next 7 years, we can say that the expected return for Vanguard Total Bond Market Index Fund is about 0.46% below inflation over the next 6.5 years.

But that’s just an expected return. The actual nominal return could be meaningfully different from the 1.19% figure. Or inflation could be meaningfully different from the 1.65% figure. And as discussed above, for periods shorter or longer than 6.5 years, there’s an even greater degree of uncertainty.

How Does the Fed “Prop Up” the Stock Market? (Interest Rates and Stock Prices)

A reader writes in, asking:

“I’ve read over and over this year that the Fed is ‘propping up’ the stock market by keeping interest rates low. How does that work?”

Broadly, there are two ways in which low interest rates help to keep stock prices high.

Firstly, to the extent that corporations are borrowers, keeping interest rates low reduces their costs and therefore directly improves their profitability, which of course helps keep their share prices higher. In the case of a struggling corporation, having access to low-cost capital can even make the difference between declaring bankruptcy or not. And of course avoiding bankruptcy proceedings is good for shareholders.

The second effect has to do with the way stocks are priced. (I think it’s actually easier to understand this effect from the perspective of increases in interest rates. So we’ll start with that.)

Stocks are quite a bit riskier than Treasury bonds. So why do you own stocks at all, rather than just buying Treasury bonds with all of your savings? Presumably, you own stocks because you hope to earn additional returns beyond what Treasury bonds earn. That additional return that you hope to earn is known as a risk premium (i.e., additional return to compensate you for the additional risk).

The price of a stock reflects the (market’s consensus as to the) present value of the future cash flows from the stock. And the discount rate used in that present value calculation is usually something along the lines of “whatever we could earn from bonds, plus a risk premium.”

So when interest rates go up, the necessary discount rate goes up. A higher discount rate means a lower present value, which means stock prices go down.

Or you can think of it this way: imagine that TIPS yields suddenly went way up to 3%, rather than the roughly -1% range where they are right now. Maybe you had been estimating that stocks would earn a 4% real return going forward. Before, that was a 5% risk premium. But with TIPS yielding 3%, a 4% real return would only be a 1% risk premium. Maybe you decide that a 1% expected risk premium isn’t high enough to justify the additional risk from owning stocks, so you sell your stocks to buy TIPS.

Collectively, lots of people would be selling stocks to buy bonds in such a scenario. So the price of stocks would fall. When the price falls, the expected return going forward goes up (because a new buyer is paying a lower price for a given amount of dividends/earnings). And the price would continue to fall (i.e., people would keep selling stocks) until the price was low enough that the expected return was high enough to earn whatever the market collectively decided was a sufficient risk premium over bonds.

So that’s what happens when interest rates go up: it has a downward effect on stock prices.

When governments or central banks make efforts to keep interest rates low, the opposite occurs: it exerts an upward pressure on stock prices. That is, low interest rates make the alternatives to stocks not look very appealing — and that helps keep stock prices high.

To be clear though, while low interest rates have an upward effect on stock prices (i.e., they make stock prices higher than they would otherwise be, all else being equal), they do not prevent stock prices from falling. When events occur that worsen the outlook for corporate profitability, stock prices will still fall.

Why is the Market Doing Well Lately?

A reader writes in, asking:

“We’ve basically had a full blown bull market since the bottom in March. VTI has a positive 34% return in just two months. How does that make any sense at all? Unemployment is higher than any time since the Great Depression. The death toll continues to climb, and everybody still says that a vaccine is a year away at least. What gives? It seems like the market has become completely disconnected from reality.”

The first thing to understand is that there’s a big difference between “the stock market” and “the economy.” And this distinction is not a new COVID-19-related phenomenon.

The value of the stock market at any given time is essentially the market’s consensus as to the present value of the expected future earnings of publicly traded companies. That is, the stock market is concerned with the profitability of publicly traded companies. Nothing more or less than that.

So unemployment only affects the stock market to the extent that it affects expectations of profitability. If unemployment goes up by, for example, 10%, that doesn’t mean profits will go down by 10%. The change in expected profits could be greater or smaller than the change in unemployment. Relevant factors there would include:

The second critical point to understand is that that the stock market’s valuation is based on an “expected” (i.e., probability-weighted) value of earnings.

The easiest way to understand this concept is to imagine a company that is undergoing a massive lawsuit. If the suit fails in court, the company would be worth $100 billion. But if the suit succeeds, the company will be bankrupt. Given those facts, what is the company worth right now? That depends on the likelihood of the suit succeeding. If the suit has a 30% probability of success, the company should be worth $70 billion right now (that is, 70% chance that it ends up being worth $100 billion, 30% chance it’s worth zero). If the suit has a 50% probability of success, then the company should be worth $50 billion right now.

As the apparent probability of success of the lawsuit changes, the firm’s value will change.

In the middle of March, extremely catastrophic COVID-19 scenarios (e.g., millions of deaths in the U.S.) were being discussed as real possibilities. We really didn’t know what to expect, and the range of potential outcomes was very wide.

Now, those very worst-case scenarios appear quite a bit less likely. Even if the most likely outcome is approximately the same as it was two months ago (i.e., still not good at all), the probability-weighted outcome can be quite a bit better, because the very worst outcomes have become (apparently) less likely.

But of course that means that the market could still fall again in the near future. If something happens to make the really bad outcomes appear more likely — or if something happens that makes the most likely outcome appear somewhat worse — or if something happens to make the best-case scenario outcomes no longer as good — then the market would probably fall again.

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