Stocks have not reacted too well to the recent snag in trade talks with China. Reportedly, China and the United States had been close to an agreement. However, that tentative agreement fell apart after China allegedly backtracked on some important concessions it had previously agreed to. The U.S. responded with 25 percent tariffs up from 10 percent on $200 billion of imports, with more to come soon if no deal is reached.
Stock markets don’t like trade wars because they have a very bad effect on the global economy. The U.S. seemingly has less to lose as it exported only $120 billion worth of goods to China in 2018, compared with the $540 billion it imported. Although China has a lot less American exports to tax, they can still cause a lot of damage. Many companies, such as Starbucks and General Motors, receive a lot of profits from China and could be hurt by Chinese retaliation. Although the U.S. would like to narrow the trade gap, they really want to stop China from continuing its widespread practice of stealing intellectual property from U.S. companies.
A new CNBC poll finds that 20 percent of U.S. corporations say China has stolen their intellectual property within the last year. IP theft — use of patents, trade secrets, trademarks, and copyrights without permission — is extremely costly. IP theft may not seem as egregious as taking physical property, but it represents either a loss of opportunity or loss of competitive advantage that reduces the revenue a company could have received.
According to CNN, the U.S. Trade Representative estimates the annual cost of this theft to be between $225 billion and $600 billion. Yet until recently, America declined to fight back: “After 20 years of having their way with the U.S., China still appears to be miscalculating,” noted a private-sector Reuters source apprised on the talks. Either way, the stock market will continue to react to new developments in the ongoing trade talks.
Every year educated “professional” money managers attempt to beat the benchmark of the S&P 500 index. Active stock managers, as a whole, have failed to beat the S&P 500 each of the last nine years — trailing by an average of 1.7 percent per year.* Individual investors have fared even worse according to research done by Dalbar. The average mutual fund investor significantly under performs the market due to fees and poor market timing decisions.
The S&P 500 has been a fantastic investment over the past 10 years, averaging about 16 percent per year for the decade that ended March 31. Unfortunately, most investors did not receive anywhere near the full benefit. Even fee-conscious, diversified, and disciplined investors have not kept pace with the S&P 500 because most diversified portfolios had exposure to other asset classes such as bonds and international equities that have not performed nearly as well as the large American stocks that comprise the S&P 500.
So, what can we learn from this? It may seem like investors should just invest in the S&P 500 index and call it a day. This strategy has a couple flaws; first, many investors can’t tolerate the risk of investing all of their assets in stocks. After a decade of averaging 16 percent per year and relatively high valuations, the next decade may not be so rewarding. Secondly, both international equities currently trading for about 12.4 times the earnings and emerging market stocks trading at 10.5 times the earnings appear to be much cheaper than U.S. stocks at 15.3 times the earnings.**
While an argument can certainly be made that the relative stability of the U.S. affords its stocks a justified premium, at some point any asset class can become overvalued and, if history is any indicator, whenever asset classes enjoy prolonged periods of outperformance, they are often followed by long periods of underperformance — which is why most professional advisers typically recommend sticking with a diversified portfolio.
**Capital Group data as of 11/30/2018
Thus far for the month of May, the performance of the stock market has been a disappointment and has made the old adage “sell in May and go away” look prophetic. However, most of us realize investing in equities should be a long-term venture and works especially well when investors systematically add to their investments. When markets fall, investors are buying low as they dollar-cost average and take advantage of the dip. This process can potentially enhance return. However, when investors are pulling money out of their accounts for income needs, they are essentially reverse-dollar-cost averaging.
If there is a down year and an investor takes a withdrawal for income, they are essentially locking in a loss on the amount withdrawn. The S&P 500 has averaged 7.16 percent*, including dividends, for the 20-year period that ended in 2018. If an investor had earned the full returns of the S&P 500 on their $1 million investment for the past 20 years and withdrew $60,000 per year (6 percent of initial investment) their account balance would have ended the period worth only $273,245. However, if the investor had earned a fixed 6 percent return each year and pulled out $60,000 per year their account would still be worth $1 million after the same 20 years.
The last 20 years has taught us that a more consistent lower return may wind up being much better for those who are taking income from their investments than higher return with greater volatility. Although the stock market averaged 7.13 percent* per year for the past 20 years, most investors earned far less due to management and trading costs, taxes and poor market timing decisions. Therefore, for those in or near retirement, when evaluating investment alternatives, evaluate not only the expected return but the expected volatility as well, and overweight choices with less volatility in order to help create a higher probability of success.
*Source Yahoo Finance
One of the largest sec¬tors of the U.S. economy is comprised of smaller private companies that typically generate between $50 million and $2.5 billion in revenues. These middle market companies exhib¬ited 7.8 percent revenue growth, for the 12-month period ended in 2018, compared to 4.7 percent for the S&P 500.
Banking regulations have changed over the last 20 years. These changes have made it much more difficult for traditional banks to make loans to companies in this arena. In 1995, 33 percent of banks were making loans to these companies, yet today, only 3.9 percent of banks are active in this space. These middle market companies are now forced to pay higher interest rates for access to capital needed to finance growth. Because of this need, Congress created a new type of lender to serve this market called business development corporations (BDC) to encourage capital flow to small and mid-sized companies.
Loans made to these companies are typically senior-secured floating rate, meaning they occupy the senior most position in a company’s capital structure. These loans are generally secured by a company’s property, plant equipment, or other collat¬eral, and have priority over a company’s shareholders and unsecured creditors.
What’s attractive about these loans for investors is they typically pay almost 4 percent more per year in interest than high-yield bonds; they also have had less default losses than high-yield bonds. At the end of 2018, the Cliffwater BDC index was yielding 10.7 percent compared to 6.5 percent for the Barclay’s High Yield Bond Index. Moreover, the interest rates float higher or lower with prevailing market interest rates.
Therefore, floating rate loans don’t have interest rate risk to the lender or investor. If interest rates rise, so does the interest paid to the investor. This asset class can provide a very nice yield to investors. However, the underwriting of these loans is critical, and investors should look for BDC’s with an excellent track record of low default rates.
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