November 20, 2012

Wishing you all a Wonderful Thanksgiving!

Risk Management Is Back On The Forefront

The announcement last week that Hostess Brands, the maker of iconic treats such as Twinkies and Ding Dongs, was going out of business highlights the need for investors to have a solid risk management strategy.

As you contemplate making an investment, here are three things important to know:

1. The rationale for the investment and the research behind it.
2. What constitutes "fair value" for the investment.
3. What would trigger you to sell the investment.

Number three above is where many folks trip up - they don't have a sell discipline. Although Hostess Brands long ago ceased being a publically traded company, it's an example of how a company with well-known brands can run into trouble and fail. To avoid riding an investment all the way down to zero, it's critical to have a system in place to monitor your investments and hit the sell button if there's a material change that makes the original investment thesis no longer valid.

Sometimes a risk management strategy causes you to sell an investment only to see it turn around and go right back up. While frustrating, that's better than not having any sell discipline in place and holding on to an investment that drops dramatically and never comes back.

Viewed another way, it's better to take a small occasional loss than to hang on to everything forever and be exposed to a potential big loss down the road on your irreplaceable capital.

Risk management is back in the forefront as U.S. stocks continued their post-election slide last week. And, while we would all prefer to see the market go up, we remain focused on our risk management discipline as a key component of our overall portfolio management process.

Data as of 11/16/12	1-Week	Y-T-D	1-Year	3-Year	5-Year	10-Year
Standard & Poor's 500 (Domestic Stocks)	-1.5%	8.1%	9.9%	7.0%	-1.4%	4.2%
DJ Global ex US (Foreign Stocks)	-2.1	4.5	2.2	-1.6	-6.8	6.6
10-year Treasury Note (Yield Only)	1.6	N/A	2.0	3.3	4.2	4.0
Gold (per ounce)	-1.4	8.8	-2.4	14.9	16.8	18.3
DJ-UBS Commodity Index	0.1	0.2	-5.5	1.2	-5.0	3.1
DJ Equity All REIT TR Index	-2.0	12.1	17.4	17.4	3.1	11.3

ARE LOW INTEREST RATES GOOD OR BAD for the stock market? As you are painfully aware, interest rates in general are very low. There are three main reasons for this:

1. Consumer demand for interest-bearing products is relatively high.
2. Business demand for loans is relatively low.
3. Central banks in many developed nations are engaged in an "easy money" policy.
Source: The Economist

All three of the above are associated with the fact that our economy is relatively weak. In difficult economic times like today, central banks have a vested interest in keeping rates low. The thinking is low rates will reduce the "hurdle rate" for businesses to reinvest and, as a result, encourage them to expand and hire new people. As businesses expand, the economy will grow and begin a new virtuous circle.

So, let's see if this virtuous circle of low interest rates applies to the stock market, too.

Using data from the Barclay's Capital Equity-Gilt study, The Economist took a look at U.S. stock market returns between 1926 and 2011 and sliced the data into periods when the real rate on Treasury bills (the rate after subtracting inflation) was positive and negative. What they discovered was startling:

"In the 33 years where real yields have been negative, the average gain from equities has been 2.3%; in the years when real yields were positive, the average gain was 6.2%."

In other words, low real interest rates (which we have today) have typically been associated with low stock market returns.

As we all know, data can often be presented in ways that support whatever position you're taking (just like in the past election cycle!). So, putting that aside, the key is to interpret the data. Since we've been in a low rate environment for a long time, stock prices have likely had time to adjust accordingly. The key now is to watch for the turning point - the time when rates start a new rising trend.

When rates start to rise, that could signal the economy is on the mend as businesses start demanding more money for loans to expand and central banks pull back on the easy money policy to avoid too much inflation. This would be a "good" reason for rates to rise. Alternatively, rising rates could signal investors are losing faith in our country's ability to pay its bills. This would be a "bad" reason for rates to rise.

We're watching interest rates closely for any sign of a new trend and, importantly, the reason behind that trend. It's just one of many indicators we monitor as we keep a close eye on your investments.

Weekly Focus - Ode to an Icon...

"I love Twinkies, and the reason I am saying that is because we are all supposed to think of reasons to live."

—Stephen Chbosky, novelist, screenwriter, director,
and author of The Perks of Being a Wallflower

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management

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