Quarterly Investment Update: 2017 Quarter 4

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We’re Off to See the Wizard!

FC Advisors Quarterly Investment Update – Q4 2017

            As readers may recall, in “The Wizard of Oz,” Dorothy was knocked unconscious and transported to a magical dream world. Disoriented and scared, Dorothy desperately wanted to get home. Shortly after arriving in Oz, she learned that her best chance at getting back to Kansas was to see if the Wizard of Oz could help her. Along her journey, Dorothy picked up 3 companions who also needed help – a scarecrow who thought he needed a brain, a tin man who wanted a heart and a cowardly lion. Each new companion was eventually convinced that the Wizard of Oz could solve his problem, and so the legend of the Wizard kept growing. Needless to say, expectations for “The Wonderful Wizard of Oz” were running high. Unfortunately, the Wizard was actually a two-bit con artist who used bluster, bravado and superficial insights to control and amaze his victims. Ironically, the Wizard didn’t need any magical powers to get people to do his bidding because he knew that the easiest people to fool were the ones who wanted to believe in his powers the most. Thus, the high expectations of Dorothy & Co were doubly dangerous. First, their chances of being disappointed rose as expectations went ever higher. And second, they were easily deceived because they so desperately wanted to believe that the Wizard could solve their problems.

Just like Dorothy & Co, today’s financial markets are “off to see the wizard!” Investors now face the dual risks of high initial expectations and a widespread desire to believe that stock prices can rise ever higher. While we must admit that there is no limit to how much higher prices and optimism can go, historically when optimism and prices have been this high, investors have been very disappointed when they finally see what’s behind the curtain.

Executive Summary

  • The Quarter in Review
  • Sentiment & Value Update
  • Tax Cuts
  • Crypto-currency 101
  • Buy the Rumor, Sell the News

The Quarter in Review

            The boom in crypto-currencies became daily front-page news. Stock markets around the world advanced steadily and powerfully in the fourth quarter on accelerating global growth and the anticipation of corporate tax cuts in the US. Bond markets had the best of both worlds in which Fed rate hikes began to short-term savers, but long-term bond yields remained steady as inflation statistics remained low. With so much good news for investors, one has to wonder; can things get any better?

Relevant Index Performance

Total Returns as of 12/31/17

Index                                    Qtr to Date                 Year to Date

S&P 500                                  6.64%                              21.83%

MSCI World ex-US                4.29%                              24.81%

MSCI Emerging Mkts           7.50%                             37.75%

S&P Municipal Index           0.64%                              4.95%

10-Year Treasury                   1.15%                              5.78%

Sentiment & Value

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The chart above shows our opinion on where various markets are as of December 31st 2017. Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant). Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant).

Click to enlarge

            In 2017, for the first time ever, the S&P 500 recorded a year in which performance was positive every single month. Investors of all stripes appear to be gearing up for another year of gains. With expectations for the economy and the stock market at extreme levels, the last remaining pieces for a classic market collapse are beginning to come into place. While we hope that the good times continue, this is the point in the cycle when investors must be focused on preparing to endure a period of losses. We believe that portfolios should now be at or near their most conservative settings. This means accepting smaller gains while the good times keep rolling in order to achieve long-term success. When the going inevitably gets rough, our clients will be in the enviable position of dealing with a vulnerable market from a position of strength. All things being equal, if the S&P 500 were to trade below 2,400, we would be interested in buying US stocks and if the 10-year treasury yielded more than 2.75% we would be adding to long-term bond positions.

Tax Cuts

Issue: The new tax bill became law on January 1st. It makes significant changes to how US corporations and individuals are taxed.

Impact: There are many opinions about who wins/loses and what the tax cuts mean for the economy in both the short and the long-term.

FC Advisors’ Take: There are two main parts to the tax bill and we will take them one at a time.

Corporate taxes: Short-term positive, long-term positive. While there was certainly disagreement about how to change the corporate tax system, most agreed that the US corporate tax rate of 35% was too high to compete globally. In the short-term, the lower corporate tax rate of 21% is likely to boost profit margins and make room for wage increases. In the long-term, both domestic and foreign companies will have more incentive to direct more of their growth toward the US. Good tax policy depends on maintaining an environment that is conducive to economic growth. Corporations are the main driver of economic growth and employment; therefore, we generally believe the best policy is to emphasize low corporate tax rates.

Personal income taxes: Short-term positive, long-term negative. In the short-term, we expect most households, particularly those in states with low property and income taxes, to get a significant tax cut. This is likely to boost household spending for at least the next year. However, longer term, the personal income tax cuts will expire in 2025. Therefore in just a few years, the same households that benefit today will be bracing for an increase in taxes. Additionally, the tax cuts are likely to add significantly to the national debt, which is already creating a drag on economic growth. Thus, from our perspective, the personal income tax cut looks like a short-term positive in exchange for a long-term negative.

Crypto-currency 101

For simplicity sake, we will discuss bitcoin in this article, but most of what follows applies to virtually all crypto-currencies.

No physical form: Bitcoin has no physical form, despite the images of a physical coin that the media insists on attaching to any article about bitcoin. While a currency having no physical form may seem novel, the concept has actually been around for a long time. Credit and debit card transactions, direct deposits, and other electronic payment systems are simply lines of computer code, much like bitcoin.

Blockchain: A bitcoin (or a fraction thereof) is a complex alpha numeric code that when entered into the bitcoin algorithm shows a history of the transactions on the bitcoin network that are agreed to by a majority of the other users of the bitcoin currency. This process is what is known as “blockchain” technology.

Transparency: Despite assertions that transactions in bitcoin are 100% anonymous, they are not. As mentioned above, each bitcoin contains a history of the transactions on the bitcoin network. Each bitcoin user has two “keys”, a private key and a public key. The private key is used like a password and must be entered before money can be sent from a user’s account. The public key is similar to an account number and it is recorded on the blockchain every time money is sent to or from a user’s account. So, if a public key can be associated with a person, then all of that person’s transactions would be 100% transparent! However, for the time being, virtually all bitcoin users are still anonymous and this has made bitcoin attractive to money launderers and organized crime.

Theft: There are plenty of stories about bitcoin being stolen or hacked. Though, surprisingly, it is actually almost impossible to steal bitcoin in the traditional sense. Because bitcoin cannot be physically possessed and all transactions need to be verified, there are only two ways to “steal” bitcoin. The first is to steal a victim’s public and private keys. Once a criminal has control of both keys, they can easily transfer the bitcoin to another account. In doing so, the network will verify this transaction as a legitimate transfer of money between two parties. The second is to simply trick victims into sending bitcoin to the wrong account. This is often done by hacking into a legitimate site and changing the public key that customers will send their bitcoin to when intending to purchase goods or services.

Inflation: Bitcoin and most other crypto-currencies have a pre-programmed maximum number of coins that can ever be issued. This acts as a cap on the total amount of inflation that bitcoin can ever experience. The inflation cap is one of the primary differences between crypto-currencies and traditional currencies, which can be printed in unlimited quantities by the governments that control them. The prospects of eliminating inflation risk and reducing government control continue to be the most appealing arguments in favor of crypto-currencies.

FC Advisors’ Take: While the inflation risk in any one crypto-currency may be capped, there is no limit to the number of new crypto-currencies that can be created. According to Wikipedia, there are now over 1,300 crypto-currencies. With no way to know which crypto-currencies will survive and a high probability that most of them will eventually be worthless, bitcoin and other crypto-currencies are also “off to see the Wizard.” We suggest limiting any investments in crypto-currencies to an amount equal to or less than what you would be comfortable losing on your next trip to Las Vegas.

Buy the Rumor, Sell the News

Issue: “Buy the rumor, sell the news” is one of the most common expressions in investing. What does it mean & what can we learn from it?

Impact: A more thorough understanding of how markets work can help even novice investors avoid emotional pitfalls.

FC Advisors’ Take: The stock market and the economy are not the same thing. The stock market is a mechanism for discounting what the future of publicly traded companies looks like. While the economy is the system in which people, corporations and governments interact. The economy unfolds in real time, while the stock market is constantly focused on what the future looks like, thus the difference often comes down to expectations. “Buy the rumor, sell the news” explains a phenomenon in which investors are excited about the possibility of a positive change, but that once it becomes a reality there is suddenly nothing left to look forward to anymore.

Human beings are blessed with powerful imaginations. When combined with our emotions, our imaginations can create powerful feelings.  Sometimes these imagined feelings can be even more powerful than the real world experience. Have you ever dreaded an experience, perhaps an uncomfortable doctor visit or an onerous chore, only to discover that once you finally did it that that is wasn’t nearly as awful as you imagined? Have you ever looked forward to trying a highly rated restaurant, only to discover that it didn’t live up to the hype?

In financial markets, just as in life, often the anticipation is the point of maximum dread or elation. Therefore, by the time the news is finalized, the price change is complete or even overdone. The chances are good that expectations and excitement today are a little too high for the benefits of tax cuts. Unless something new and wonderful to look forward to materializes, investors should not be surprised if markets experience a letdown.

Click here for a downloadable PDF 2017 Q4 Investment Update

If you have questions about these topics or any other financial needs, please contact

FC Advisors at:

415-528-2826

hello@fcadvisors.us

www.fcadvisors.us

Following Claire Advisors, LLC DBA FC Advisors is a Registered Investment Adviser. This brochure is solely for informational purposes and is not intended to provide investment advice. Advisory services are only offered to clients or prospective clients where FC Advisors and its representatives are properly licensed or exempt from licensure.  Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by FC Advisors unless a client service agreement is in place.