Spokane Journal of Business

Looming fiduciary rule could create ‘black swan’ event

Asset selloffs could spur market disruptions soon

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The first half of 2017 was tormented with political commotion in the U.S., geopolitical uncertainties, Brexit, and a myriad of issues throughout Europe.

We have shared those concerns with a number of our clients regarding the general direction of the stock and bond markets. From time to time, we see heightened concern among our clients, but recent feedback has been particularly acute. 

Some clients have expressed a visceral fear of enduring another large correction, such as “The Tech Wreck” at the turn of the century and the financial crisis of the late 2000s, while others have cited more academic unease over the length of this cycle, high valuations, concerns over the new administration, and other geopolitical concerns.

We sympathize with all of these stresses, but feel a sensible investment approach is counterintuitive to what has worked in the past. In 1999-2000 and again in 2008-2009, simply moving to cash and fixed income would have saved most investors a lot of money and heartache. Additionally, if people didn’t get back into the market for over a year, they still would have doubled their money in the recovery. 

Unfortunately, the global investment world has changed. During the last eight years, the stock market has become detached from economic data. If you look at S&P 500 index earnings over the past three years, earnings have declined from $118.23 in 2014 to $116.75 per share in 2016, based on Thomson Reuters data. Over this same period the S&P 500 total return is up over 40 percent. 

Some market pundits argue that multiple expansion is justified because growth this year should rebound. Keep in mind that those same Wall Street pundits made this argument in 2015, 2016, and now 2017.  Additionally, if you look at real gross domestic product growth from the Bureau of Economic Analysis for the first quarter of 2017, it was 1.2 percent annualized. That’s the lowest reading since the first quarter of 2016, when earnings declined more than 6 percent.

Staunch market bulls often quote soft data and discount hard data, which is actually the real data. Soft data refers to increases in consumer sentiment, which is being driven by expectations for infrastructure spending, tax reform, etc. 

The hard data is actually what is happening in our economy, where there are more retailers expected to close down brick-and-mortar stores than any other time in our history, muted income growth, and tepid capital investment. Additionally, consumer debt levels are near all-time highs and a number of credit card companies are now increasing their provision for defaults.

Manito Asset Management has spoken about this in the past, but it appears that the excessive money printing by central banks—U.S. Federal Reserve, European Central Bank, and others—has to find a place to go, which can cause short-term inconsistencies in global markets that cause a reaction that is counterintuitive to conventional thinking.  

Estimated global currency printing exceeds $12 trillion since the collapse of Lehman Brothers in 2008. That massive global printing has artificially propped up U.S. equity prices and forced low and negative bond yields across the globe in a search for perceived safe assets.  

Those governmental asset purchases haven’t rekindled animal spirits because the massive investment purchases created an imbalance between investment asset prices, such as stocks and bonds, and real-world asset prices, iron ore, cotton, and many others. While stocks and bonds are at all-time highs, industrial commodities are almost three years into a bear market. In the summer of 2014, the iShares Commodity Index Trust was trading at over $33.50 and today it is priced below $15, a decline of more than 50 percent. 

The Fed recently has been the most aggressive in reversing the easy money policy by gradually increasing rates, which makes our markets the most vulnerable to a short-term shock. That interest rate experiment likely will be short lived given any marginal decline in investable assets would further our ongoing economic malaise. Since the inception of the Fed, it has tried to increase interest rates 13 times and put us back in recession10 of those 13 times. Additionally, in previous cycles, interest rates were being increased because the economy and inflation were growing above trend. That’s not the case today.

So, despite all of the concerns listed above, the market probably will stay elevated until global currency is removed from the system or there is the next black swan event. A black swan is an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; the term was popularized by Nassim Taleb, a finance professor, writer, and former Wall Street trader. 

Unfortunately, there is a black swan quickly approaching that will temporarily remove liquidity from U.S. equities. Very few investors are aware or understand the potential short-term impact. This time, the black swan appears to be traveling from Washington, D.C., to the corner of Wall and Main Street. This new government swan is a rare bird called the DOL Fiduciary Rule. This new rule was implemented on June 9, and all investment firms must be in full compliance by the end of this year. 

There are two key components that could create problems for U.S. equity prices. First, advisers who conduct commission-based business will be forced to have their clients sign a Best Interest Contract Exemption agreement that states the adviser may be putting his or her financial interest ahead of the client’s interests. For any commission-based advisers, that’s not the best marketing pitch and has the potential to disrupt a number of relationships. 

More troubling for traditional advisers, both commission and fee, is that all fees now must be disclosed to clients. Prior to the DOL Fiduciary Rule, some advisers took advantage of a hidden industry secret that enabled them to hide up to 3 percent of fees, which clients would never see. Those new required disclosures are certain to create major problems for advisers using high-fee mutual funds that often charge exorbitant 12B-1 and other expenses that clients never see. 

Most of these unscrupulous advisers currently are trying to transfer their clients to lower, fee-managed accounts or self-directed platforms. Clients that don’t make this transition are certain to be disturbed by the previous lack of disclosure. Unfortunately, as these investors liquidate their accounts over the summer, selling begets selling. As markets decline, more investors scrutinize their investment adviser, creating multiple waves of nonfundamental selling. 

How do all these moving pieces affect a sensible approach to investing? At Manito Asset Management, our stock selection has become much more defensive. We have increased cash levels as various stocks have surpassed our price targets and as we have made conscious decisions to get out of sectors that are most susceptible to a market downturn. 

We particularly like health care, consumer staples, and niche technologies that will be in demand even if there is a shock to the system. We also would advise holding government bonds and high quality corporate bonds as investors scramble for cover. 

Another sensible place is in non-U.S. developed equities and emerging market equities as they will be less affected by this U.S.-created market correction. Any nonfundamental pullback in the U.S. markets should be used as a buying opportunity because the Fed will be forced to reverse course and prop up the economy and U.S. equities again.

William K. Lang, CFA, is the CIO of Manito Asset
Management, 
a Spokane-based, high net-worth investment manager.
For more details on this article, contact Erin Olsen at (509)321-8986.

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