I just finished up teaching a Retirement Planning class at Fairfield University. I generally ask at the beginning of class how many of the attendees had some level of motivation to sign up because the 2008 collapse remains in the back of their mind. With teaching this course for the past 4 years, I would say over half the people raised their hand and did so with legitimate concern on their face. But this most recent class, I witnessed a lot of shrugs, “Eh, that was 10 years ago.”
My gut is that it’s less about the time frame and more the double digit returns the markets provided in 2017. Now, this blog isn’t going to be a Debbie Downer about the market and economy. I’m actually quite happy with the growth of corporate revenue and earnings, dramatically lower unemployment, Trump’s implementation of promises and yes, I believe what he’s doing with Tariff’s is not only brilliant, but necessary.
It is important, however, to still be sober about the height of this market and any vulnerabilities that could bring an uncomfortable shock. Which is why I want to discuss the differences between today and 2008. There are 3 measurable dynamics: Interest Rates are lower, the Federal Reserve is massively over leveraged and the Ascendancy of ETF’s.
The first two don’t need a lot of commentary. Its obvious rates are going up, how high is the question. As for the Fed, this headline from last September says it all: In sign of U.S. economy’s strength, Fed to start reducing $4.5 trillion balance sheet. Here’s the link: Fed Balance Sheet
The ETF dynamic needs a bit more vetting, because a situation occurred at the end of January that caught everyone on Wall Street flat-footed. You didn’t hear much about it, mainly because all the wizards of wonder don’t know what to do about it. If you follow Zero Hedge, you’ll find some articles, but for the most part it’s been “move along, nothing to see here”.
Let's Talk About ETF's...
First, let’s do a little primer on what an ETF is, why it was designed and some of the good/bad dynamics that are a result of its architecture. Index funds are popular, in fact the single largest mutual fund holdings in aggregate are built off the Standard & Poors (S&P) 500 chassis. Vanguard was the…well Vanguard, when John “Jack” Bogle founded the first index mutual fund in 1976. As a generalization, index funds are popular because they’re low cost and since so many money managers struggle to beat their corresponding index benchmark after fees, may investors choose to cut out the extra cost.
Like all mutual funds, they are traded once per day, after the closing bell. Not a big deal, except that during times of extreme volatility or a sharp drop in the market, you’ll be standing in line waiting. For instance, if upon the opening bell at 9:30am, something dramatic occurred in Europe or China and you wanted to get out, you could call your advisor and tell him or her to sell. They’ll certainly put the order in right away, but it won’t get filled till the end of the day.
Both Wall Street and Investors were looking for a better solution and thus the ETF was born (1993). They didn’t catch on right away; by 2002 there were still only 246. That number jumped over 700 post the 2008 collapse and now…there are over 5,000.
The ability to trade daily on an unlimited basis is what separates an ETF from a straight Index Mutual Fund. And something very important is created when you can trade at will – Liquidity. If you have complete confidence and ability to inject or remove capital from an instrument, that Liquidity dynamic moves you to a completely different dimension of investment popularity. Once Wall Street got their arms around this new liquid instrument, the applications for diversification and hedging exploded.
Liquidity is always a good thing. That’s why the U.S. Treasury Notes and Bonds are a critical component to institution and government portfolios. You always know you can convert the bond and get your cash; you also always know that if you have cash and need to put it somewhere, you can buy a Treasury.
But, sometimes Liquidity can catch investors flat-footed. Meaning, when there’s a jitter in a market segment and investors want out, they can do so in a hurry, leaving the unaware holding the bag. And in cases like this, the investors bag is always much lighter than when they started.
As I mentioned earlier, something occurred that illustrates what I just described. It’s best if I show you versus type it out, so the balance of this blog will be a brief video. It’s not too long, so don’t worry about getting any popcorn...