THIS IS AN ARCHIVE POST. CLICK HERE FOR THE CURRENT TSP ALLOCATION GUIDE UPDATE.
I hope that everyone had a safe, wonderful Fourth of July weekend. I would start this post off with some witticism about the stock market starting July off with fireworks of its own, but you will quickly grow to hate me if I become that trite and predictable.
As we enter the second half of the year, I am up 8.31% in my Thrift Savings Plan year to date. Not bad, and if I could somehow lock that in at an annualized rate of 16.6%, I would take that deal in a heartbeat. From an economic indicator perspective, there is no reason to believe that the market won’t continue to trend up over the next year. It is anyone’s guess exactly where we will find ourselves come New Year’s Eve because odds are we will see some bumps in the next few months and it just depends on when they come and how severe they are. But I’m not seeing anything to cause real concern.
Two main bits this month: (1) a look at the first half of 2014’s improving economy and its impact on the stock market, and (2) the drumbeat for an overdue market “correction.”
Bottom line up front: my current TSP allocation remains 100% in the TSP S Fund (this reflects both my contribution allocation as well as where my existing balances are invested).
“It’s the economy, stupid.” – James Carville
A terrorist super-army is taking over Iraq, the Third Intifada is beginning in Israel, and Ukraine has abandoned the cease fire. But the stock market continues to set records almost daily. Is it possible that a dry, boring employment report outweighs all that blood and drama on TV?
As it turns out, yes. In the absence of definitive economic news, investors and the financial media look for other things to base their decisions on, and often choose whatever is in the news no matter how unlikely to impact the values of US domestic equities. When the economy is in that grey area, the current events described above would likely have had a noticeable, albeit temporary, impact on the markets.
But right now, the economy is not in that grey area. Don’t get me wrong, there is still plenty to complain about, but most investors seem to have finally come to the conclusion that we are well past the tipping point and the recovery will continue to strengthen.
As we have discussed ad infinitum on this website, employment correlates with economic growth more than any other indicator. Last Thursday’s jobs report was stronger than expected, with 288,000 net new jobs created. And the previous two months’ reports were revised higher at the same time. But more than that, this report marked the fifth month in a row with more than 200,000 jobs created – the first time that has happened since 1999. This has economists, the Fed, and investors convinced that the recovery is on solid footing.
So if this is such great news, can I explain what the market did today? Don’t worry, I will give it a shot:
- the stock market overreacted to the good news last week, just like it always does. And then over corrected to the down side.
- just over half of trading days are positive during bull markets (between 11 and 12 out of 20). That means 8 or 9 out of 20 will be negative.
- a significant majority of daily moves of over 1% occur to the downside. That often gives investors the impression they are looking at a down market, but those extra positive days more than make up for the attention grabbing down days and we wind up with annual charts which look like this:
The Looming Stock Market Correction
So the economy is doing well. The DOW just passed 17,000. The S&P 500 just set its 25th all-time closing high this year (on average setting a new high every five trading days). And I just told you that the start to this week is probably inconsequential. So it is all onwards and upwards from here?
Just prior to the euphoria created by last week’s jobs report, the talking heads on financial television and the link-bait headline writers out on the internet had started to pound the drum for a correction. And not just any correction, a 10% correction. And they returned to beating that drum early this week.
Eventually they are going to be right. As we have discussed before, the market will see about five declines of at least 5% in a typical year, and on average, there will be one 10% correction every year and a half.
It has now been three full years since our last 10% correction all the way back in the summer of 2011. And headline writers love round numbers, so they were sure to note we have just passed 1000 days since the last one.
While a future correction of some sort is unavoidable, none of that means a correction of any size is imminent. Averages are meaningful in a large enough universe of data (like a baseball player’s hits over the course of a 162 game season), but stock market corrections are a less common bird. They sometimes occur very close together, sometimes far apart. There were no 10% corrections for the seven years from 1990 to 1997, or the four years from April 2003 to September 2007. So it is certainly very possible that we may go another full year or even longer without a 10% correction assuming the economy continues to grow.
Unfortunately, we often see these memes become self fulfilling prophecies. Even among people who understand there is no law of nature which causes these corrections to occur at regular times, there will be justifications made that the market “is over extended” or “overbought”, and that a correction is order. Although you will note that none of the pundits ever explain why that “correction” made any sense at all when the market almost inevitably recovers and surpasses the previous highs in a matter or weeks or months.
So here is my prediction – there will be a correction of some magnitude in the next few months. There is no real reason it should hit 10%, but because that magic number has been bandied about so much in recent weeks, I believe there is a chance (let’s call it 30%) that the market will get run down 10% before rebounding (as if there was some higher power guiding the stock market which cared about the arbitrary units of measure which we have created). We saw exactly that with the biotech decline earlier this year – the mob decided there had to be a correction, and because it isn’t officially a correction until it hits 5%, buyers stayed out until that magic number was reached and then they poured back into the market.
Of course whenever this correction occurs, it will play nicely into the “Tired Bull Market” meme which we saw earlier this year. Plenty of investors and newsletter writers will decide that the bull market is over, panic and sell, then miss the inevitable recovery.
So what does knowing there is a reasonable possibility this will all play out exactly as I’ve described above do for me?
- I won’t get out of the market now, or delay making any investments, because while a correction could happen next month, it could just as easily happen a year from now and I could miss a 20% gain while waiting for a 10% decline;
- I won’t try to sell when the correction does appears to be happening because the decline is well over before I can react in the TSP;
- I will buy at the bottom in my non-TSP accounts. If I have cash available I will plow it into a small cap value fund (like VBR) when the decline approaches 10%;
- I will sleep easily through the entire event because I I have seen this movie a dozen times, I know it is coming in one form or another, and I know that the market will recover and go higher in relatively short order.
TSP Allocation Guide Performance through market close on 07/03/2014 (because you say you like my writing, but all you really care about is the money):
Year to Date: 8.31% Last 12 Months: 26.65%
Year to date TSP fund performance:
- TSP C Fund: 9.54%
- TSP S Fund: 8.31%
- TSP I Fund: 7.50%
- TSP G Fund: 1.18%
- TSP F Fund: 3.56%
The June Economic Numbers
As always, I will run through the key indicator data I use in determining where I think we are in the economic cycle and what that data means to me (these indicators are explained in some detail in How to Determine the Current Phase of the Business Cycle):
(1) employment numbers: as described above, the June 2014 jobs numbers were very strong and cap off a run of five strong months. I obtain these from the Bureau of Labor Statistics:
Total nonfarm payroll employment increased by 288,000 in June, and the unemployment rate declined to 6.1 percent. Job gains were widespread, led by employment growth in professional and business services, retail trade, food services and drinking places, and health care.
(2) Purchasing Managers’ Index (PMI): as usual I went to the Institute for Supply Management and pulled up their most recent report. Any number above 50 indicates economic growth:
Economic activity in the manufacturing sector expanded in June for the 13th consecutive month, and the overall economy grew for the 61st consecutive month, say the nation’s supply executives in the latest Manufacturing ISM® Report On Business®.
The June PMI® registered 55.3 percent, a decrease of 0.1 percentage point from May’s reading of 55.4 percent, indicating expansion in manufacturing for the 13th consecutive month. The New Orders Index registered 58.9 percent, an increase of 2 percentage points from the 56.9 percent reading in May, indicating growth in new orders for the 13th consecutive month. The Production Index registered 60 percent, 1 percentage point below the May reading of 61 percent. Employment grew for the 12th consecutive month, registering 52.8 percent, the same level of growth as reported in May. Inventories of raw materials remained at 53 percent, the same reading as reported in both May and April. The price of raw materials grew at a slower rate in June, registering 58 percent, down 2 percentage points from May.
The following table shows the progression of the PMI over the last year:
(4) yield spreads: I obtain my data for this section from the Cleveland Federal Reserve. The Cleveland Fed notes:
Using the yield curve to predict whether or not the economy will be in a recession in the future, we estimate that the expected chance of the economy being in a recession next June at 1.99 percent, down a bit from May’s reading of 2.31 percent, but up a bit from April’s probability of 1.78 percent. So although our approach is somewhat pessimistic with regard to the level of growth over the next year, it is quite optimistic about the recovery continuing.
The below chart shows the historical probability of recession based on where the yield curve is now:
(4) money growth: Money Supply M2 (which includes savings deposits, money market mutual funds and other time deposits which can be quickly converted into cash or checking deposits) continued to grow in May 2014. I obtain this data from the Federal Reserve.
Money Supply M2 in the United States increased to 11288.60 USD Billion in May of 2014 from 11214.80 USD Billion in April of 2014. Money Supply M2 in the United States averaged 3293.76 USD Billion from 1959 until 2014, reaching an all time high of 11288.60 USD Billion in May of 2014 and a record low of 286.60 USD Billion in January of 1959. Money Supply M2 in the United States is reported by the Federal Reserve.
(5) the stock market: a trailing indicator as it relates to the economy for the most part, but worth tracking on a monthly basis for signs of significant disruptions. The TSP C Fund is up 9.54% year to date, and the TSP S Fund is up 8.31%. That is well above average for this point in the year, so the market seems to think the economy is doing well.
So again, all of the indicators are pointing in the same direction, and I believe that we remain in the Recovery Phase of the Economic Cycle for all of the reasons which I described in my earlier post on The Business Cycle Theory of Investing. For that reason, I remain 100% invested in the TSP S Fund.
The Other TSP Funds
My views of the other funds remain largely unchanged from last month, but I have copied those here for new readers:
TSP C Fund: The C Fund will likely perform just fine and roughly parallel to the TSP S Fund, but historically S Fund will outperform in this phase of the economic cycle. You really aren’t diversifying by choosing a slightly different basket of US stocks, so I don’t see any value in splitting my allocation.
TSP I Fund: I still don’t see a basis for predictable gains in the TSP I Fund. I believe it is likely to be volatile, and is as likely to be down for the year as up. There is certainly potential for strong returns in the I Fund, but I feel it would be a gamble, whereas the US equity funds are much more predictable. If you haven’t read it yet, I’ve got a post on the TSP I Fund which explains under what circumstances it performs well here: The Best International fund of the 1970’s Today.
TSP F Fund: The Fed’s continued taper of Quantitative Easing will likely result in interest rates trending up, which will typically result in flat to negative returns for the TSP F Fund until they stabilize (see the F Fund vs G Fund post for the details on why that will happen).
TSP G Fund: The TSP G Fund would be my safe haven of choice these days, if I needed a safe haven.
TSP L Funds (the lot of them): If an investor just doesn’t want to bother looking at things for 40 years, an L Fund would be better than the default TSP G Fund. But I believe we can do better than the mediocre to average returns which the L Funds are engineered to achieve.
Individual stock picking for fun (and occasional profit)
This non-TSP talk is for fun, not at all a recommendation to buy. The vast, vast majority of my investments outside the Thrift Savings Plan are in great big index funds, not individual stocks. While I have had some great winners over the years, overall I would have been much better off if I had put all of the money I have invested in individual stocks into those index funds. So this is Vegas money, just for fun. Really.
We discussed Business Development Companies (BDCs) a few times over the past few months. They were removed from Russell indexes in late June (not because there is anything wrong with them, but because they are basically leveraged holding companies so their inclusion results in the stocks which they hold being counted twice). It appears the damage has been done and these are starting to rebound nicely. BDCs pay outrageous dividends – many in the neighborhood of 12%. The big names in this area are ARCC, MCC and PSEC.
The Next Update
I will update this post again during the second week of next month after all of this month’s data comes in unless something shocking happens which requires me to send out a new update. I send out a notification of these updates (or allocation changes during the month) to the email list which you can subscribe to here: Subscribe
If you want to see what I am reading throughout the month, I also have a twitter account to which I usually post items of interest which I have stumbled across for investors, Feds and the military once or twice a day at: @TSPallocation
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