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Lessons for the Next Crisis

Written by Dimensional Fund Advisors LP.

September 2017

It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.  Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.

BENEFITS OF HINDSIGHT

In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as "Worst Crisis Since '30s, With No End Yet in Sight," "Markets in Disarray as Lending Locks Up," and "For Stocks, Worst Single-Day Drop in Two Decades" were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.

It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.

Exhibit 1. The Market's Response to Crisis
              Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)

In US dollars. Represents cumulative total returns of a balanced strategy invested on the first day of the following calendar month of the event noted. Balanced Strategy: 12% S&P 500 Index,12% Dimensional US Large Cap Value Index, 6% Dow Jones US Select REIT Index, 6% Dimensional International Marketwide Value Index, 6% Dimensional US Small Cap Index, 6% Dimensional US Small Cap Value Index, 3% Dimensional International Small Cap Index, 3% Dimensional International Small Cap Value Index, 2.4% Dimensional Emerging Markets Small Index, 1.8% Dimensional Emerging Markets Value Index, 1.8% Dimensional Emerging Markets Index, 10% Bloomberg Barclays Treasury Bond Index 1-5 Years, 10% Citigroup World Government Bond Index 1-5 Years (hedged), 10% Citigroup World Government Bond Index 1-3 Years (hedged), 10% BofA Merrill Lynch 1-Year US Treasury Note Index. The S&P data are provided by Standard & Poor's Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup Indices used with permission, © 2017 by Citigroup. Bloomberg Barclays data provided by Bloomberg. For illustrative purposes only. Dimensional indices use CRSP and Compustat data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Rebalanced monthly. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. See Appendix for additional information.

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.

CONCLUSION

In the mind of some investors, there is always a "crisis of the day" or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.


APPENDIX
Balanced Strategy 60/40
The model's performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor's decision making if the advisor were actually managing client money. The balanced strategies are not recommendations for an actual allocation.

International Value represented by Fama/French International Value Index for 1975–1993. Emerging Markets represented by MSCI Emerging Markets Index (gross dividends) for 1988–1993. Emerging Markets weighting allocated evenly between International Small Cap and International Value prior to January 1988 data inception. Emerging Markets Small Cap represented by Fama/French Emerging Markets Small Cap Index for 1989–1993. Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One‑Year prior to January 1990 data inception. Five-Year Global weighting allocated to Five-Year Government prior to January 1990 data inception. For illustrative purposes only.

The Dimensional Indices used have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index's index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses.

Index Descriptions
Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market‑capitalization‑weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country's companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country's value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country's respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country's small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.

Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.

Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country's companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country's value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.

Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

[1]. wsj.com/articles/SB122169431617549947.

[2]. washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091700707.html.

[3]. nytimes.com/2008/09/30/business/30markets.html

Source: Dimensional Fund Advisors LP.
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Banking Retreat

Written by Bob Veres & Gerald E Gasber, CFP®, CIMA®, CPFA.

Low interest rates and added regulation designed to head off another global financial crisis has made it more expensive and complicated to run a banking operation these days. Gone are the heady days when banks were building 200 new brick and mortar locations a month in the U.S. market, leading up to the market top in 2008, when there were 100,000 bank branches in the U.S.—35 for every 100,000 adults, twice as many, per capita, as Germany.

Today, lenders are cutting back. Since the financial crisis, banks have closed an average of three branch offices a day, and the pace has picked up. In the first half of 2017, a net of 869 brick-and-mortar bank branches shut their doors.

Community organizations have noted that much of the cutback has occurred in areas where less-wealthy people live, and in rural areas there are now more than 1,100 "banking deserts" in the U.S.—defined as places where consumers have to drive at least ten miles to the nearest bank branch. At the other end of the spectrum, half of Americans, chiefly from wealthier neighborhoods, live within one mile of their nearest bank.

The lack of banking locations hits small businesses and homeowners the hardest, since many of their lines of credit are dependent on relationships. The local banker knows them and their character, even if their balance sheets might not be spotless. A study in 2014 found that when branches close, new small business lending falls by 13% in the surrounding area. In low-income areas, the impact comes in at something closer to 40%.

Source:

http://www.economist.com/news/finance-and-economics/21725596-banks-have-shuttered-over-10000-financial-crisis-closing-american?fsrc=scn/tw/te/rfd/pe

 

Super Babies or New Rules?

Written by Bob Veres & Gerald E Gasber, CFP®, CIMA®, CPFA.

You probably noticed the headlines: for the first time, U.S.-based scientists have genetically modified a human embryo. This follows similar news from China, which, like the U.S., has touted the ability to correct defective genes that cause inherited diseases like cystic fibrosis, or to resolve the predilection to cancer or heart disease.

This marks the new era of human gene editing—what some are calling "designer babies," what others might soon be calling "super babies." The question for all of us to wonder is: where will this lead?

A recent article by popular scientist Vivek Wadhwa lays out some of the possibilities. He says that the new CRISPR process to edit genes in humans and animals has basically made it as easy and nearly as cheap to snip and replace bits of DNA as it is to edit computer code—and scientists see some similarities between the two. Computer code and DNA are both shorthand commands for very complex processes, and as those commands are understood, their possibilities expand.

The ability to modify an embryo doesn't necessarily have to stop with genetic-related diseases. While they're checking for the gene for cystic fibrosis, would you want a medical team to make a few nips and tucks, and guarantee that the child will be born with blonde hair, blue eyes or greater intelligence? There are reports of parents who have given their young children human growth hormone and anabolic steroids in order to turn them into more successful adult athletes. What if a creative, clandestine team of researchers approached that same family and promised that they could tinker with the next embryo and produce a seven and a half foot, four hundred pound gridiron competitor?

Other parents might want to add a few IQ points to their childrens' intelligence, and scientists have recently uncovered several places in the human DNA that seems to code for intelligence. Why stop at a few IQ points when you could conceivably ensure that your child would be a transcendent genius with intelligence off the conventional charts? And what would be the impact on society of a dozen, a hundred or a few thousand super-intelligent, genetically-engineered citizens?

Meanwhile, as it becomes easier and less expensive to hack the life code, we could see terrorists creating frightening new viral or bacterial diseases for which there is no cure.

In February, an advisory body from the National Academy of Sciences announced support for using CRISPR to edit the genes of embryos exclusively to remove DNA sequences that doctors say can cause serious heritable diseases. But rather than hailing this as a first step in an ethical debate about modifying life as it has evolved on this planet, many scientists see the go-ahead as the first step down a long pathway that could lead to very serious consequences in the future.

Source:

https://singularityhub.com/2017/07/31/the-era-of-human-gene-editing-is-here-what-happens-next-is-critical/?utm_content=buffer0002e&utm_medium=social&utm_source=twitter-hub&utm_campaign=buffer

 

Don't Sell on Headlines

Written by Gerald E Gasber, CFP®, CIMA®, CPFA & Bob Veres.

So far, the world markets seem to be shrugging off the sabre-rattling coming from North Korea (normal behavior) and the U.S. White House (complete departure from prior administration policy). The smart money is betting that the distant but suddenly headline-grabbing possibility of the first conflict between two countries armed with nuclear weapons will amount to a tempest in a teapot.

Meanwhile, the U.S. stock market has been testing new highs for months, and experts cannot quite explain why valuations have been rising amid such low volatility.

So the question is quite logical: isn't this a good time to pare back or get out of the market until valuations return to their historical norms, or at least until the North Korean "crisis" blows over?

The quick answer is that there's never a good time to try to time the market. The longer answer is that this may actually be a particularly bad time to try it.

What's happening between the U.S. and Korea is admittedly unprecedented. In the past, the U.S. largely ignored the bluster and empty threats coming out of the tiny, dirt-poor Communist regime, and believe it or not, that also seems to be what the military is doing now. Yes, our President did blurt out the term "fire and fury" in impromptu remarks to the press, and later doubled down on the term by suggesting that his warning wasn't worded strongly enough. But the U.S. military seems to be responding with a yawn. There are no Naval carrier groups anywhere near Korea at the moment; the U.S.S. Carl Vinson and the U.S.S. Theodore Roosevelt are both still engaged in training exercises off the U.S. West Coast, and the U.S.S. Nimitz is currently patrolling the Persian Gulf. Nor has the State Department called for the evacuation of non-essential personnel from South Korea, as it would if it believed that tensions were leading toward a military confrontation.

Meanwhile, on the home front, the U.S. economy continues to grow slowly but steadily, and in the second quarter 72.2% of companies in the S&P 500 index have reported earnings above forecast.

What does that mean? It means that you will probably see a certain amount of selling due to panic over the North Korean standoff, which will make stocks less expensive—a classic buying opportunity. History has given all of us many opportunities to panic, going back to World War I and World War II, and more recently 9/11—but those who stayed the course reaped enormous benefits from those who abandoned their stock positions.

If you're feeling panic over the North Korean situation, by all means, go in the nearest bedroom and scream—and then share some sympathy for the Americans living in the island territory of Guam, which is in the direct path of the North Korean bluster. Just don't sabotage your financial well-being in the process.

 

Measuring the Market

Written by Gerald E Gasber, CFP®, CIMA®, CPFA & Bob Veres.

Have you ever wondered what stock market professionals and equity analysts talk about in their spare time? Recently, the Bloomberg website featured a debate about something that is getting a lot of attention recently: the historically high, and still-rising U.S. stock market valuations. People have been willing to pay more, and more, and more for a dollar of corporate earnings. What does that mean about future returns?

Let's look over the shoulders and see how two professionals approach the question of how to look at today's markets.

Bloomberg Gadfly columnist Nir Kaissar starts by noting that the Standard & Poor's 500 Index has beaten both the MSCI EAFE Index -- a collection of developed market stocks outside the U.S. -- and the MSCI Emerging Markets Index by 6 percentage points a year since March 2009, when the market hit bottom, through May, including dividends. Whether you measure market prices by price-to-earnings ratio, price-to-book or price-to-cash flow, U.S. stocks are now more expensive than their foreign counterparts.

To Kaissar, that suggests that investors should consider moving at least some of their money out of American companies and into companies domiciled elsewhere.

Bloomberg View columnist Barry Ritholtz countered that valuation is largely driven by psychology. We are experiencing a bull market in American stocks, which can be defined (in psychological terms) as a period when investors become willing to pay more and more for a dollar of earnings. Eventually this will turn around, and the regional performance gap between the U.S. and Europe will reverse.

But for Ritholtz, the important issue is timing. You could have used Kaissar's argument four or five years ago, gotten out of U.S. equities, and you would have missed a nice runup while foreign stocks were going nowhere. Is it possible that the same will be true over the next few years? (Hint: it is definitely possible.)

Kaissar responded with a definition of risk vs. valuations—the idea that investors are generally willing to pay more for less risky stocks. So can we make an argument that the S&P 500—with a price-to-book ratio about twice as high as the EAFE basket of stocks—is half as risky as stocks trading in the rest of the world? He doesn't think so, and the conclusion is that American stocks are mispriced.

Ritholtz says that rather than trying to time which part of the world is going to do better or worse, it's better to own it all. Instead of U.S. stocks vs. world stocks, own a portfolio that includes all of them in proportion.

Aha! says Kaissar. U.S. investors commonly allocate 70 percent to 80 percent of their stocks to the U.S., even though U.S. stocks represent only 50 percent of global market capitalization. He says that if you believe in true diversification, it would make more sense to create portfolios with a U.S. stock allocation that's closer to 45 percent, tilting slightly toward the global stocks that are currently trading on sale.

Ritholtz makes a final argument, saying that sometimes cheap stocks get cheaper and continue to fall; other times expensive stocks get more expensive and keep going up. He doesn't want to abandon U.S. equities, but he finds common ground with Kaissar when he recommends that people with U.S.-heavy portfolios consider diversifying into MSCI EAFE and MSCI EM indexes—not for timing purposes, but because it's prudent diversification. You can see exactly how boring the cocktail conversations of stock analysts can be by viewing the entire discussion here: https://www.bloomberg.com/view/articles/2017-06-26/how-to-know-when-stocks-are-properly-valued-a-debate#596235f3a911d

Source:

https://www.bloomberg.com/view/articles/2017-06-26/how-to-know-when-stocks-are-properly-valued-a-debate#596235f3a911d