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Market Top or Room to Run?

It feels like we have been asking this question for a few years now.  Every time the market makes new highs, pauses or pulls back slightly every pundit comes out of the woodwork to proclaim the market has topped out or the bull market is over. And yet, the markets just continue to march higher. I have discussed this off and on in some of my commentaries and other blog posts and seem to continually get questions from clients and prospects about this issue. This bull market that started at the end of the financial crisis can’t just keep going, or can it?

Investor Sentiment: One of the many drivers behind most bull markets and one that eventually leads to its demise is investor sentiment.  Famed investor John Templeton once said in regards to investor sentiment “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” In a note to investors this week, Goldman’s chief US equity strategist David Kostin notes, “investors today are situated between skepticism and optimism,” he continued” because investor euphoria is nonexistent, an imminent start of a long decline seems unlikely.”

Looking back over the past 9 years it is safe to say that much of this axiom has held true but also the pattern doesn’t always happen in a straight line. It is safe to say that most investors are not euphoric about the current markets. However, throughout the current bull market we have gone thru the pessimism stage and then bounced back and forth between the skepticism and optimism stages a number of times, even occasionally touching on euphoria and pessimism sides of the spectrum but never once reaching the euphoric levels that we saw during the tech bubble or the run-up to the financial crisis. If this axiom continues to hold true we will need to see that before a longer term pullback materializes.

It is important to point out though that even without reaching a full euphoric market, short term pull backs of 5 or 10% still are very realistic.  The low volatility environment we are in has made us forget that these types of pullbacks are normal and should be expected.

Valuation: By almost all measures, valuations are quite stretched. Whether these stretched valuations are justified is a discussion for another blog but on the surface, it would seem that most of the market is overvalued.  Looking at the Shiller P/E below, which adjusts for inflation and helps to smooth out the earnings over a longer time frame, you can see that the Shiller PE currently stands at 30.54. That is almost double the long term average of 16.78. Additionally, we have only seen this metric reach this level on two other occasions in history, Black Tuesday just before the market crash of 1929 and during the Dotcom bubble in the late 90s.

Now, just because valuations seem quite high does not mean that the market does not still have room to run or that earnings growth can’t accelerate to justify these current valuations. It also doesn’t mean that the market is at a top. It simply means that historically speaking, the markets are factoring in a much larger earnings multiple than they have in the past. This increased multiple could be a factor of the low interest rate environment we have been in or simply a result of the back looking time frame that this metric uses in its calculation. The earnings number used in the calculation is an average of the previous 10 years of earnings. Which means this includes 2008 and 2009 when earnings dropped almost 90%. If those years are removed or just normalized then the markets still look stretched but the valuation situation doesn’t look nearly as dire.

Economic Data: From a fundamental standpoint the economy is running strong.  GDP for last quarter was recently revised up to 3%. Monthly job growth has averaged around 175,000 leading to one of the lowest unemployment rates in history. Even with this record low unemployment, the number of job openings in the US currently sits at an all-time high meaning the employment situation in this country looks like it will continue to be strong. Wages have been growing at around 2.7% and consumer confidence is also at its highest level since 2001.

With all of this positive economic data, it seems difficult to imagine that a recession is imminent. It is important to point out that market performance is not directly correlated to economic performance, but a relative correlation does exist.  This positive economic data won’t prevent a short term market pull back but could help buffer any longer term pullback and does create a great foundation for companies to continue to grow.

Uncertain Factors: There are other variables in the market that could also signal the end to this bull-run or at least slam on its breaks. I often discuss the many uncertainties in the market, especially around tail risk events.  These risks are not being fully priced into the markets and should one occur could lead to a major sell-off as people flee to safer assets.

On the flip side, other uncertain events could do the opposite and just add fuel to this market pushing it thru the optimistic stage.  If tax reform or regulatory reform becomes more of a certainty over the coming months than we could see a sharp leg up in the markets.  The general consensus is that we are far from any real legislation but such a positive surprise could add to investor optimism leading us closer to a market top. However, this would only be after a move higher.

So where does this leave us now? Investor sentiment and economic fundamentals are pointing to a continued run of the bulls.  Valuations and geopolitical risks are implying that we should proceed with caution. The real answer is to make sure you are positioned somewhere in the middle.  During these times a balanced portfolio can be your best friend.  It is also important to avoid panic selling if the market does correct at all. As we have seen recently these pullbacks will happen but the markets have been resilient.  If we do see a more pronounced correction of 10% just remember that these types of corrections are normal. If you can’t stomach a decline like that then you shouldn’t be as highly as invested as you are. You should reduce your equity exposure to a more comfortable risk tolerance.

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Where has all the volatility gone?

A lot has been discussed in recent weeks about the period of low volatility we are currently experiencing in the markets.  I touched upon this briefly in one of my recent market commentaries but I felt like a deeper dive was needed into the phenomenon.

By almost any measure, volatility is at historic lows.  The VIX, which tracks the 30-day implied volatility of S&P 500 component stock options, and is widely accepted as the markets barometer for volatility has steadily marched lower since the financial crisis.  During the peak of the crisis in 2008, the VIX reached levels near 60 but in the last week, we have seen it hover at historically low levels near 10. So far this year we have also seen a number of record setting stretches including when the market went for almost 5 months without experiencing a 1% negative move on any day.

So the big questions that emerge are: what is causing this low volatility environment? Is this new low volatility the new norm or will we snap back to more “normal” levels? And most importantly, when will volatility return?

There are a number of factors that could explain why volatility is so low. Here are few of the more interesting ones:

  • Changes in information flow: This is an interesting one that I don’t normally hear discussed. However, I think it is an important one to consider. Over the last 20 years we have seen access to and the flow of information increase dramatically.  The internet, social media, the 24-hour news cycle and Twitter have put almost any information we could possibly need right at our finger tips. With so much access to information, there are fewer surprises. Everyone from the Warren Buffett to the trader at home knows everything that is going on in the world at all times. All of this data overload has reduced the number of shocks to the markets. Based on advanced modeling, leading indicators and the speed of information flow the market has the ability to react by the millisecond. If there are no surprises and all information is always available than one would assume that the markets would become more efficient and volatility has to come down as a response
  • ETF and Index trading: In a recent podcast Steve Bregman discusses this topic and I think it is an important one to consider because if he is right then it is setting the stage for a potential rapid increase in volatility if this trend reverses. In summary, the rise in popularity of ETF investing over the past few years, and the massive inflows away from active management and into passive are causing a wide range of stocks to be propped up artificially.  When a large ETF, like SPY, sees inflows, management has to go out and buy a majority of the stocks in the underlying index in order to mirror performance. This buying is not selective and has little to do with the fundamentals of the underlying companies. Since they are forced to buy, this dynamic is creating bids to buy all of these stocks, even the low-quality  These “artificial” bids prevent these stocks from selling off to the extent they really should if they were trading on their underlying fundamentals. This reduces overall volatility and mutes any potential market pullbacks. As long as flows continue into these passive vehicles there will always be someone out there buying the stocks.  The scary part about this is that if this trend reverses and flows stop going into these stocks then the pullback could be dramatic.  The artificially propped up stocks will not only give back these artificial gains but then pull back to where their fundamentals say they should be trading. Further, there will be forced selling of the quality stocks too, exacerbating the problem. The argument against this has been made that a lot of stocks have seen big pullbacks over the last few years so all ships are not being lifted with the ETFs.  My contention, however, would be, would these companies have pulled back even more if there weren’t ETFs being forced to buy them?
  • Post crisis tail risk fear: Following the financial crisis market confidence was at all-time lows and the fear of another tail risk event was on everyone’s mind. This fear caused many investors to pay crazy amounts for options to hedge any exposure they had. With investors willing to pay so much for protection, implied volatility stayed high. Even further, hedge funds who had missed out on making money on the financial crisis began to make more and more bets on tail risk events, hoping for another shock to the system. In the 9 years since the financial crisis, few of these tail risk bets have paid off so managers are now more reluctant to make them causing the VIX to drop. As the crisis moved further into the past, investor’s confidence also returned and their desire to buy option protection decreased. As options become less expensive, implied volatility also comes down dragging the VIX with it.  The interesting thing we have seen, however, is that numerous pundits are now screaming about an impending pullback but volatility still remains low.
  • Calm, stable period: The simplest answer to the low volatility question may be the most probable. Maybe we are just in a very calm, stable period for the financial markets.  The economy is currently at full employment, inflation is low and although GDP growth has been below its long term averages it has been very stable and predictable over the past few years. Additionally, even though we hear a lot of talk coming out of Washington, not a lot has happened to shock the system. Further, there are a lot of geopolitical tensions in the world but it has been years since we saw a major geopolitical threat come to fruition. A stable economy, minimal shocks to the system and no tail risk events coming to fruition may have just lulled the markets into this complacent state. This isn’t the sexiest explanation and even in this environment valuations may be getting stretched but until there is a major catalyst to shake things up the markets are comfortable with their slow steady march forward.

These are obviously only a few of the possible variables that may be driving this low volatility environment and it is most probable that a combination of factors has led us to where we are. As an investor, the questions still remains, what will change this current pattern?

Every day we read more and more about how a major pullback is coming. Whether this pullback is simply a natural market consolidation driven by overstretched valuations or a more severe geopolitically driven sell-off, it is important to not get lulled to sleep by current conditions.  As I’ve written about in the past market pullbacks are normal. The risk lies in whether there have been changes in market dynamics that could lead to a more severe pullback than normal.  If multiple factors are contributing to this low volatility environment and a few of them reverse or break down than the pullback could be exaggerated.

I, for one, think the fundamentals in the market are strong and without any major geopolitical disruption or major policy shift in Washington expect the market to continue to march higher.  We may see some profit taking here and there and some short term pullbacks but the foundation is set for the bull market to keep marching.

My fear, however, still lies in a tail risk event that causes panic selling. While we are years removed from the financial crisis, most investors still remember it vividly and they don’t want to be there if it happens again.  And while ETF flows may have propped up stocks on the way up, they could have the reverse impact on the way down, as forced selling drags down the quality stocks too. As low as the probability of such an event may be, all of this paints a dire picture if a real shock hits the markets.

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You Sold Your Company: Now What?

I’ll start by clarifying one thing, this post isn’t just for people that have sold a company. As much as we hear about company acquisitions in the financial news, selling a company is pretty rare. With all of the entrepreneurs and start-ups in the world, the actual number of companies that grow to a point of acquisition is tiny and most of the ones that do sell are not your Snapchats and Instagrams that reach rapid, almost overnight, success.  They are companies that grow gradually over time, maybe even being passed down through generations before being sold. With that said, the lessons from this post can also be applied to other transitions in life.  It could be a windfall from an inheritance, the realization of profit from stock options or even a simple transition to retirement.  In any case, the planning that you do leading up to, during, and after such an event can have a vast impact on the success of the transition and your future goals.  This applies not only to the financial side of things but also to the emotional transition people experience.

So, you sold your company. Congratulations. You worked your butt off and now you are about to reap the benefits. You can kick back, relax and spend the rest of your days lounging on the beach, sipping pina coladas. As idyllic as this may sound to some, this is not reality.  Yes, you have some new found wealth, more flexibility in your schedule, but you still have work to do.  Transitioning from building a company to life after the company isn’t like flicking a switch.  You need that new wealth to provide you with income. You need that new wealth to last for the rest of your life.  All this while adapting to a life where the main focus isn’t the company anymore.  Many people I work with struggle with this emotional part more than any other.

So how do you make this transition successful?

Pre-Planning

Just because your company is in the growth phase and hasn’t sold yet doesn’t mean there aren’t strategies that can be implemented to benefit you and your family in the long run.  During this time frame it is important that proper ownership of company stock is reviewed and that steps are taken to create a transition plan.  There should be a plan in place to make the transition from earning money to needing income.  This plan should be reviewed and discussed prior to any sale to ensure there is appropriate liquidity from the start and there isn’t a lag period.

There are also some wealth transfer strategies that lose their effectiveness the more mature the company gets.  The key to most wealth transfer and estate planning strategies is to control when and at what valuation something is included in your estate or gifted to a trust or other individual.  This discussion is much more complicated than can be covered in this blog post and will be the topic of a future post. However here are two basic strategies that could be appropriate.  As with all estate planning and tax related strategies, please speak with your tax or estate planning attorney to decide what strategies are appropriate for you.

  • Gifting: This is the simplest form of wealth transfer. You can simply gift shares of your company to a child or other individual.  The IRS sets forth lifetime gifting rules and restrictions so being able to gift an asset when its valuation is low can allow any future growth of an asset to avoid being included in your estate.  This is not always the best strategy from a control standpoint but could allow you to shelter significant growth from your estate.
  • GRAT: A Grantor Retained Annuity Trust also allows you to remove appreciation from your estate in return for a stream of income over the life of the trust. An asset (in this case, company stock) is placed in the trust for a set period of time. During that time the trust must pay out an annuity stream back to the grantor during the life of the trust.  With interest rates still at such low levels, this income requirement is quite low allowing more money to stay in the trust.  When the life of the trust expires the remainder passes along to the beneficiary of the trust. The beauty is that any asset growth during the life of the trust is not included in the gift amount. The gift amount is determined by valuation when the trust is established. If you expect your company stock to appreciate rapidly prior to an exit this can be a very efficient vehicle to keep that growth out of your estate and pass it on to your beneficiaries. (This is a very high-level description of a GRAT. There are many other caveats and details that should be considered and taken into account).

Transition to income

Financially, this is the major shift that someone will go through.  Throughout the lifespan of the company, you were working all the time and probably drawing some sort of paycheck to cover your bills and live your life.  Once the company sells this income stream vanishes. This means you must recreate a monthly income stream while also making sure there is enough capital to provide this income stream for many years to come. Too often I find people focusing exclusively on the income side of things and not taking into account that your principle also needs to grow in order to last the rest of your life.  If you sell a company when you are 50 you may need your assets to last more than 40 years, and often times you want to make sure there is some sort of legacy left behind.  To put this in perspective, with historic inflation averaging just over 3%, the amount of income you will need to maintain the same lifestyle as today will double in just over 20 years.  You need to make sure your principle is keeping up with this, especially if you have any legacy ambitions.

  • Income: Income can be created using a number of different strategies. Most commonly we create a balance between fixed income instruments (often times utilizing municipal bonds for the tax advantages) and dividend paying stocks. The balance will be dependent on the interest rate environment and a few other factors.  We also have the option of selling off security positions that have appreciated.  While traditionally this hasn’t been the most advantageous option, with capital gains rates at such low levels it can be considered if managed properly.
  • Growth: With many people I talk to that are either selling a company or transitioning to retirement they only focus on the income side of things. They are under the mindset that they need to cut out as much risk as possible.  Yes, I think for any money that you may need to spend in the next few years you should reduce risk substantially but with a large portion of retirement or post exit dollars the time frame can be longer than you think and this money should be managed appropriately.  This growth side could look very similar to your pre-exit/ retirement portfolio as the time frame is also longer term.  A longer term portfolio has the ability to withstand larger fluctuations in order to achieve long-term growth.

This strategy may seem different than what most people hear while they are building their wealth. We are always told to have a growth mindset while we are accumulating our wealth and then we should cut our risk when we make the transition to the income stage of life.  What I hope is apparent is that is exactly what we are doing.  By adding in an income producing layer we are reducing the overall risk within your assets but are still providing some opportunity for growth.

Future ventures

All of this financial management sounds great, but is this how the real world works? With most entrepreneurs I speak with, they don’t look at an exit as the end.  They look at it as a stepping stone to the next venture.  This can sometimes be a dangerous mindset from a financial planning standpoint.

It’s not always as simple as selling a company and then using that money to create income for the rest of their life. Many entrepreneurs want to take this new found wealth and use it to create the next big thing.  As a financial planner, this can create some difficult conversations. It is my job to help clients reach their goals. However, it is also my job to communicate the risks and rewards of financial decisions.  These risks and rewards are not just limited to financial outcomes but stretch across all aspects of life; family, work, philanthropy, lifestyle, and legacy.  It is important to understand that by simply taking a windfall and investing in the next venture you are not just risking financial loss but you could be risking your family’s long-term financial security.

Entrepreneurs can sometimes be blinded by success, often feeling like if they hit it big with one company they can easily do it again. You got rich by taking risks, but taking risks is not how you maintain wealth. You maintain wealth by managing risk. As I mentioned earlier, the success rate of start-ups is quite low so more often than not the prudent course of action is to create a balance between maintaining long-term wealth and taking a risk on the next opportunity.  This balance is going to look different for everyone but this is a very important time to evaluate risk well beyond financial loss. The goal is not to prevent future risk-taking and potentially miss out on creating that next great company. The goal is to put yourself in a position where you can have both.

Emotional Transition

This can sometimes be the most difficult part of selling a company (or retiring).  Entrepreneurs can grow attached to their companies and to their work.  It gives them purpose and in some cases is almost like another family member.  When you sell the company you need to fill this void, both from a time and an emotional standpoint. As a financial advisor, this is not my area of expertise but I think it is important to mention because the impact of this emotional transition can affect your financial lives especially when it comes to decision making.

There is no one way to emotionally handle this transition. Some people do it by relaxing. Some people get active with philanthropy. While others simply jump back into the waters with another venture, consulting work or board member responsibilities.  Whatever path works for you, it is just important to be mindful of this void and its impact on the rest of your life.

So, congratulations. You sold your company. Just remember, the work isn’t over yet.

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Get Rich Quick: An Exercise in Risk

There is an old adage, “slow and steady wins the race.”  It has been shown time and time again that the best way to build and maintain long term wealth is a well-disciplined savings and investment plan that starts early and builds over time.  For most people that are trying to retire or working their way there this is going to be the key to success.  As a financial adviser, I believe in this wholeheartedly.  I preach this to clients and help provide these clients with the correct discipline to stay on track. However, there is a large group of my clients, entrepreneurs and executives alike, that didn’t earn their wealth this way.  They took a risk by either starting a company themselves or accumulating a concentrated position in one company as part of their compensation. In either case, these companies took off and the individuals became wealthy as a result.  Their wealth was primarily created by being highly concentrated in one stock or business. So how do I rationalize stories like these, with the belief that a well-diversified, disciplined savings approach is the best way to build wealth?

The simple answer is these individuals have different ways of diversifying, different ways of balancing risk and, most importantly, a comfort with the risks they are assuming. So while their way of building wealth seems much different than a traditional wealth accumulation strategy there are many similarities.q

Calculated Risk:  In speaking with entrepreneurs and other professionals that built their wealth by being highly concentrated I have found one common thread.  These people understood the risk they were taking.  They understood that they could end up with nothing and they were comfortable with it.  For most people this type of risk would be unfathomable.  They would not be able to sleep at night knowing that all their hard work could amount to nothing. But these “risk takers” had calculated the risk and felt that the potential payout was worth the inherent risk. As an adviser, my job is to help clients manage their financial lives based on the client’s risk tolerance and goals. So while for most people that means a steady savings and investment plan, for these individuals the calculated risk that they were taking fit into their risk profile.

Conservative Balance: The interesting thing I have also found with these same individuals is that while they were comfortable with the risk they were taking within their business lives. They were very risk averse when it comes to any money outside of their concentrated position or business.  They build up larger cash reserves than most people typically should and their investment portfolios outside of their business definitely skew more to the conservative side.  With all of the risk they are taking in one area, they are balancing it out in most others.

De-risking: While these individuals are comfortable taking these initial risks they often struggle with letting go of the risk when it is appropriate.  This tends to be a time when many of these individuals engage with me or other advisers to help proved some investment discipline.  As with most entrepreneurs or successful professionals, they have an endless drive and are convinced that no matter what happens they can go out and build another company or do something to earn enough money to be happy.  This is where investment and financial discipline is important.  Although these people built their wealth by taking risks, maintaining this wealth is about de-risking.  Whether the wealth was created by the sale of a business or a jump in stock, de-risking and setting money aside creates a foundation for future success and can put them in a position to still take calculated risks when appropriate. The goal is to help these individuals avoid what I call “Serial Entrepreneur Syndrome.”  Too often I speak with people that built and sold a business, only to reinvest everything in a new venture and have it fail and them be back to zero.  At the time of the initial sale had they taken the steps to de-risk even a portion of their proceeds, they still can start a new venture but this time  they have a safety net that wasn’t there before and their family and future are secure no matter what the outcome of the second, third or fourth venture.

This same thought process holds true for folks that build their wealth from stock accumulation.  They become so emotionally tied to their company that they think that is the only way to continue to build their wealth. But by taking a little of the exposure off the table they set themselves up for a more stable future.  They already have their income tied to the success of the company, there is no reason to have all of their wealth tied to it as well.

Diversifying in other ways:  When we talk about diversification we are almost always talking about it from an investment portfolio standpoint. We spread our investments over a series of asset classes in an attempt to reduce our overall risk. These entrepreneurs diversify their risk in a different way.  They view their company as the investment portfolio.  They reduce their risk by making sure the business is running correctly and by reducing risks within the company. They try to hire the right people. Allocate their capital appropriately and manage revenue and expenses efficiently.  By taking these positive steps they are reducing the potential of failure within the company.  So while their overall risk is much higher than if they had a well-diversified portfolio of investments they are taking steps to reduce their risk exposure along the way. Yes, there are other outside risk factors that can always effect a business and not everyone does a great job managing their companies risk exposure. But that is why this type of risky behavior is not for everyone and why the potential payout or benefit can be so great.

In order to rationalize this more risky wealth accumulation strategy it is important to understand that these individuals are not just putting all of their eggs in one basket for the remainder of their life.  They are calculating the risk it will take to create their wealth. They are then taking steps to balance that risk in other areas of their life, hiring professionals to help them de-risk and help maintain their wealth and diversifying their risk exposure in other ways. This type of wealth accumulation strategy would not work for most people.  Most people don’t have the stomach to deal with the potential negative consequences of this level of risk. But for those that do, and also have the discipline to assess their situation thoughtfully along the way, this can be a very powerful way to create wealth as long as they are comfortable with losing it just as quickly.