Business sectors are set for massive changes this fall

By Path Financial President and Chief Investment Officer Raul Elizalde

2018-06-04 14_05_27-Sector ETFs Are Set For Massive Changes This FallThe Global Industry Classification Standard (GICS) is a taxonomy system developed by MSCI and Standard & Poor’s that organizes companies into 11 economic sectors. This classification is applied to sector indices, which are in turn used to build ETFs and mutual funds that track them.

But the GICS system was created almost 20 years ago, and the world has changed a lot since then.

Facebook, for example, is no longer the online curiosity it was when it first started. It is now a huge delivery system for content, marketing and advertising. So it no longer seems appropriate that it should coexist in the same “information technology” box as Akamai, for example, which builds internet delivery networks and focuses on security and reliability.

To accommodate these changes the good folk at GICS have produced a preliminary list of more than 200 companies around the world that will be reclassified to reflect better what they actually do today. A final list will be published in July, and changes will be effective in September.

The technology sector will lose many big names to a new communications sector (a rebranding of the current telecommunications sector) such as Alphabet, Google and Twitter. Consumer discretionary will lose Comcast, Disney and Twenty-First Century Fox to communications as well.

These huge changes will fundamentally change the technology, communications and consumer discretionary sectors. Investors unaware of these changes will be in for a big surprise.

For example, the market cap of the communications sector will jump from today’s $1.7 trillion to perhaps as much as $10 trillion, according to a study from State Street, one of the largest ETF providers. Consumer discretionary and technology will shrink.

Additionally, as the State Street study points out, communications will be far more correlated to the S&P 500 than before. It will also include 13 stocks in the top 50% of returns in 2017, a huge change for a sector that today has a large proportion of high-dividend, defensive stocks. Furthermore, historical studies of sector volatility and correlation will be rendered largely useless. Investors who strive to build efficient portfolios using that data will find themselves in the dark.

ETFs, which have been the investors’ vehicle of choice to track indices, will be particularly affected. For example, State Street’s SPDR Technology Sector XLK, Consumer Discretionary XLY and Telecommunications XTL that track the S&P Select Sector indices (built around GICS) will be revamped to mirror the new compositions.

Vanguard, which also has sector ETFs (the Technology VGT, Telecommunications VOX and Consumer Discretionary VCR) structured as a class of their mutual funds adopted an interesting approach. Between May and September they will track custom MSCI Investable Market Transition indices to avoid sudden changes to the funds, in lieu of the current MSCI Investable Market Indices.

Fidelity’s U.S. sector ETFs track U.S.-only versions of the MSCI Investable Market Indices, which will change as well. On the other hand, some of Blackrock’s US-only sector ETFs will be unaffected, such as the Technology IYW and the Telecommunications IYZ, because they track US-only Dow Jones Sector indices that are not aligned with GICS. Adding to the confusion, Blackrock’s global sectors ETFs such as the Global Telecom IXP are linked to GICS definitions, and will change.

This is enough to make any investor’s head spin. What investors must remember is that some of the sector funds they use today may no longer represent their investment objectives after September. Keeping abreast of the upcoming changes will go a long way to avoid surprises down the road.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Forbes Names Raul Elizalde as Contributing Columnist Covering Market Trends & Investing

Raul Elizalde President Path FinancialForbes has named Sarasota investment advisor Raul Elizalde as a full-time contributor for its website Forbes.com, which boasts a monthly digital readership of roughly 53.9 million. Elizalde has been a guest contributor for Forbes for over a year; beginning May 2018, he will write under his own byline (http://www.forbes.com/sites/raulelizalde) covering market trends, investment mistakes, and overlooked risks. His first column, “Sector ETFs Are Set For Massive Changes This Fall,” is already online at https://tinyurl.com/y8obut2r. Elizalde is the founder and chief investment officer of Path Financial, a Florida-registered investment advisory firm.

Elizalde focuses on analyzing historical trends to avoid current and future market risks and minimize investment vulnerability for his clients. As a former Wall Street strategist, Elizalde has advised portfolio managers across the US and the globe, and has made presentations at the World Bank, appeared as a market commentator on television (Reuters and Bloomberg TV) and has been quoted in the financial pages of The Wall Street Journal, The Washington Post, the Financial Times and The New York Times. Elizalde’s economic and investment analyses have been published online by some of the most respected financial media in the country, including Investopedia, Morningstar, Motley Fool, the Street and Yahoo! Finance. He also shares his insights monthly through Path Financial’s free, subscriber-based newsletter, “Straight Talk.”

In 2008, Elizalde relocated his family to Sarasota from New York City where his Wall Street career included positions as Global Fixed Income and Quantitative Strategist for ING Barings, Head of Research at Santander Investment Securities, and Fixed Income and Emerging Markets Strategist for Banc of America Securities. He holds an MS degree in engineering from University of Buenos Aires, Argentina, and an MBA degree from University of California at Los Angeles. He was licensed as a NYSE Supervisory Analyst and currently holds a NASAA 66 Investment Advisor Representative license.

Elizalde is the past chair and current member of the Asset Management Committee at State College of Florida. Path Financial, LLC, is located at 1990 Main St., in Sarasota, Florida, and is a Florida-registered investment firm, partnered with preferred account custodians Charles Schwab & Company and TD Ameritrade. For more information, call 941.350.7904, or connect on Twitter (@pathfin) and Facebook.com/PathFinancial.

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Why the trade tantrum is bad for stocks

today imageThe tariffs and penalties recently announced by the US represent a significant change in US relationships with its trade partners that creates uncertainty and stokes market volatility. Worse, they offer no outcome that would make the whole thing worthwhile. This is because the US has a lot to lose by alienating traditional partners who could help achieve its goals. This is not good for the stock market.

Let’s start with the botched attempt to impose steel and aluminum tariffs. The vast majority of economists opposed it and, in fact, Forbes did not find a single one who thought it was a good idea.

A tariff on goods imported into the US is a tax charged to US buyers. When a tariff is sufficiently high, the final price of the import becomes higher than the price of the same good produced domestically, which in theory should boost local production. This was the goal for the steel and aluminum tariffs announced in March.

All this may sound like a good idea. Yet, domestic buyers of those metals, who use them to make other things in the US, warned that they would have to raise prices for US consumers. Commerce Secretary Wilbur Ross argued tenaciously that the tariffs’ effect on local prices would be minimal (“less than six-tenths of one cent on a can of soda, less than half of one percent on a car”).

If what Secretary Ross says is true, then those particular tariffs served no purpose because such tiny price increases can be easily absorbed by consumers. Will anybody rush to deploy massive amounts of capital on new aluminum smelters or steel plants to replace imports? Most likely, any domestic substitution effect would come in the form of a small increase in capacity utilization.

The tariff gambit, in short, was ill-considered because it offered small potential upside compared to the possible downside of an escalation of tit-for-tat tariffs that could detonate a broader trade war. It is unsurprising that the administration eventually watered down the initial proposal as it also became clear that the main villain in its eyes, i.e. China, was unlikely to suffer much from tariffs on aluminum and steel.

The US then changed tack, announcing $60bn in tariffs and penalties specifically on Chinese imports, this time in response to US accusations of intellectual property theft.

The feeling that the US is itching for a confrontation with China is unmistakable. But the US has a lot to lose and the room for error is small.

The US is the largest exporter of goods and services in the world (China is larger just on goods) and therefore has the most at risk if a trade war unfolds. Additionally, foreigners hold 42% of all outstanding US Treasuries – 64% of which is held by governments. The fact that such a large proportion of US creditors are foreign is not a point of strength in negotiations.

More generally, a trade war could negatively affect the benign market outlook generated by other policies, such as the 2017 tax cut bill. While that bill created serious long-term problems (see How the tax bill made the next recession much more painful, 1.23.2018) there is no doubt that it gave stocks a short-term boost. A trade war, on the other hand, has no positive effects on the stock market.

A trade war will hurt US exports, corporate profits, and growth. US imports will also suffer, which will lead to higher inflation if cheap imports are substituted by more expensive local products.

While curbing intellectual property theft is a desirable goal, it is unlikely to be achieved through a trade war. Most experts agree that a coordinated approach by the US and other nations also affected by China’s actions would be more direct and have a higher chance of success.

For example, the US, Europe, and other allies could tighten restrictions on Chinese acquisitions of companies that own sensitive technology, or demand an easing on China’s regulations that force foreign companies to joint-venture with locals to establish a presence there. Alas, the US policy has so far been more directed at venting grievances with US allies over cars (Germany) or lumber (Canada), rather than convincing them to coalesce around common interests.

The US decision of abandoning the Trans-Pacific Partnership (TPP) also complicates the issue.

The TPP was advanced by the US to strengthen commercial and investment ties with much of the Pacific Rim. It excluded China, thus reining in its ambitions while reinforcing US influence on the region. When the US walked away from the TPP, China quickly moved in to revive talks on the competing, and far more advantageous (to China) Regional Comprehensive Economic Partnership, or RCEP. In addition, the US-less TPP’s successor – the Comprehensive Progressive Trans-Pacific Partnership, or CPTPP – now also includes China.

As the US surrenders influence in Asia, it cedes power to China. Pounding traditional partners over the head with tough rhetoric on trade simply drives them away, hurting US influence elsewhere. Meanwhile, confronting China’s ambitions in Southeast Asia is not made any easier by the rather inexplicable absence of a US ambassador to South Korea or the chaos in the State Department, which is currently awaiting the confirmation of a new Secretary of State after the sudden dismissal of Rex Tillerson.

In sum, the trade tantrum is not positive for the stock market. Since the bull run is already quite long in the tooth, some will see the trade issue as a possible catalyst for the rally’s end.

We believe that a full-on trade war is unlikely, but tensions need to be defused. The US must also formulate a coherent trade policy and refocus diplomacy on global cooperation favorable to US interests rather than confrontation with allies. Otherwise, the bull market could end soon.
What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting exposure to risk through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, always putting their interests first. That means we do not profit from transactions or from selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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How the tax bill made the next recession much more painful

today blog photoIf the stock market rally was a party, someone would be wondering if the punch bowl should be taken away. The tax bill, instead, has refilled the bowl to the brim. Party fun goes on, and the coming hangover has just gotten worse.

Shortly after the bill passed, Walmart, AT&T, Comcast and many other companies announced $1,000 bonuses to hundreds of thousands of employees. And this is peanuts compared to the large and permanent reduction in the corporate tax rate corporations get. The breaks extend to a mountain of profits accumulated abroad and a variety of loopholes that may lower taxes even further when they bring them back.

Corporate America was already flush with cash. The extra pile courtesy of the tax bill will spur some marginal increase in business investment and wages (as the $1,000 bonuses show), but the historical relationship between taxes and economic activity suggests that this effect is bound to be small.

Far more importantly, the extra money will accelerate stock buybacks. Data by the US Federal Reserve shows that corporate repurchases of stock have been a major source of demand for equities and arguably the most important factor in pushing stocks higher in recent years. Because it operated under the radar of individual investors, general belief in the soundness of the bull market never caught on. But now the tax cut is in place, and people are increasingly aware that offshore money will mostly go to dividends and repurchases. This is bringing a lot of investors in, pushing stocks even higher.

The tax cut, therefore, not only will have some marginal effect on economic activity, but also a hugely positive impact on the demand and supply of stocks. This makes it without a doubt a positive for the stock market. So what is not to like?

In our view, the tax cut comes exactly at the wrong time.

Back in the aftermath of the financial crisis the world desperately needed a fiscal shot in the arm – lower taxes, higher spending, or both. But politicians in the US and Europe, claiming concern by high levels of debt, declared that austerity was the only acceptable way to fight the crisis and denied the world of this medicine.

This was an enormous policy error. Without any fiscal help, central bankers were forced to engineer a global recovery through aggressive monetary loosening, at the cost of severe distortions such as zero (or negative) interest rates, massive asset inflation, and a huge accumulation of private debt.

But monetary authorities accomplished their goal. The world is firmly in growth territory, the US is at full employment, and inflation has stayed low. Not only we came out in pretty good shape, but conditions are now ideal for dealing with those distortions created by “unconventional” policies.

The tax bill, however, injects a sharp fiscal stimulus that not only is unnecessary at this time but also creates the opposite problem. If the economy speeds up too much or inflation starts rising, central bankers could be forced to raise rates too quickly to keep things under control. This is dangerous in a world with high indebtedness. And once again, fiscal and monetary policies will be at odds.

Even if inflation stays low and the economy does not overheat, the tax cut is bound to increase levels of public debt by at least $1TN over the next decade, according to the Congressional Budget Office, the Joint Committee on Taxation, and the Tax Policy Center. This will leave even less room for deploying fiscal tools (i.e. higher spending and/or even lower taxes) to fight the next recession when it comes.

This is a serious issue. While things look good right now, the business cycle is not dead. The current expansion has been running for 104 months straight, and we are well positioned to break the 120-month all-time record. When the streak ends, the size of outstanding public and private debt are very likely to be much larger than in 2008.

And it is a good bet that, unless the world’s political landscape changes radically, politicians will again be horrified by levels of debt and refuse to stimulate the economy through fiscal means, just as they refused during the last crisis. Monetary authorities will have no choice but loosening policy way too much, and the cycle will start all over again from a more extreme point of indebtedness.

Thus the tax bill has quite certainly, and unnecessarily, made future downturns far more painful than they needed to be. But when people party they don’t think about hangovers, especially when everybody was served another round. Higher stock prices in the short term are likely. What may happen later will not be as fun.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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How the New Tax Bill Affects You

By: Oxana Saunders

path picWhile many of us are preoccupied with the recent volatility of the stock market, it is important to remember that we are in a tax filing season, and April 17 (this year’s deadline) is just a little over nine weeks away. Last year’s Tax Bill has many people wondering what their taxes will look like next year and whether any of these changes will have an impact on their 2017 filings.

The Tax Bill document is quite complex and even many tax professionals are still sorting out all the changes. A notable change for 2017 is medical expenses: If you itemize and have high expenses, the threshold for deduction temporarily goes back to 7.5% from 10%.

529 plans have been expanded as well: starting in 2018, parents may now use $10,000 per year from 529 accounts to pay for K-12 education tuition (see our previous blog on the topic).

Personal exemptions go away in 2018, which could result in higher taxes for married couples filing jointly with children.

Below is a link to a timely Investopedia article that we found very useful in summarizing some of the biggest changes in the tax code, and how they may impact you.

investopedia smaller

For any questions how tax changes may affect your personal finances, call us at 941.350.7904 for a free consultation.

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Oxana Saunders Vice President Path FinancialOxana Saunders is the Vice President of Path Financial, LLC. She may be reached at 941.894.2571 or oxana@pathfinancial.net.

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How to Handle the Flash Crash of 2018

path flash crashAfter a meteoric rise, the stock market lost more than 6% in only two days. Why did this happen, and where do we go from here?

At the close of Monday, February 5 2018, the S&P 500 gave up more than all the year’s gains. Put in perspective this is not a large move: the index is roughly back to where it was just a couple of months before. Also, there are no clear fundamental reasons behind the decline: both the economy and corporate earnings are strong, unemployment is low, and the global economy is in good shape.

Some reasons behind the sharp fall are most likely technical, such as the high levels of margin debt, elevated P/E ratios, side-effects brought about by the purchase of insurance by some market participants, and so on. These kind of factors rarely portend a large, structural move to the downside.

There are, however, some fundamental weaknesses in the system. The most important is the enormous increase in private sector debt that both households and non-financial corporations have accumulated in the last few years. When and if interest rates rise too much or beyond a certain threshold, a much more serious credit-driven problem can materialize and evolve into a full-fledged crisis that could profoundly affect markets. The quick rise in interest rates last week may therefore have something to do with the stock market move, but we think that rates are not yet close to trigger widespread credit problems.

As we described in a recent newsletter, the recent tax cut is another reason for concern. This is because coming at a time of full employment it can cause the economy to overheat and inflation to climb, driving the Federal Reserve to tighten monetary policy. This could trigger the kind of credit crisis we fear.

Additionally, the tax cut is likely to create a large increase of public debt, which would limit options to fight the next inevitable recession and thus turn a normal deceleration of the economy into a more serious downturn.

We believe, however, that we are not yet at the edge of recession or a negative credit event. The swift market fall seems due, instead, to the kind of technical factors that we mentioned earlier. If so, it could be useful to explore what happened in similar situations in the past when stocks had technically-driven two- or three-day declines of more than 6-7%.

We looked at the history of the S&P 500 since its inception and we identified nine such instances, from the “Kennedy Slide” of 1962 to the China-driven volatility of August 2015. We did not include the Crash of 2008 because it was not a mere technical decline but the result of serious fundamental concerns about the viability of the banking system. While technical factors could have exacerbated the 2008-2009 market rout, they were clearly not the cause.
path image for post
In all these instances we observed that after a few days, weeks or months the market recovered virtually all the lost ground. While the market fell more than 6% twice during the bear market of 2000-2003, it also found full relief soon after, even if it eventually resumed its downward march.

In conclusion, it seems that it rarely pays to sell immediately after a sharp two- or three-day move. Waiting for markets to stabilize instead appears to be a better strategy, because prices eventually tend to rebound even if they keep falling later on. This appears to be the case especially after climbing for a while, as can be seen in the charts of 1987, 1989, 1997, 1998, 2000, 2011 and 2015.

Even though we are concerned about the longer-term market outlook due to the stretched credit conditions, we think that investors who want to reduce their exposure to risk assets will not have to wait long before the market reaches a better point if they want to sell.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Using 529 savings for private elementary and high school tuition

By: Oxana Saunders

saving for collegeIn a past blog, we wrote about 529 college savings plans as one of the tax efficient ways to start funding children or grandchildren college tuition. With the recently passed tax bill, parents can now use 529 plan savings to pay for private elementary and high school tuition as well.

While 529 contributions cannot be deducted on the federal tax return and Florida does not have income tax from which contributions can be deducted, all growth is tax-free.

For more details on recent changes to 529 college saving accounts, click on the SavingforCollege.com image below.

saving for college website image

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Oxana Saunders Vice President Path FinancialOxana Saunders is the Vice President of Path Financial, LLC. She may be reached at 941.894.2571 or oxana@pathfinancial.net.

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Huge change in market conditions and what it means for fund fees

newsletter imageFees charged by fund managers have come under attack, and this is especially true for “active” funds that try to beat an index. In recent years, they have struggled to perform better than much-cheaper “passive” funds that simply match their benchmarks, so their higher fees have been harder to justify.

From this, some observers have concluded that active management has proven to be pointless and all investment in the future will be passive – that is, nobody will even try to beat a benchmark anymore. This is a wild exaggeration, to say the least. Active management will have its moment in the sun again, and, as we will see, that moment may be coming soon.

Critics also accuse active managers of barely deviating from their benchmarks anymore. If that is true, they provide little, if any, added value or diversification, and therefore they are charging too much for a job they are not even performing.

There is some validity to the claim that active managers have not been very “active” in recent years. But there is more to this than meets the eye.

We measured the correlation between some popular large-cap mutual funds and the S&P 500, and found credible evidence that after the financial crisis “active” funds indeed became more “passive”, i.e. more correlated with the index. The group we studied, which includes funds large and small, clearly provided much less diversification or additional value over the S&P 500 from 2008 to today.

graph one

But it may be incorrect to conclude that managers have simply become too lazy to do their job. A deeper look at market dynamics suggests that scaling back their efforts to outperform the market was a rational response to a significant change in market conditions.

When we looked at the characteristics of this group over 20 years, we found that regardless of size, the funds least correlated with their benchmarks performed better than the ones that followed their benchmarks more closely. In other words, the ones that were more “active” reaped the largest returns.

But the last 9 years of so show a very different picture: the closer those funds matched the index, the better they performed. Trying to produce returns different from the index was not a successful strategy. What changed?

graph two

The simplest explanation, and the one that much of the financial media has embraced, is that managers have indeed gone lazy or “lost their touch.” In our view, it is quite unlikely that a whole industry of professionals could have somehow become incompetent almost overnight.

The more likely explanation is that a change in market dynamics made it much more difficult for them to beat their benchmarks. If this is so, then we need answers to three questions: what kind of change took place; did managers respond to that change correctly; and is that change temporary or permanent. The answers to these questions yield a much more favorable picture of active managers than the financial media has been willing to paint.

After the financial crisis, individual stock price changes became highly synchronized, making it very hard to identify which stocks would deliver above-average returns without increasing portfolio risk beyond prudent levels. There is plenty of evidence that this is the case.

graph three

Trying to squeeze extra returns from assets that move close together is a losing strategy. Margins are slim, and whatever a manager may be able to extract is likely to be wiped out by trading costs, behavioral biases, and mistakes. In such an environment, the rational response for a professional portfolio manager is to embrace the benchmark. Interpreting this as a sign of laziness or ineptitude is too harsh. In our view, active managers came to a realistic admission that they cannot beat the market through stock-picking when stock correlation goes through the roof.

The opposite is true when correlation drops. When the spread between outperforming and underperforming stocks widens, the reward for choosing the “right” basket of assets is much higher. Leaving aside the much-debated question of whether it is actually possible to identify such basket, the fact is that in low-correlation markets, such basket in principle exists and its potential payoff is much higher.

A high-correlation environment became prevalent after the financial crisis, but it is finally coming to an end. In the last few months, inter-asset correlations have dropped noticeably and, remarkably, the group of funds we studied has itself become less correlated with the index. Active management seems to have been doing its job all along – decoupling with the index when correlations were low and hugging the index when correlations were high.

The decline in inter-asset correlations has important consequences. First, it argues against the premise that in the future all investing is destined to become passive (i.e. merely index-following). As stock picking becomes once again a likely source of excess returns, the attraction of active funds will grow. Second, it bodes well for the market as a whole. Lower correlation is usually accompanied by a drop in volatility, which is a key component in bringing back the retail demand for equities, which has been weak in the wake of the financial crisis. All this supports our view that the mid- to long-term outlook for risky assets such as stocks has significantly improved, and that the bull market is far from over.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk.

You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Contact Path Financial here.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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How Personal Biases, Past Mistakes Can Block Investment Growth

By: Oxana Saunders

today imageOne of the biggest challenges related to managing our money is figuring out how to preserve and grow our capital. These decisions are often influenced by personal biases and past financial mistakes or bad experiences we might have had. They can lead us to avoid investing in financial markets and only focusing on capital preservation by keeping money in savings accounts or CDs. This type of bias also leads to failure to realize the power of compounding interest and what it means for our investments long-terms.

The article from online magazine The Balance, linked below, elaborates on these issues.

If you are struggling to overcome negative biases associated with investing, please call us for a free consultation. We can walk you through investment strategies that may help you overcome simple obstacles that get in the way of your investments.

the balance
Overcoming a Major Retirement Planning Hurdle: Present Bias

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Oxana Saunders Vice President Path FinancialOxana Saunders is the Vice President of Path Financial, LLC. She may be reached at 941.894.2571 or oxana@pathfinancial.net.

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Falling number of shares a key factor behind the market rally

By: Raul Elizalde
today's photoWhen a stock pays a dividend rate higher than the interest at which the company can borrow money, it makes sense for that company to issue debt and buy back its own stock. This is exactly what happened as interest rates fell to historic lows. We believe that the retirement of equities is a key factor in the stock market rally, making them look “expensive” when compared to traditional measures of value, but not when considering their shrinking supply.

We measured changes in the number of outstanding shares of about 350 stocks with an aggregate market capitalization of $17.4 trillion (the total market is currently around $28 trillion). We found that since the beginning of 2011, the number of shares dropped by about 8%. If those shares had not been retired, this group would have a $1.7 trillion larger market capitalization. This extrapolates to a $2.8 trillion shortfall for the total market of US equities due to corporate buybacks.

image 1This estimation is remarkably similar to the $3.0 trillion retired equities calculated by the Federal Reserve. In addition, the Fed tallies the value of shares retired due to mergers and acquisitions, which adds up to another $2.3 trillion, for a total of $5.3 trillion in that period. This was only partially offset by $2.9 trillion of new issues coming to market. On balance, therefore, corporate America retired $2.4 trillion of equities value, which is on par with the GDP of the United Kingdom.

image 2This has vast implications. Stock prices go up disproportionately to the number of shares retired, meaning that a 1% reduction in supply causes a price appreciation much larger than 1%. More precisely, the marginal change in price due to the marginal change in supply is very high. This effect is not easy to isolate and measure, but it is undoubtedly present, and we believe that it is an important factor behind the market rally.

It also helps explain why equities seem expensive against traditional measures of value, such as P/E ratios. A corporation finds value in buying its own stock if it reduces its cost of capital, regardless of what those indicators show. The fact that top management compensation is often linked to the price of their stock may also play a role in a company’s decision to repurchase stock.

As long as this activity continues, the market will continue to seem “expensive”, and it may become more so if the Trump administration’s attempts to reduce the corporate tax rate eventually succeed.

Many US corporations with profitable global operations have not brought back those funds because they are subject to taxation once they come in. According to Moody’s, non-financial US companies hold close to $2 trillion abroad. If a corporate tax cut persuades companies to bring back their overseas profits, the likelihood is that they will be used to repurchase company stock. It is quite doubtful, as proponents of the tax cut argue, that they will be invested in their respective lines of businesses. Given that businesses have easy access to historically cheap credit, money sitting abroad does not seem to be a hindrance to financing any investments that seem promising.

Most recently, both our numbers and the Fed’s numbers show a slight decline in the pace of equity retirement. It could be “noise”, or it could be due to the modest interest rate rise of late last year.

It is reasonable to assume that if interest rates or equity prices go up much further, the economic benefits of retiring shares will end. The danger of higher rates is small, in our view, because it is difficult for the Fed to justify lifting rates much more when inflation has been falling further and further away from its target. As much as the Fed wants to “normalize” monetary policy, hiking rates when inflation is falling is risky.

On the other hand, earnings-per-share have been climbing, both on a trailing and (especially) on a forward basis. Moreover, Europe looks stronger and global GDP projections have improved. These fundamental factors support higher equity prices everywhere, regardless of the impact of corporate demand for equities.

These fundamental factors could make equities seem less expensive in the medium term when compared to traditional measures of revenue and earnings, and could well spur a new wave of demand from retail investors who, because of low interest rates, have few other places to go for returns. The market rally will end one day, but the combination of corporate demand, improving fundamentals, benign outlook for rates and a potential for growing retail demand are pushing that day further into the future.

What now?
We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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