Will the New Money Market Rules Affect You?

The Securities and Exchange Commission (SEC), the government agency that regulates the investment industry, recently announced new rules changing how money market funds operate. Subtle regulatory changes may sounds like esoteric legal minutia, but many investors have some of their wealth in money market funds: in total more than $2.5 trillion is invested in these funds. So will the new rules affect your portfolio? The answer is that the changes are somewhat limited, so (at this point) they probably won’t have much of an effect on individual investors.

Mary Jo White
SEC Chair Mary Jo White

The most headline-grabbing change relates to the constant one dollar per share value that money market funds maintain. This constant value makes them very low-risk investments, but can create problems if the company that manages the fund can’t maintain that one dollar per share guarantee (which happened to a large money market fund during the financial crisis in 2008). The SEC therefore considered eliminating the constant one dollar per share value, forcing the price of the funds to vary based on their underlying investments (just like other mutual funds).

In the end they only applied this change to “institutional” money market funds, which are used by large investors such as pension funds and endowments. Most individual investors generally can’t invest in these institutional funds, although there are a few exceptions (there are sometimes institutional money market funds in 401k plans, for example).

A second change helps money market funds to implement policies to prevent withdrawals from the fund in the event of a crisis. Though this change could affect investors who expect to be able to redeem their investment in a money market fund at any time, it would only apply in extremely rare situations (such as a financial crisis).

The Effects of Innovation

iPad

Is more innovation good for stocks? Given the success of Apple after the release of new products such as the iPhone or surging stock price of electric car manufacturer Tesla Motors, it may seem obvious that new innovations lead to better investment returns. But for the stock market overall, or even an entire sector of the market, that’s not necessarily the case.

The reason is that the gains from innovation for one company often come at the expense of other companies. Apple’s success in selling iPhones and iPads, for example, resulted in lower sales for competitors such as Blackberry, Dell, Hewlett Packard, and Nokia. And innovation can force everyone in a sector to have to spend more on research and development to keep pace, leading to lower profits for other companies even if their sales don’t decline.

Furthermore, the gains from innovation sometimes go to companies that aren’t listed on the stock market (such as smaller startups), so stock market investors don’t benefit. Until its initial public offering in 2012, for example, the increases in Facebook’s value from the growth of its social network only went to private investors such as venture capitalists. But its growth may still have hurt publicly-traded internet companies, such as Google and Yahoo!, which had to compete with Facebook.

That doesn’t mean innovation is “bad”. Innovation is almost certainly good for the people who get to use the new products, and for the economy as a whole. But just like when companies raise prices to increase their profits, what’s good for consumers may not always be good for the stock market.

How Long Can Bond Yields Stay Low?

10Y US Treasury Yield

Despite numerous predictions that bond yields would soar (and therefore bond prices would fall), yields have actually fallen so far in 2014. After rising from record lows last year, the yield on 10-year US treasury bonds is currently around 2.5%, still far below its typical historical range. How long can bond yields stay so low? The answer is “possibly a very long time” based on the experiences of other countries.

The country that has the most experience with low bond yields is Japan. Following its real estate and stock market collapses a quarter century ago, interest rates started declining, with the yield on 10-year Japanese treasury bonds falling below 2% in the late 1990’s. It’s stayed below 2% almost constantly ever since, as weak economic growth and a low (even sometimes negative) inflation rate have given investors little reason to ditch the perceived safety of the country’s government bonds.

10Y Japan Treasury Yield

It’s unlikely that the US will experience such a lengthy period of such low yields. There are a few key factors working in favor of stronger economic growth for the US economy, such as more favorable demographic trends and an inflation rate that has mostly stayed in positive territory. In theory US policymakers should also be able to learn from Japan’s long stagnation to help avoid a similar fate.

Still, there’s no rule of economics that says that interest rates have to revert toward their average historical levels. The lesson from Japan’s experience should be that if economic growth remains weak and the inflation rate remains subdued (and there are plenty of economists who have this outlook), bond yields could remain low for a very long time.

The Key Differences between Mutual Funds and ETFs

With all the jargon commonly used in the financial industry, it can be difficult to parse out the differences between similar investing concepts. Take mutual funds and exchange traded funds (“ETFs”), for example. Both are “funds” (collections of stocks, bonds, and other investments that make it easy to achieve diversified exposure to a segment of the market). So are there differences between them that could affect your portfolio?

There are, although they are small and subtle: all other things being the same, whether a fund is a mutual fund or an ETF generally won’t have a dramatic effect on your portfolio’s performance. But there are a few key differences to pay attention to when deciding which is right for a specific situation.

The main difference between mutual funds and ETFs is that they tend to represent very different investment philosophies and therefore contain different underlying investments. Most mutual funds are actively managed, meaning that the people who manage the fund select which specific investments the fund should hold. Most ETFs, by contrast, are passively managed and simply try to track the performance of an index of stocks or bonds (although many ETFs track customized indices that aim to achieve higher returns than conventional indices and therefore could be considered actively managed). There is plenty of overlap, however: there is a large number of both mutual funds and ETFs that are passively managed and try to track the performance of the S&P 500 index, for example.

In those cases where the aims of the mutual funds and ETFs are similar, the differences are even more subtle. There can be differences in the fees that you pay when buying or selling a fund: typically you have to pay a small commission when trading an ETF (just like when buying or selling individual stocks), whereas there can be a slew of fees associated with mutual funds (such as “front-end load fees”, “back-end load fees”, or “redemption fees”). These fees can vary dramatically depending on the fund and the situation: some brokerage companies offer free trades for specific ETFs, and many mutual funds have none of these extra fees.

Lastly, there can be differences in taxes. Whenever a mutual fund sells one of its underlying investments for a profit, it is considered a capital gain for the fund’s investors and can be taxed. Investors may therefore need to pay some capital gains taxes throughout the time that they hold the mutual fund in their portfolios. With ETFs, by contrast, investors usually don’t need to pay any capital gains taxes until they actually sell the ETF. ETFs are therefore generally considered to be more “tax efficient” than mutual funds, although this difference wouldn’t have any effect in tax-exempt accounts such as IRAs.

Are Stock Valuations Too High?

US stocks have continued to climb this year even after surging by more than 30% in 2013. Earlier this year we argued that US stocks appeared to be slightly overvalued, but other analysts argue that stocks are fairly valued. Which analysis is correct?

To answer that question it’s important to remember the basics of how valuations apply for long-term investors. When valuations for a specific asset class are above their long-term average, we can expect the future medium-term returns for that asset class to be below their average. The opposite is true when valuations are below their long-term average.

In their latest quarterly outlook, analysts at JP Morgan have presented the following charts seeming to show that US stocks are fairly valued:

Stock Valuation Charts

The problem with this analysis is that their “long-term average” is based on 25 years of data, a brief interval in the long history of financial markets. The average value for the Shiller P-E ratio, for example, has been 25.1 over the past 25 years, only slightly below the current value. But its true long-term average (using data since the 1880’s) has been only 16.5, suggesting that current valuations are higher than normal.

Of course, valuations don’t tend to have much of an impact in the short-term (technology stocks continued climbing in the late 1990’s long after valuations reached extreme levels, for example). And US stocks today appear to be only slightly overvalued, unlike the extreme overvaluation of, say, technology stocks in the late 1990’s or Japanese stocks in the late 1980’s). So while valuations suggest that the future returns for US stocks may be slightly lower than they otherwise would be, they don’t preclude the possibility of the current bull market continuing for a while.

Are More Share Buybacks a Good Sign?

Share buybacks—companies using cash to buy stock in their own company—are becoming a more common way for American corporations to spend their money. In the first quarter of 2014 share buybacks from the largest US companies increased by 50% relative to the first quarter of last year, according to analysts at FactSet. Is such an increase a good sign or a bad sign for investors? The answer (perhaps unsurprisingly) is “it depends”.

First the positive aspects of share buybacks. They indicate that companies are confident about their future prospects, since otherwise they presumably wouldn’t be spending money to buy their own stock. They also are a way, like paying dividends, of returning cash to shareholders (when a company buys back its stock it reduces the total number of shares outstanding, increasing the remaining investors’ stakes in the company). Returning cash to shareholders is therefore a bullish sign for those who believe that companies would otherwise squander their excess cash by failing to invest it profitably. And share buybacks are more tax-friendly than dividends, since they don’t count as income for investors.

For each of these positives aspects, though, there is a negative side. Making substantial share buybacks may indicate a short-term focus on boosting earnings per share rather than trying to grow a business over the longer term. It can also increase vulnerability to an economic downturn: many companies that had repurchased shares in the mid-2000’s found themselves without enough spare cash when the financial crisis struck in 2008. And studies have shown that companies tend to destroy value for their investors by repurchasing shares when stock prices are high.

The bottom line: each company’s decision may be good or bad depending on why it’s doing the buyback and how good it is at predicting the future. Share buybacks can’t be universally categorized as “good” or “bad” for investors.

Q2 Recap: Stocks and Bonds Both Rise as Low Volatility Reigns

There were plenty of potential triggers that could have sent financial markets into a panic in the second quarter of the year: it was revealed that the economy contracted in the first quarter at an annualized rate of almost 3%, the Federal Reserve continued to scale back its monetary stimulus, and oil prices rose as Iraq was overrun by insurgents. But financial markets shrugged off these developments, and the quarter was characterized by low volatility (few large ups and downs in the markets).

Both stocks and bonds did well, with emerging markets in particular rebounding strongly after lagging last year and in the first quarter of this year. Cash, with its return of essentially 0% in the current low interest rate environment, was the worst-performing asset class.

Q22014 Asset Classes

Every sector of the stock market made gains in the second quarter. Energy stocks led the way, partly driven by increases in the price of energy commodities such as oil. For many sectors 2014 has so far been a reversal of the trends of the previous year. For the second straight quarter, utilities (the worst-performing sector in 2013) were near the top while consumer discretionary (the best-performing sector in 2013) was near the bottom.

Q22014 Stock Sectors

The top-performing countries in the second quarter were a potpourri of emerging markets, largely as a result of political developments. Turkish stock leapt following local elections at the end of March, although they lost some ground toward the end of the quarter as conditions in neighboring Iraq deteriorated. Indian stocks surged as Narendra Modi was elected in the country’s May elections.

The worst-performing countries in the second quarter were Greece and Ireland, countries on the European periphery that had been central figures in the continent’s sovereign debt struggles. Not all such countries did poorly, however: Spanish stocks returned more than 6%.

Q22014 Countries

The outlook going forward depends on a few factors. Most economists expect the US economy to rebound strongly in the rest of the year after its negative growth rate in the first quarter (which has generally been blamed on rough winter weather), but any continued economic slowdown could cause stocks to give up their recent gains.

A second factor is inflation, which has ticked up recently. A continued rise in the inflation rate could lead to losses for bonds, which have benefited from an inflation rate below the Federal Reserve’s 2% target in recent years.

Lastly, the outlook for China continues to be a major influence on the global economy. So far the Chinese government has been able to manage a slowdown in the country’s growth rate without triggering a broader economic collapse, and the second quarter saw some encouraging data about the state of the Chinese economy. Continued success in avoiding a broad financial crisis would support stocks globally and in particular could boost Chinese stocks, which gained almost 5% in the second quarter.