Adjust Expectations: Planning for “better than” and “worse than” investment scenarios

Over the past several years, investors have been introduced to a host of phrases and acronyms that arose out of the ashes of the financial crisis and the “Great Recession.” Terms such as “TARP” (the “Troubled Asset Relief Program”) originated from the actions of Congress following the collapse of Lehman Brothers in 2008.

“PIIGS” entered the vocabulary in 2009, referencing the group of European nations – Portugal, Italy, Ireland, Greece and Spain – succumbing to severe levels of debt, coupled with unsustainable spending and declining revenues. (Greece was the first of those countries to attempt austerity programs in hope of curtailing government spending in the face of insurmountable debt burdens, and Spain is succumbing currently. Recently, the Dutch government fragmented as its parties attempted to implement budget cuts to comply with the European Union’s fiscal targets.)

Another phrase, “the New Normal,” entered the scene several years ago, as investors faced the need to revise their expectations of normalcy – one reflective of slower growth, lower returns and decreased expectations – amid global financial challenges.

Challenges Ahead

If you attended our Outlook events this year, you heard us discuss the challenges of building investment strategies capable of delivering on expectations, when returns are expected to be “bimodal” in nature rather than neatly organized within a normal distribution pattern.

Think of “bimodal” as a series of observations with two peaks: one at the left side of the chart, and one at the right side. Each peak represents the probability of an event occurring, with the left peak showing the probability of materially lower-than-normal returns and the right peak showing the probability of materially higher-than-normal returns. What doesn’t exist in a bimodal environment is the center of the graph, the “normal” peak, which would show what we would expect to be “normal” returns: 8% long term returns on stocks, for example.

Market Engagement

For decades, investors have based their expectations and built their strategies around this normal peak. Today, however, this area of normalcy is gone because of the unprecedented and massive involvement of central banks to support faltering countries and to stimulate economic growth. Investment strategies must be reevaluated and refined to consider the two peaks – the “better than” and “worse than” scenarios – and the bimodal nature of future returns.

Around the globe, it’s easy to see the effects of this development. Consider that the U.S.-based S&P 500 index is experiencing record quarterly profits, with 79% of the companies beating their earnings estimates – yet Spain is experiencing unemployment of near 25%. Concern is building over the slowing economic growth in China, pressuring commodities and global equity valuation expectations – while at the same time, the U.S. had nine consecutive quarters of positive economic growth. While the world postures for yet another Middle East war over Iran’s nuclear ambitions, the U.S. NASDAQ stock market has rallied 34% over the last seven months.

See what we mean about the dual nature of potential returns? Another example here at home: Investors are now growing concerned with the approaching “fiscal cliff” of January 2013, when a massive, legislated $500 billion fiscal tightening program will begin. At the same time, more market strategists are expecting still stronger returns through the remainder of 2012. How can that be? Are over-hyped negative issues drowning out real data that would indicate a growing economy, improving employment conditions and rising earnings?

Our world is experiencing a huge struggle over fiscal discipline, debt sustainability, deficit spending and an increasing entitlement mentality. When Spain recently tried to implement government spending cuts to bring its annual deficit to less than 4% of gross domestic product (GDP), riots ensued. Here in the U.S., we are expecting our annual federal deficit to approach 9% of GDP, with our total debt-to-GDP ratio exceeding 100% for the first time in modern history. In this environment, the challenge of building investment portfolios that have a high probability of meeting our client’s investment goals has never been more difficult. We must invest bimodally as well – positioning portfolios to capture upside movements in the market (and exceeding expectations), while protecting the value of the portfolio when the downside risk could be substantial.

Trust Us

Bell State Bank & Trust’s Investment Committee has more than 150 years’ combined experience in managing client investments. With the most experienced and credentialed team in the region, we provide our clients world-class investment strategies, focused on the management of risk and the attainment of their financial goals. We are proud to have been entrusted with more than $3 billion in assets under management. Thank you for your business and for your trust in our team.

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