Wow, what a difference a year makes. What happened to the TSP I fund? As we will see, part of what happened was really what is not happening to the international fund.
Note: I have never recommended the TSP I fund or Lifecycle funds for a number of reasons as discussed in Best TSP Allocation and Strategy. Some of those reasons are evidenced in 2018 as you will see in the first chart.
First let’s discuss the TSP S fund
The TSP small cap fund lost ground to the large companies in the TSP C fund in 2017, then in 2018 it outperformed. But if we look back about 2 years we see these two funds basically tied in performance. The flip in performance from 2017 to 2018 matches the change in direction of the dollar to world currencies.
Divergence
In 2017 a declining dollar benefited the 38% of SP500 revenue which is generated overseas, then in 2018 the rising dollar hurt the translation of overseas SP500 profits into US dollars. The small cap fund is considered less exposed and became a safe haven in the US from a rising dollar as well as benefiting from the bounce back in energy prices.
Divergence Returns to the I fund
The same dollar effect of course happened with the International fund but to a larger degree. But this does not explain all of the divergence. The lack of significant tech exposure in the international fund explains a big part of the I fund’s weakness over the long run and nothing changed in 2018 to improve this situation.
Shifting sentiment also added to the divergence. In 2017 Europe’s economy finally looked like if might lift off, but 2018 has seen expectations come down. Since the elections, US sentiment skyrocketed and stalled in mid-2017.
The passing of the tax cuts for large corporations gave US asset owning class a sentiment surge in late 2017 and also hit the tape for 2018 earnings reports (a one-time bump). In 2018 the US is hitting peak expectations.
But wait there’s more…
I’ve talked about corporate buybacks and price-insensitive central bank buying of financial assets for some time. I think we are hitting a peak in this area also in 2018 since central banks are pulling back (but still positive) and corporate buybacks will not have cash repatriations in 2019 to match 2018.
But it is more involved than a simple question of are they buying or not.
Here is a new concept…
…bear with me. I’ll start with an extreme example to help keep your eyes from glazing over.
I wrote about this and Stock Market Melt-Ups back on 4 January. The main takeaway was that JP Morgan found “that a mere $6 billion in net inflows… resulted in a market cap [increase] of $330 billion” for a particular security seen below.
Think about that awhile… how can $6 billion in buying increase the total value of all outstanding stock to $330 billion. That means for every $1 of new money invested in buying, this security’s market cap went up $55! Huh?
The answer is marginal supply & demand with the focus on the word “marginal”.
Stay with me… if the current holders of the bubble seen in the next chart would not sell but demand grew then the price had to surge to bring out sellers. The surging price brought in more demand – a bubble dynamic.
marginal supply and demand at work
Another marginal story
Now think housing: 95% of households do not buy or sell a house every year. So it is the selling 5% that set prices for those online Zillow appraisals of your house. If supply is constrained by lack of building or people holding on to their properties just because the value is going up faster than the interest they are paying, a bubble dynamic takes hold.
Supply and demand makes sense for setting the price of apples and oranges. But houses and to an increasing extent the stock market, it is those marginal buyers and sellers that set prices. Hence “marginal supply & demand” matters.
Back to the TSP funds
Okay, unglaze your eyes because we are back to your investments. What is happening to the marginal supply & demand of US stock and bond funds? Marginal madness…
Take away the unsustainable corporate buybacks in blue and what do you have? Selling.
Now consider the markets in general…
Supply-side:
- Increasing passive investments which usually means buy & hold so no supply here
- Corporations are reducing supply of stocks through buybacks
- Central banks significantly reduced the supply or global bonds and even stocks to the tune of 12 trillion dollars since the financial crisis
Demand-side:
- Corporations are responsible for the largest inflow of funds into stocks. This demand only holds true while they are in buyback mode, meaning it is unsustainable.
- Institutional investors are net sellers, so when #1 ends look out below.
- And those who bought simply because the market was going up, will simply sell when the market goes down.
There is more, but the point is the marginal supply & demand dynamic is squeezing our stock market higher and higher in valuations relative to revenue growth. International funds do not have the corporate buyback binge going on which is a large part of the divergence in performance. Although Japan does have an out-of-control central bank.
The Bank of Japan has taken control of supply and demand in gov’t bonds which is why Japan’s gov’t bond market is dead – no longer a free market. The Bank of Japan is also a buyer of Japan’s stocks and is now the largest share-holder in Japan. If this stops, global demand takes a hit because this also means the Japanese are increasing their buying of international stocks as they sell to the BOJ. Same with the bond market in Europe.
You are living with the most expensive global stock and bond market of all-time. Until some of the above marginal supply & demand factors reverse the markets can be squeezed higher. Then at some point the opposite dynamic will occur on the way down. It happened to our example. Yes, a more extreme case. But it can happen to the stock market (your funds) too.
Remember non-existent profit and economic growth did not prevent the market from surging higher, so don’t count on profits or slightly higher economic growth to prevent a bear market when marginal demand for stocks dries up and reverses to become supply.
The dynamic I am talking about is new and unique to the US stock market. Corporate buybacks exploded after 2000. Central bank buying exploded after the financial crisis. Global debt has also exploded and someone is going to suffer the consequences. Wall Street banks have made sure it is not them this time.
Awareness matters. There is much more of course so you might want to review the Best TSP Allocation and Strategy on other considerations among the TSP funds…
…and definitely TSP Charts: About Those Valuations.
Invest safe, invest smart
Michael Bond
TSP and Vanguard Smart Investor
Categories: Perspectives