I gave a talk here at Commonwealth yesterday, updating our staff about the economy and the markets. One point kept coming up over and over—that we’re now at or close to normal levels of growth, as of the mid-2000s, which was a pretty good time. In some areas, such as employment, we still haven’t returned to normal levels in total, but getting normal growth is the first step.

(As an aside, this type of internal training and education is part of what makes Commonwealth exceptional. Everyone is welcome, and these talks happen all the time on many different subjects.)

A couple of bad days recently have rattled many investors. After the strong run-up in the stock market to the end of last year and the continued strong economic reports, many expected the market would continue to perform strongly. Instead, we have had stability for most of the month, with small declines followed by recoveries—until the past week, when we’ve seen one of the worst sell-offs in the past couple of years. What gives?

The key phrase there is “the past couple of years.” So far, we have seen, at worst, about a 4-percent decline, and as of this morning, the market has ticked back up. Is this something we should be worried about?

In the past couple of weeks, there have been several indications of a slowdown in the U.S. recovery, and international markets have shown weakness. Over the past week, we’ve seen that translate to drops in U.S. interest rates and declines in the stock market. Since we ended last year, thinking there was nothing but blue skies ahead, clouds have rolled in. Should we be worried? And if so, about what?

Let’s start by looking at the U.S. economy. The first cloud was the shockingly weak jobs number three weeks ago: only 74,000 jobs were reported as created, against an expectation of around 200,000. I analyzed that figure and concluded, based on other data, that it was a false signal, due primarily to severe weather. Nonetheless, I saw it as something that should signal caution.

— Guest post from Peter Essele, senior investment research analyst

There’s been quite a bit of speculation lately regarding the long-term direction of interest rates, particularly around movements on the short end. We’ve heard numerous specialists’ thoughts on the subject, and most believe the Fed won’t hike rates on the short end until late 2015, at the earliest. Although they make for good sound bites on CNBC, there really doesn’t seem to be much basis for many of these prognostications, so we decided to put pen to paper to assess the direction of rates.

Today, I want to tie together my posts over the past week. If you remember, we talked about the mismatch between current return expectations and what history suggests as likely, and what investors could do about it. I talked about truly diversified asset allocation and regular rebalancing as a required base strategy, along with possibly using some other risk-reduction technique, like market timing, to guard against large drawdowns. This discussion was interrupted, in a very timely way, by a response to turbulence in emerging markets and a relatively large (in recent terms) market decline in the U.S. on Friday.

One of the themes of the past few posts (and of my market commentary in general over the last several months) has been the need for caution and a willingness to recognize—and plan for—risk factors.

One way to plan for them is to decide, ahead of time, what conditions would make you change your asset allocations—in this case, to dial back on risk—and then what conditions would make you reverse that again.

In the last several posts, we’ve talked about two problems. The first is that drawdowns—which is to say, losses—is a better risk measure for most investors, and something to be avoided. Portfolios should therefore be designed to avoid drawdowns as much as possible. The second problem is that market valuations are very high right now, which both raises the risk of drawdowns (back to point 1) and also makes it very likely that future returns will be below what most people expect.

Stepping back a bit, what both of these points address is the problem of terminal failure—that is, of simply not achieving your investment goals at the end of whatever your target time period is. Drawdowns can make an investor unwilling to take enough risk to reach his or her goal, while returns below expectations may also mean the goal isn’t met, even if the investor is willing to bear the risk. This is the real problem we face as investors and advisors: taking enough risk to meet our goals, but making sure that our expectations will be met in return for taking that risk.

If you look at the future returns, by valuation level, in the chart in yesterday’s post, you see that the higher the initial price, the lower the future returns. This makes sense both theoretically and empirically, but it creates a problem for investors right now, in that their expectations are totally out of line with what has happened in the past. While investors often expect miracles, many investors today are essentially relying on one—and have no idea that is the case.

The problem isn’t limited to stocks, either. For bonds, assuming interest rates remain the same, returns are the coupon payments—and then you get your money back. Your real return is coupon less inflation, which means on a par, on a real basis, with what stocks are likely to return on average. If rates rise, on the other hand, you could face capital losses, which would further erode returns. The only scenario in which bonds might make up for lower stock returns is if interest rates decline—and that’s very unlikely to happen on a consistent basis over the next decade. Anyone looking for higher returns won’t do it in bonds.

I closed last week with a discussion of how, for individuals, the focus should be on actually achieving their goals, and how risk measures (and the portfolio design process) should be oriented to managing the risks that really matter—in my opinion, drawdowns.

Closely related to this is the issue of expectations. Just as variance of returns isn’t the best measure of risk for individuals, longer-run measures of return are also misleading in this context. Many of the guides put out for investors talk about long-run returns, focusing on the need to stay the course. Just as with rationality and variance, this is a pretty good approximation for institutional investors, who have that kind of long time frame and whose liquidity needs aren’t typically onerous. For individual investors, though, whose time frames are measured in a handful of decades at most (and who will actually need to spend the money at some defined point), this is misleading and damaging. As we have seen, there can be multi-decade periods where, in fact, returns do not match previous expectations—and if the money isn’t there when needed, the investment process has failed.

The Yogi Berra post I did a couple of days ago drew a distinction between steady single investments and home-run investments. Baseball is a popular metaphor for a number of things, but, given the intersection of statistics and uncertainty, it’s particularly relevant for investing. Michael Lewis, for example, is noted for writing about both Wall Street (Liar’s Poker) and baseball (Moneyball). Nate Silver, the former New York Times political statistician, has made ventures into both finance and baseball.

A key to success in each of these areas is to determine which numbers actually matter. This is one of the issues at the core of Moneyball. I would argue that we have the same problem in investing, particularly for individual investors. We’re simply looking at the wrong things.

I want to continue on the path I started with yesterday’s rerun post, but a couple of things came across my desk today that, together, warrant discussion. They’re examples of the kind of slow, steady progress in the economic recovery that, over time, is adding up to big things.

Let’s start with Washington, DC. The federal government—and particularly Congress—has been part of the problem for so long we kind of expect it to be a drag. The recent unexpected budget agreement (for two years even) was a positive sign, but it left open the possibility that legislators wouldn’t be able to agree on actual spending numbers. The passage of a spending bill yesterday by the House on a vote of 359–67, with 167 Republicans voting in favor, says that both parties are now focused on solutions rather than creating train wrecks as a negotiating tool. In particular, it shows that the Tea Party caucus no longer has the power to force the rest of the Republican party to vote against a deal. You can argue over the economics or the politics, but the uncertainty created by the prior theatrics was undeniably harmful, and the fact that they’ve come to an end (at least for now) is a good thing. This is also a good signal for the pending debt ceiling negotiations early next month.

I originally wrote this article for InvestmentNews back in 2008—forever ago, in the financial world. I want to revisit it now for a couple of reasons (and also because I’m kind of proud of it). First, I think it’s held up pretty well and is still applicable, despite all the changes since then. Second, it sets the stage for an extended conversation that’s becoming increasingly important for investors and advisors.

That conversation revolves around expectations—i.e., what are you trying to accomplish with the portfolio?—and risk. We have the standard questionnaires and measures of risk and return, but, based on my frequent conversations with advisors, I’m not sure those tools really capture the dynamics of what’s going on. We need to do better.

I’ve spoken with several reporters yesterday and today, all of whom are asking, “What is happening in the stock market?” In some respects, it is a little unreal—not that long ago, a market decline of about 1.25 percent was considered normal volatility. But given how the market has climbed almost continuously for the past several months, a decline like this has people asking questions.

Perhaps they should be. The market pause since the end of last year could be suggesting a couple of things investors ought to be aware of. If you look at performance at the end of 2013, you see a consistent run-up from October to early December, a pause while everyone worried about the Fed and the taper, and then a last burst of energy. Since then, it’s been bouncing around, but with a downward trend, exemplified by yesterday’s performance.

A couple of weeks ago, we had a fairly spirited debate in an Asset Management department meeting over the economic consequences of raising the minimum wage. Just for fun, and because I like to argue, I strongly took the pro side, contending that the positive consequences would outweigh the negative. This is not a particularly common (or popular) stance in the economics and investing community, but it turns out that you can make a good case for it.

Listen to Brad’s interview on MarketWatch, where he discusses the stock market’s behavior in the first weeks of 2014.

After all the optimism embodied in the Fed’s recent minutes, at least as I read them, the employment report this morning was a shocker. Instead of the expected 200,000 or so gain in jobs, the figure came in at 74,000, well below the lowest estimate. What the heck happened?

Reading through the December meeting minutes of the Federal Open Market Committee (the group that decided to start reducing the Federal Reserve’s monthly purchases of Treasury and mortgage bonds), I was very surprised. Considering the Fed has, historically, gone out of its way to be obscure, the minutes’ clarity was unusual. In the words of former chair Alan Greenspan, “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant.”

The Fed under Chairman Bernanke has made an effort to be more straightforward, but it still tends to focus on “one hand, other hand” discussions. Harry Truman’s search for a one-armed economist goes on.

I’ve been writing for some time about how the economy is recovering. When I write or speak about this, though, I make a point of noting that I’m talking about aggregate numbers, and that a lot of people out there are still hurting. This is and will always be the case for any economic downturn, but as we move into the recovery, it’s worthwhile to think about it in more detail, looking at the data to see if there are any patterns we can learn from. To the extent that the employment market is not efficient, everyone suffers.

The first step is to identify the groups that have been hit the hardest, and who have been the slowest to recover.

http://www.youtube.com/watch?v=_mx57subjTU

Every year, I struggle with the notion of preparing an outlook—I won’t use the term forecast—for the following year. Every year, I point out, to no avail, that it would be much better to do a forecast for the previous year: better data, much more context, and certainly greater accuracy. I’ve had no more success this year than usual, so I’m preparing my outlook as you read this.

The reason I call it an outlook, rather than a forecast, is that forecast implies a level of certainty that, even in principle, simply isn’t achievable. I used the simile the other day that the Fed’s job is like trying to repair a Seiko watch based on a Timex manual, using a sledgehammer operated by a robot controlled from the next room, in the dark, and I stand by it.

As the new year begins, there’s definitely a change in the atmosphere. Not the 18 inches of snow that my snowblower very efficiently directed right into my face. Not the arctic air of the past couple of days, or even the 50-degree rainstorm of today. (If you live in New England and want the weather to change, wait 10 minutes.)

The change I’m referring to is a definite aura of hope for the economy. Carmen Reinhart and Ken Rogoff—the economists who wrote This Time Is Different, about how financial crises are never different—have come out with a study that suggests the U.S. economic recovery is actually doing pretty well, compared with the experiences of other countries emerging from similar crises.

In the past couple of days, I’ve mentioned that things are improving in the world economy, but we still face risks. One of the best ways to get a handle on these risks is to understand where we came from, what has changed, and what has not.

As part of that, I have been reading or rereading books about the crisis, with a particular focus on those that look at bigger-picture issues rather than the play-by-play. One of the easiest to read in this category, and in many respects the most entertaining, is Boomerang: Travels in the New Third World by Michael Lewis.

Much of the talk recently about economics has focused on how 2014 will be better than 2013. My last post was on exactly that, and I stand by it. When I woke up this morning, however, there were two significant changes that could mitigate some of that positive momentum.