Huge ripple effect if U.S. consumers stop spending

David Berman, Financial Post

Cash registers didn’t ring very loudly in April. Some U.S. retailers are blaming the relative silence on the unseasonably cool weather that month, which postponed the sale of new outfits. Others are blaming it on the Easter Bunny, who arrived early this year and kicked a lot of pre-Easter sales activity into March.

Here’s a better explanation, which is currently weighing on investors around the world: The U.S. consumer is in big trouble, thanks to higher borrowing costs, spiking gasoline prices and the fact that the deteriorating housing market has robbed them of an important source of income.

Either way, U.S. retailers had set themselves a very low bar last month and managed to plough right into it. According to Thomson Financial, sales at stores open for at least one year were expected to be 0.4% higher in April over the same month last year.

Instead, so-called same store sales for the month fell 1.8%. That’s way below the 3% gain that reflects a healthy consumer and a rare reversal from the usual spend-more attitude that has been propelling the U.S. economy for years. In fact, Thomson Financial said it is the worst reversal on record.

Specifically, U.S. same store sales at Wal-Mart Stores Inc., the world’s largest retailer, fell 3.5% in April. That is the worst showing since the company began reporting the numbers 28 years ago. Over at The Gap Inc., same store sales plummeted 16%.

Bullish investors will call the setbacks an aberration, especially given that sales at U.S. retailers actually picked up at the end of the month over a disastrous start. But bulls and bears alike are now training their eyes on that nation’s check-out lines (”Is that guy buying just one pair of socks?”). May is about to become the most carefully watched month for retail sales in, arguably, decades.

“May is going to give us the conclusion as to what is really going on,” said Jharonne Martis, an analyst at Thomson Financial.

Presumably, some nervous investors can’t wait that long. Yesterday, the Dow Jones industrial average fell 147.74 points, or 1.1%, for its biggest one-day drop in two months. The S&P 500 fell a steeper 1.4%. The decline was by no means confined to retailers — 93% of the broader index’s stocks fell — which illustrates the unique ability of consumer spending to infect other areas of the economy that feed off healthy consumers.

In Canada, the S&P/TSX composite index held up reasonably well, falling just 42.03 points or 0.3% yesterday. Retail sales have been far more healthy. This week, Rona Inc. reported same store sales for the first quarter fell a modest 0.1%. Its rival, Canadian Tire Corp., saw same store sales rise 6.6% in the same quarter, a likely product of a robust housing market here.

But if U.S. consumers are indeed wounded, Canadian exports will get walloped, which could affect everything from Canadian banks to oil and gas producers. In fact, there will be few places in the world to hide. Consumers, the world is watching you.

By J. ALEX TARQUINIO

AS stock indexes flirt with previous highs — or forge ahead of them — many investors have no urgent need for celebration.

The Dow Jones industrial average is well above its year 2000 peak and the Standard & Poor’s 500-stock index is close, although it has not quite clawed back yet. But if you measure the broad stock market against its perch in 2000, the last seven years have been a washout. Taking that long to break even in nominal terms — a bit faster, if you count dividend reinvestment — is hardly impressive.

Bonds, as well as asset classes like real estate and commodities, have done much better over that stretch — to the delight of investors who have held them. What lessons can investors take away from the experience of the last seven years? Many strategists say that the discrepancies among asset classes provide a classic example of the need for diversification and rebalancing in an investment portfolio.

“Rebalancing your portfolio takes a lot of emotion out of investing,” said John C. Bogle, 78, the longtime advocate of dispassionate index-fund investing who founded the Vanguard Group and is now president of the Bogle Financial Markets Research Center.
The value of diversification and rebalancing is clear enough when you crunch the numbers, as Mr. Bogle’s research center did for Sunday Business. Mr. Bogle used data drawn from the performance of Vanguard index funds that are meant to mirror broad sections of the stock and bond markets.

An investor who held only the Vanguard 500 Index fund, which tracks the S.& P. 500, since the market peak in March 2000 would have had big losses in 2000 and 2001 and wouldn’t have broken even until October 2006, ahead of the S.& P. 500. That’s because the fund reinvests dividends.

The picture was much brighter in a diversified portfolio of index funds. A portfolio with 20 percent invested in bonds, and the remaining 80 percent divided among the S.& P. 500, small-cap stocks and international stocks would have broken even in November 2004. (The stock portion of the portfolio would have been divided this way: 60 percent in the S.& P. 500 index fund, 20 percent in a fund tracking small caps and 20 percent in international stocks.)

Thanks to the outstanding performance of bonds over the last seven years, a portfolio split 50-50 between bonds and stocks — with the same mix of large-cap, small-cap and foreign stocks — would have broken even more than a year earlier, in May 2003. Portfolios like this one, with a big dollop of bonds, are generally recommended for more conservative investors.
This analysis assumes that for all of these portfolios, investors kept their money in the funds through the hair-raising markets of 2001 and 2002 and rebalanced the portfolios annually, returning them to their original allocation. But such disciplined rebalancing can be a tough sell, said Hersh M. Shefrin, a professor of behavioral finance at Santa Clara University in California. “We are pleasure-seeking beings who want to avoid pain,” Professor Shefrin said.

Rebalancing, he said, would have forced investors to do exactly the opposite — by making them either prune assets that had done extremely well, or to load up on assets that had disappointed them.

Rebalancing can have a modest, stabilizing effect on performance. The Vanguard portfolio that was 80 percent invested in stocks at the end of March 2000 would have had average annual returns of 4.3 percent with yearly rebalancing but just 3.97 percent without rebalancing. The portfolio that was divided 50-50 among stocks and bonds would have had average annual returns of 5.35 percent a year with rebalancing, and 4.74 percent without.

Many investors might look at those modest average annual returns — and the relatively small differences between them — and wonder what all the fuss is about. Indeed, under other market conditions, the portfolios that were not rebalanced might come out ahead. The main reason for rebalancing is not necessarily to enhance long-term performance, experts say, but to make sure that a portfolio stays diversified over the years, better cushioning it from jolts in one asset class or another.

“It’s kind of like being your own chiropractor, and giving yourself small, regular adjustments to keep from getting out of alignment,” Mr. Shefrin said.
For example, if an investor owned a portfolio with 80 percent stocks in 1995 — and did not touch it during the expansion of the Internet bubble — it would have held close to 90 percent stocks by March 2000. That could have set up the investor for returns much more like those of the pure S.& P. 500 investor, who had to wait more than six years to break even.

Most strategists agree that occasional rebalancing is important, but there is a wide range of opinion about how often it should be done — with advice ranging from every six months to two years. Some strategists say that rebalancing can be overdone — for example, by rebalancing quarterly or whenever the portfolio varies by just five percentage points from a target allocation. That can be expensive, especially when a portfolio contains individual stocks and bonds.

“Even with low volatility, a 5 percent move can happen relatively quickly, and you can chew up your returns with transaction costs and taxes,” said David M. Darst, the chief investment strategist at the Global Wealth Management Group of Morgan Stanley.
Even if taxes are not a consideration, because the assets are held in a tax-deferred account, Mr. Darst said investors who trim their winners too quickly might miss out on the bulk of a rally.

He recommends that investors check their asset allocations once or twice a year — and then make adjustments only if their portfolios are at least 10 percentage points from their target allocation. For example, a 50-year-old investor who wants to hold 40 percent of his portfolio in bonds might rebalance if bonds have either fallen to 30 percent or risen to 50 percent of his total portfolio.

MR. DARST said that younger investors, or those who are more comfortable with risk, might want to stay with their winners longer. In that case, he said, they should still rebalance their portfolios if they varied by as much as 15 or 20 percentage points from their goals.

Sam Stovall, the chief investment strategist at S.& P., said that investors who were still in the middle of their professional lives did not necessarily need to trim the stars in their portfolios in order to stay within their target allocations. Instead, they can do a little buying. For his own investments, Mr. Stovall says, he uses new money to buy assets that have fallen out of favor.

“It is more of a filling-in strategy, than a lopping-off strategy,” he said.