High Optimism

June 18, 2017

Last week I looked at two simple rules: 1) don’t bet on which chicken will lay the most eggs, and 2) don’t put all your eggs in one basket. This week I will look at index averages and I promise I won’t mention chickens.  Lastly, I will look at a metric that disturbs me.

When I first started investing in Vanguard’s SP500 index mutual fund VFINX, I thought I was buying the average performance of the top 500 companies in America. Like many index funds, VFINX is weighted by market capitalization. With this methodology, a relatively small number of companies have more influence on the movement in the index than their numbers might warrant.

Let’s turn to Vanguard’s breakdown of the top ten stocks in their VFINX fund. These ten stocks are household names, including Apple, Microsoft, Google (Alphabet), Amazon, and Facebook. These five tech stocks are 1% of the 500 companies in the index but make up 13% of the fund. The ten companies make up 20% of the fund.

For investors who want to cast a wider net, there is an alternative: equal weighted funds. Guggenheim’s RSP is an equal weighted ETF first offered in 2003. Using Portfolio Visualizer, I started off in 2004 with $100,000 and invested $500 a month. Despite the higher expense ratio, RSP had a better return, besting a conventional market cap index by 1% annually.

VFINXVsRSP

Why does RSP outperform VFINX?  Funds that mimic the SP500 are heavily weighted to large cap stocks. Equal weight funds have a greater percentage of mid-cap companies which may outperform large caps in a particular decade but that outperformance may come at a price: volatility.

Standard deviation is a statistical measure of the zig and zag of a data series, like measuring how much a drunk veers as he stumbles along his chosen path. The standard deviation (Stdev column above) of RSP is slightly higher than VFINX, and the maximum drawdown of RSP is almost 5% higher during the 2008-2009 financial crisis.  The Sharpe ratio is a measure of risk adjusted return, and the higher the better. As we can see in the Sharpe column, the two strategies are within a few decimal points.  In the past 13 years, an equal weighted strategy produced higher returns with only a slightly higher risk.

If I want to mimic some of the diversity of an equal weight index, I can spread out my investment dollars among large-cap, mid-cap and small-cap funds. As SP500 index products, neither RSP or VFINX includes small cap stocks, but let’s add a small percentage into our mix.

Into my comparison of strategies, I’ve added a portfolio with a 40% allocation to VFINX, 40% to VIMSX, a mid-cap Vanguard index fund, and 20% to VISVX, a Vanguard-small cap value index fund. The performance is almost as good as the equal weight RSP and the Sharpe ratio, or risk adjusted return, is similar.

VFINXVsRSPVsMix

In 2011, Vanguard published an analysis (PDF) of various approaches to indexing that may be of interest to those who want to dive into the topic.

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Household Net Worth

Let’s turn from indexing strategies to stock market valuation. We base our expectations of the future on the recent past. Those expectations are the primary driver of valuation. If we expected an affordable self-driving car in the next few years, the current value of today’s cars would be lower.

I have written before about a store of value compared to a flow of value. Savings are a store of value. Income is a flow. The historical ratio of wealth (store) to income (flow) reveals a trend that should give us caution.  The Federal Reserve charts estimates of  both household wealth and disposable income. The current ratio of wealth to income is now higher than the peaks in 2006 and 2000 when the real estate and dot-com booms inflated wealth valuations.

HouseholdNetWorthPctIncome

The current ratio is far above the 70 year average but a moving ten year average of the ratio may better reflect trends in investment allocation over the past few decades. Using this metric, today’s ratio is still very high. Rarely does the wealth-income ratio vary by more than 10% from its 10 year average.

When the wealth-income ratio dips as low as 90% of its ten year average, extreme pessimism reigns, as in the early 1970s.  A ratio that is 10% more than the ten year average indicates extreme optimism as in the late 1990s, mid-2000s and now. Today’s ratio is 13% above its ten year average.

In early 2000, the ratio was 16% above its ten year average when the enthusiasm of dot-com expectations began to deflate and the price of the SP500 fell from its lofty heights. The ratio reached 14% above its ten year average in 2005 and remained above 10% till mid-2007 when the first cracks in the housing crisis began to surface and the SP500 said goodbye to its peak.

A picture is worth a 1000 words so here’s a chart of the Household Wealth to Income ratio divided by its ten year average. I have highlighted the periods of extreme pessimism and optimism.

HouseholdWealthRatio10Year

If history is any guide, the ratio of wealth to income can stay elevated for a few years. The “haves” keep trading with each other in a game of muscial chairs until people begin to leave the game and move their dollars into other assets, other markets, or bonds and cash. Unfortunately, many slow moving casual investors are left in the game with deteriorated portfolio values.

Economist Robert Shiller, author of Irrational Exuberance and developer of the long term CAPE ratio, recommended a strategy of shifting allocation in response to periods of exuberance and pessimism.  When valuations were historically low or average, an investor might allocate 60% or more of their portfolio to stocks.  As valuations became overextended, an investor might shift their stock allocation to 40%.  The investor is not trying to predict the future. The portfolio remains balanced but the stock and bond weights within the portfolio changes.

Using this wealth-income ratio as a guide, the casual investor might gradually implement an allocation shift toward safety in the coming year.

The Price of Mispricing

June 11, 2017

In an April 2016 Gallup poll  52% of Americans said that they had some stocks in their portfolio. In this annual survey, the two decade high occurred in 2007 when 65% of those surveyed said stocks were a part of their savings. Asked what they thought was the safest long term investment, surveyed respondents answered: stocks/mutual funds. The stock market hit a high in the fall that year.

Turn the dial to April 2008. The market had declined 10% from its October 2007 high but there was still five months to go till the onset of the financial crisis in September. Americans surveyed by Gallup said that savings and CDs were the safest (Poll ). At that time, a 5 year CD was paying 3.7% according to Bankrate . What happened to turn sentiment from rather risky stocks to safe cash and CDs? The decline in the SP500 might have been responsible. A more likely cause was the recent headlines concerning the failure of the investment firm Bear Stearns. The Fed provided a temporary bailout, then arranged a sale of the firm to JPMorgan Chase.

When real estate prices were rising in the early 2000s, people thought real estate was the safest long term investment. Each of us should ask ourselves an honest question. Do I treat relatively short term shifts in asset pricing as though they were long term trends?

Here’s another thought. Do we mentally treat changes in asset pricing as though it were cash income? If I see that the value of my stock portfolio has gone up $10,000 since my last quarterly statement, do I think of that as kind of a dividend reward for my willingness to take a bit of a risk? The statement confirms that I’m a prudent investor. Do I mentally “pocket”  that $10,000 as though someone had sent me a check?

On the other hand, if my statement shows a decrease in value, I have not only lost money but now I may question my prudence. Am I taking too much risk? I might even think that “the market” is wrong. Can I trust a market that could be wrong? What if there’s another financial crisis? Should I sell my stocks and put the money in CDs? A 5 year CD is only paying a little bit above 2% but at least I won’t lose any money.

Let’s crawl out of our heads and into the pages of history. In the early 1950s, two people published ideas that have come to dominate the investment industry.

In 1951, John Bogle wrote his Princeton college thesis “The Economic Role of the Investment Company.” The paper was an in-depth analysis of mutual funds, a product that was less than 30 years old. (Excerpts). At that time, only 8% of individual investors owned stocks.

Two decades later, Mr. Bogle would go on to found Vanguard, the giant of index mutual funds.  Contrary to the founding principle of Vanguard, Bogle’s 1951 paper did not champion indexing.  In Chapter 1, he objected to the portrayal of a mutual fund as settling for the average returns of an index of stocks.  Bogle touted the active management that a mutual fund provided to an investor.  In a quarter century after he wrote the paper, Mr. Bogle’s conviction in the superiority of active management shifted toward passive indexing. Indexing is the averaging of the decisions of all the buyers and sellers in a particular marketplace.

When Bogle wrote his paper, two types of funds competed for an investor’s attention. The earliest funds were closed end (CEF) and date back to the middle of the 19th century. The Adams Diversified Equity Fund was founded in 1854 and continues to trade today under the symbol ADX. After the initial offering a CEF is closed to new investors. The shares continue to trade on the market like a company stock but investors can no longer buy or redeem shares with the company that manages the fund.

A mutual fund is an open end product, meaning that the fund is open to new investors and investors can redeem their shares at any time. The early mutual funds touted this feature but it was not statutory until the enactment of the Investment Act of 1940.

When Bogle wrote his thesis, the market was still in what is called a secular bear market. The beginning of this period was marked by the brutal crash of 1929 and would not end till 1953, when the price of the SP500 finally rose above the highs set in 1929. The 1920s had been a decade of rapid growth in the new radio industry and manufacturing. The automobile and stock markets were fueled by easy credit. In response to this short era of explosive growth, investors elevated their long term expectations. From 1926 to 1929 the stock market doubled in price, a rapid mispricing that finally corrected in the October crash of 1929.

In 1951, Bogle summarized the previous two decades:
“The depression and the great capital losses to investors which resulted from it caused a greater desire for safety of principal, but gradually confidence in stocks (and especially in a diversified group of them) returned, and during the same period bond rates fell. The combination of high income and safe principal thus shifted in favor of the common stock element. In spite of the fact that many funds urge that part of the investor’s capital should be devoted to bonds, after he has cash reserves and insurance needs filled, it seems doubtful that this advice has been widely followed. “[my emphasis]

In his analysis, Bogle identified several metrics that gave open-end mutual funds superiority over closed-end funds: prudent management to keep the fund attractive to new investors, diversification, liquidity, and income.

Bogle concluded his thesis with a caution that is timeless: “That the market will fluctuate is certain, and merely because it has experienced a general upward trend in the decade of the investment company’s greatest growth may have made many investors fail to realize that the share value, like the market, is liable to decline.”

He looked toward the future of mutual funds, and expressed what would become the business plan of Vanguard: “perhaps [the mutual fund industry’s] future growth can be maximized by concentration on a reduction of sales loads and management fees.”

In the past 15 years, only 15% of active large cap managers have beat the returns of the SP500 index.  The performance is even weaker for small cap stock managers.  Only 11% beat their index.  Individual investors have withdrawn money from actively managed funds and put that money to work in their passive counterparts.  As more money flows to index funds, the danger is that those funds will be averaging the decisions of a smaller pool of active managers. That objection is raised by advocates for active management but it seems unlikely that the pool of active managers will diminish to the point that a few remaining managers will essentially control the direction of the market.  Although recent flows of money have favored passive indexing, actively managed mutual funds and ETFs still control two-thirds of all assets (Morningstar).

In the following year, Harry Markowitz, a graduate student at the University of Chicago, wrote a paper titled “Portfolio Selection” which proposed a systemic approach to diversification called Modern Portfolio Theory. Bogle had noted the prudent rule of thumb that an investor should devote some capital to bonds as well as stocks to stabilize a portfolio. Markowitz mathematized this rule of thumb. The key to portfolio stability was a strategy of asset selection that minimized risk in the face of uncertainty. Any two assets, not just stocks and bonds, that were normally non-correlated would provide stability. When one asset zigged in value, the other asset zagged. Both assets could be risky but if one asset responded opposite the other, then the net effect of owning both assets was to lower the risk.

The key word in any talk of historical correlation is “normal.” There is no theory which can explain investor trauma, a total lack of confidence in most assets. In October 2008, every asset but one fell. Both stocks and gold fell 16%, commodities sank 25% and REITs fell a whopping 32%. Even bonds, a safe haven in times of uncertainty, fell 3%. In a world where every asset class was losing value, investors bought short term Treasuries, which rose 1%, but avoided long term Treasuries, which declined 2%. There was no safety to be found outside of the U.S. Emerging markets fell 26%, European stocks sank 23% and international real estate nose dived 32%.

But the correlation in normally non-correlated assets could not last. During the following two months, bonds rose 9%, and gold shot up 20%. Stable or defensive stocks like health care continued to lose value but at a slower pace. Some investors stepped in to pick up quality stocks at bargain prices. The stock market continued to stagger to a bottom until the passage of the American Recovery and Reinvestment Act in February 2009, soon after the inauguration of Barack Obama.

50% market repricings are relatively infrequent. That we experienced two such events in less than a decade in the 2000s caused millions of investors to abandon risky assets entirely. The SP500 index did not recover the ground lost till January 2013, more than five years after the high set in October 2007. The recovery after the dot-com bubble burst in 2000 lasted a similar time, 5-1/2 years.

When was the last time we had back to back severe downturns? We need to turn the dial back to the fall of 1968 when the market began a 1-1/2 year decline of 33%. After a few years of recovery, stocks fell again. Provoked by the Arab-Israeli war, the oil embargo and high inflation, the market began a repricing in 1973. The recovery lasted almost seven years.

In 1975, Bogle founded Vanguard, what some called “Bogle’s Folly.”  Four years later, the SP500 was barely above its high in 1968. Investors had so little confidence in stocks as a long term investment that, in August 1979, Business Week declared that stocks were dead. Since that declaration, the price of the SP500 has gained about 8-1/2% annually.  Add in 2 – 3% in dividends and the total return exceeds 10% annually.

Bogle and Markowitz have had a profound influence on the investment industry by developing two deceptively simple ideas for investors who can’t know the future.  Bogle’s thought: don’t bet on which chicken can lay the most eggs.  The complimentary idea from Markowitz: don’t put all your eggs in one basket.

Next week – what’s so special about market averages?  They’re not your average average.

The Unemployment Delinquency Cycle

June 4, 2017

I’m scratching my head. No, it’s not dandruff. The BLS released their estimate of job gains in May and it was 100,000 less than the ADP estimate of private payroll growth. We’d all like to see these two monthly estimates track each other closely, which they tend to do. In an economy with 146 million workers, a 100,000 jobs is only 7/100ths of a percent, but this discrepancy comes just two months after a HYUUUGE spread of 200,000 job gains in the March estimates.

A simple solution to multiple surveys? I average them. The result is 191,000 job gains in May, close to that healthy growth threshold of 200,000. In the chart below I’ve shown the average of the two estimates for the past five years and highlighted the downward trend of the peaks. Reasons include a decline in oil and gas industry jobs, and a natural feature of a mature recovery.

PayemsADPAvg

We saw the same pattern of declining job gains from the early part of 2006 through late 2007 before the average dipped below zero. Boosted by a hot housing market in the early part of the decade, construction employment began to cool in 2006.

PayemsADPAvg2002-2010

Some areas of the country are particularly hot. Denver’s 2.1% unemployment rate is absurdly low as is the state’s rate of 2.3%. Both are at historic lows, less than the go-go years of the dot-com boom. Colorado’s rate is the lowest among the 50 states (BLS). While income inequality has been rising in other hot metro areas like San Francisco, it has fallen in the Denver metro area.

There is a downside to strong growth. Back in “ye olden days,” like the 1970s and 1980s, I was introduced to a rule of thumb. It stuck with me because it seemed too simple. Here’s the rule: whenever the unemployment rate gets below 5% in an area, the price of some key component of  the economy is rising much faster than its long term average.   Lower unemployment leads to a mispricing of some asset.

Let’s turn to the other component of this credit cycle: loan delinquency.  The institutions who loan money expect that a certain percentage of borrowers will default. Lenders include the cost of those defaults when they calculate interest rates and loan service fees. The non-defaulting borrowers pay for the defaulters. During recessions, the delinquency rate on consumer loans usually rises above 4%. When unemployment is low and growth is strong, the delinquency rate goes below 3%.  Lower delinquency leads to a mispricing of credit risk.

Let’s review these two mispricings. The price of an asset is a price on some future flow of use or income that will come from the asset.  The interest rate on a loan is the price of money and the price of risk.  Let’s put these two mispricing together and we have another rule of thumb: as the difference, or spread, between the unemployment rate and the delinquency rate on consumer loans gets closer to zero, the more likely that the economy is overheating. A rising spread indicates a coming recession because unemployment responds faster than the delinquency rate to economic decline and increases at a faster rate. The spread changes direction and grows.

UnemployDelinquencySpread

Here’s the process. As the unemployment rate decreases, lending terms and loan criteria become more favorable. When we buy stuff on credit, we commit a portion of our future income stream to a creditor. When an economy begins to decline and unemployment increases, some income streams become a trickle or stop altogether. A loan payment is missed, then another, and those in more fragile economic circumstances default on their loans.

As the delinquency rate rises, lending policies begin to tighten again, making it more difficult to qualify for loans. Many businesses depend on the flow of credit, so this tightening causes a decline in sales, which causes businesses to lay off a few more people, which further increases both the unemployment rate and the delinquency rate. This reinforces the downward trend.

The NBER is the official arbiter of the beginning and end of recessions but often doesn’t set these dates until several years later.  This change in the direction of the spread is a timely indicator of trouble ahead. An understanding of the credit cycle is crucial to an understanding of the business cycle, which influences the prices of our non-cash assets.

Next week I’ll take a look at the cycle of asset pricing.

A Proposal

May 28, 2017

The Republican led Congress has promised tax reform in the coming year.  This week I’ll introduce an income tax program that I think will clarify the debate.

Let me begin with those on the left side of the political aisle who talk about the rich paying their fair share.  The kernel of the Democratic social plan is a promise to take care of the poor by giving them benefits. Even if I don’t get any of those benefits, I like voting for politicians who help out the poor because I’m a good person.

If I ask House Minority Leader Nancy Pelosi or Senate Minority Leader Chuck Schumer “Where should the money come from?” they answer “People with too much money.” Nancy and Chuck know which people have enough money and which ones have too much.

BBLR has long been a rallying cry for those on the right. The acronym means “broaden the base, lower the rate.” As Majority Leader in the House and as Vice-Presidential candidate, Paul Ryan has espoused this philosophy. Here is a PolitiFact article on the issue during the 2012 presidential race. Tax reform champion Grover Norquist has advocated for the same principle.

The term “broaden the base” means to have more people paying at least some income tax so that they have skin in the game, so to speak. In a very progressive tax system, people who pay little or no taxes will vote for politicians who promise them benefits. After all, it is OPM, or other people’s money. In Democratic circles, BBLR stands for a mean tax system. Here’s the debate between Nancy and Chuck on the political left, and Paul and Grover on the right:

Paul and Grover: A minority of people are being forced to pay for federal programs that benefit other people who pay almost nothing into the system.  Those people will vote for more programs because it costs them nothing.

Nancy and Chuck: Republicans are bad people because they want to tax poor people. Poor people already pay Social Security and Medicare taxes so they are paying into the system.

Paul and Grover: Medicare and Social Security taxes are essentially forced saving programs that will return that money to the taxpayer in the future. Payroll taxes do not support the other functions and expenses of government like defense and the justice system.

Nancy and Chuck: Those taxes all go into the same pot.

Paul and Grover: Democrats have always been careful to separate Social Security and Medicare programs in their rhetoric. You champion the preservation of these programs as though they are separate. You can’t have it both ways. Either they are separate or they are not.

Nancy and Chuck: You Republicans are really mean and you are pawns of rich people.

These debates usually end in name calling, particularly during election season.  Some of the rhetoric is political branding but each side remains convinced that their way is the best way.

Let’s turn to recent history and take the chance that facts might get in our way. The non-partisan Congressional Budget Office (CBO) routinely analyzes proposed House and Senate laws for their estimated impact on the budget. In this report the CBO separated income, government transfers and taxes paid into income quintiles. (Click here if you want to know more about a quintile).

CBOIncTaxQuintile2013

In the table above, the lowest and highest quintiles received the least amount of money in government transfer payments like Social Security. The highest quintile had ten times more before-tax income than the lowest quintile but paid 87 times more tax than the lowest quintile. Notice that the CBO analysis includes all taxes paid to the federal government, including Social Security and Medicare.

Pretend you are a reporter. Ask House Minority leader Nancy Pelosi “How much more should the rich pay than the poor, Ms. Pelosi? If 87 times is not fair, what is fair? 100 times? 200 times?” Each of us is an expert on what “fair” means.

In the past 35 years, despite all the rhetoric, state and federal policies have had only a small effect on income inequality. The GINI index is a standardized measure of the inequality in a data set. The scale runs from zero, perfect equality, to one, or perfect inequality. The CBO report showed a 35 year history of the separate effects of benefit and tax policies on inequality. In 1980, tax policy reduced inequality by 10%. 35 years later, the reduction was 9%. Despite major tax reform in 1986, the tax increases of the early 1990s and the tax decreases of the early 2000s, tax policy has had little to no effect on inequality.

CBOGiniIndexChange

Changes in social policy that directs government transfer payments have helped ease inequality in the past 35 years, but the CBO analysis finds the combined change from tax and benefit policies negligible. They reduced inequality by 25% in 1979. 35 years later the total reduction was 26%. The difference could be a measuring error.

Tax reform is tough because it involves contentious issues. We argue about tax rates and the income brackets for those rates. We argue about deductions and tax credits. Like pornography, we may not be able to define “fair” but each of us knows it when we see it. We can agree on what “cat” means but not “fair.”

I propose something different, something that will give us less to argue about. Let’s recognize that there are socio-economic classes and assign a portion of federal tax revenues to each income quintile. Using the CBO’s analysis, the 1st and lowest quintile paid 8/10ths of 1% into the kitty. It is such an insignificant amount that we might has well make it zero. What this means is that poor people would pay no income tax and no payroll tax. Paul Ryan led the effort on last year’s Better Way tax proposal which included the same concept:  poor people should pay nothing.

If we can agree on that, we have four things left to argue about: the percentages that each of the remaining four quintiles would pay. Let’s begin the discussion by looking at the CBO analysis of the federal revenue “pie” in 2013.. The second lowest income quintile #2 paid 4% of total individual federal income and payroll taxes, the middle quintile paid 9%, quintile #4 paid 17-1/2%, and the top #5 quintile paid 69-1/2%. I rounded the percentages.

There will be a fight over these percentages but we will be fighting over four concrete numbers, not 100 million interpretations of what the word “fair” means as it relates to thousands of pages of tax code. Once that portioning is settled, a bipartisan committee representing each quintile can argue over the details of how they raise their portion of the anticipated revenue.

Taxpayers in the highest quintile may want tax breaks for angel investors who invest in early startup companies. Sounds like a worthy cause. The members of that quintile’s committee can argue amongst themselves as to whether they can afford to carve out tax breaks for that subgroup and still raise the required revenues. Should some of the income of hedge fund managers be taxed at a lower rate like capital gains? Under the current tax system, that is an emotional issue. Why should those guys get a special interest tax break? Under this proposal, I don’t care because I’m not in that quintile. A hot button issue turns into a yawner for most Americans.

A majority of taxpayers in the middle quintile might want the mortgage interest deduction. Those people can put political pressure on that quintile’s committee members to include that carve out. The majority in the next lower quintile might prefer tax breaks on child care. Should capital gains be taxed at a lower rate? This group has little in the way of capital gains so they might prefer that all income be taxed the same. Those in the lowest three quintiles who pay small tax percentages might be attracted to the simple grade school arithmetic used by some states to calculate their state income tax. Adjusted gross Income x 10% = $tax, as an example. Tax filing made simple.

Could this proposal make the tax code more complicated than it already is? Yes, but most of the complications won’t affect each person. Under the current system, my tax software asks me questions about tax credits and situations that have nothing to do with me or my family. Why? Because all of the tax code applies in theory to all of us. Under this proposal, my tax software would know what quintile I was in and the tax rules that applied to me and my family.

But what if people move from one quintile to another? How will they plan? Incomes do change. A person gets a raise, a better job, goes to school, loses a job or retires. A simple rule would help: a person’s quintile this tax year is based on their income the previous year.

The setting of the quintile brackets could be done by another simple rule. The IRS can not provide summaries and analysis of tax data for a particular tax year till about two years have passed. Each year we could adjust the income brackets of each quintile by the annual inflation rate based on the most recent tax year data available.  Families with fairly predictable income will know in advance what their tax expense will be in the coming year.

What about the Earned Income Tax Credit (EITC) program for poor people? This program largely offsets the payroll taxes that poor people pay with tax credits paid directly by a person’s employer. The program is fraught with abuse. Under this proposal, payroll taxes for the lowest income workers are eliminated so the offsetting tax credits aren’t needed.

Will those workers in the lowest quintile still be eligible for Social Security?  Sure.  There is still a record of their labor income, which is the basis for determining Social Security payment amounts.

Tax reform has come infrequently because the tax code tries to be all things to all people. The top 40% pay most of the individual income taxes so naturally they lobby for special interest tax breaks which are slipped quietly into the tax code.  Under this proposal, those special interests can lobby all they like, just as long as they meet their revenue targets.

Is it fair that someone making a half a million dollars gets a tax break on their vacation home on the Outer Banks in North Carolina? Of course not. Under the current system, I get angry about that. Under this proposal, I simply don’t care. If that person is getting a break, some other equally rich person is having to pay for that tax break. None of my business.

As it is now, we struggle to understand the various tax proposals. Politicians talk in non-specific terms about what is fair, or they speak in slogan tax talk like BBLR. Tax reform rhetoric has become a rallying cry to get out the vote.

This proposal will not stop the political fights. We will continue to debate the amount of  federal spending, the role of government and what tax revenues should be spent on. We will fight bitterly about the percentages of tax revenue expected from each quintile. But this proposal will direct the debate to specific percentages that most of us can understand. So let’s put on our debating gloves and get into it!

 

 

Circumstance

May 21, 2017

Last week I mentioned the 20 year CAPE ratio, a modification of economist Robert Shiller’s 10 year CAPE ratio used to evaluate the stock market. This week I’ll again look at equity valuation from a different perspective.  The results surprised me.

The date of our birth is circumstance.  When we retire is guided by our own actions and the circumstance of an era. We have no control over market behavior during the twenty year savings accumulation phase before we retire or the distribution of that savings during our retirement.   Let’s hope that we live long enough to spend twenty years in some degree of retirement.

The state of the market at the beginning of the distribution phase of retirement can have a material effect on our retirement funds, as many newly retired folks found out in 2008 and 2009.  Some based their retirement plans on the twenty year returns  prior to retirement.

I’ll use the SP500 total return index ($SPXTR at stockcharts.com or ^SP500TR at Yahoo Finance) to calculate the total gain including dividends. The twenty year period from 1988 through 2007 began just after the stock market meltdown in October 1987 and ended just as the 2007-2009 recession was beginning in December 2007. The total gain was 742%, or 11.3% annualized. Sweetness! Sign me up for that program.  Those high returns led many older Americans to believe that they didn’t need to accumulate more savings before retirement.  Then came the double shock of zero interest rates and a 50% meltdown in stock market valuation.

Now let’s move that time block one year forward and look at the period 1989 through 2008. Still good but what a difference one year makes. The total gain was 404%, or 8.4% annualized. That’s a drop of 3% per year! Investors missed the 16% bounce back in 1988 after the October 1987 crash, and the time block now included the 35% meltdown of 2008. There was even more pain to come in the first half of 2009 but I’ll come back to that.

1995 through 2014 was a good period with total gains of 550%, or 9.8% annualized. Shift that time block by two years to the period 1997 through 2016 and the gains fall off significantly. The total gain was 340%, or 7.7% annualized.

We can make a rough approximation of total returns during the late 1970s and into the 1980s, an ugly period for equities. In 1980, someone quipped “Equities are dead.” Twenty year periods ending during this time did not fare so well but still notched gains of more than 6%. Bonds, CDs and Treasuries were paying far more than that at the time. In today’s low interest environment, 6% seems a lot better than it did during the double digit inflation of 1980.

In past weeks I have written about the overvaluation of today’s stock market based on trailing P/E ratio and the smoothed 10 year CAPE ratio. Let’s look at the current valuation from the perspective of this twenty year return. It would come as no surprise that the total twenty year gain hit a low at the end of February 2009 when the market was about a 1/4 of its current valuation. That 20 year annualized gain was 5.7%. What surprised me was that the current valuation shows the same 20 year gain! Using this metric as an evaluation guide, the market sits at a relatively low level just like it was in 1988 and 1989.

The historical evidence shows that stock returns may be erratic but consistently make over 5% over a twenty year retirement period. Those who are newly retired or about to retire might understandably desire more safety. The safest approach is not to suddenly shift one’s portfolio entirely to safe assets.

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Income Inequality

Much has been written about the growth of income inequality. The GINI coefficient is the most popular but there are other measures (for those who want to get into the weeds of inequality measures). The Social Security Administration offers a simple indicator of the trend. They track the average and median incomes of millions of earners every year.

When the median and average are fairly close to each other, that indicates that the numbers in the data set are uniformly distributed. As the ratio percentage of the median to the average falls, that indicates that a few big numbers are raising the average but do not raise the median.

Here’s a simple example of an evenly distributed set. Consider a set of numbers 1, 2, 3, 4, 5, 6. The average is 3.5. The median is also 3.5 because there are three numbers in the set below 3.5 and three numbers above 3.5.  The percentage of the median to the average is 100%.

Let’s consider an unevenly distributed set: 1, 2, 3, 4, 5, 12. The median is still the same value as the earlier example: 3.5. But the average is now 4.5. The ratio of the median to the average is 3.5 / 4.5 = about 78%.

The ratio of the median to the average income has fallen from 71% in 1990 to 64% in 2015. This indicates that there is a growing number of large incomes in our data set.

SSAIncomeAvgMedian
Here’s the data in a graph form

SSAIncomeAvgMedianGraph
Median wages have doubled, or grown by 100%, while average wages have grown by more than 150% in the last quarter century.

Next week I will look at a hypothetical income tax proposal based on income. It might just blow your mind.

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Dividend Payout Ratio

FactSet Analytics grouped dividend paying stocks in quintiles (20% bands) by the dividend payout ratio (Chart). This is the percentage of profits that are paid to shareholders in the form of dividends. Over the last 20 years of rolling one month returns the stocks that had the highest and lowest payout ratios had the lowest total return. Think about that. Both the highest and lowest quintiles did the worst. What performed the best? Those stocks that were in the middle quintile, the companies who balanced their profit distributions between investors (dividends) and investment (future sales and profits).

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CWPI

Each month I compute a Constant Weighted Purchasing Index built on a combination of the two Purchasing Manager’s surveys (PMI) each month. For the six month in a row, this composite has shown strong growth and the three year average first crossed the threshold of strong growth in January 2015.

A sub-index composite that I build from the new orders and employment components of the services survey (NMI) shows moderate growth. Its three year average has shown moderate growth since early 2014.

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Surprises

May 14, 2017

Surprises, the good, the bad and the ugly. When we are in retirement, we are less resilient when the bad or ugly surprises happen. There are event surprises and process surprises. An event surprise might be the damage and loss from a weather related event. A process surprise can be even more deadly because it happens over time.

Misestimates and unrealistic expectations are two types of process surprises. Let’s look at the first type – misestimates. In a recent survey, Boomers were asked to estimate the percentage of income they would have to spend on healthcare. The average estimate was a bit less than 25%. The actual average is a third of retirement income. Let’s say a couple gets $4000 in monthly income from Social Security, interest and dividends. If they had budgeted $1000 (25%) of that for healthcare costs, then discover that they are spending over $1300 a month, that extra cost will slowly eat at their savings base.

A good rule of thumb is to estimate that, in the first few years of retirement, we will spend as much if not more than we spent before we retired. If we are wrong and we spend less, that’s a good surprise. In those first years we may find that we are spending more in one area of our lives and less in another.

The second type of process surprise – unrealistic expectations. Let’s say I expect to make 8% per year on my savings with a small amount of risk. People with a lifetime of experience in managing money struggle mightily to accomplish this and all but a few fail. Either they must take on more risk or lower their expectations of return.

Vanguard and other financial companies provide the expected risk and returns of several different allocations over many decades. Here‘s a chart at Vanguard that does not include a cash allocation in its calculation.  These long term calculators have another drawback: they include rather unusual times in history – the 1930s Depression era and World War 2.

We could use the last twenty years of actual returns to guide our expectations for the next twenty years. In past articles, I have linked to the free tools available at Porfolio Visualizer and there is a permanent link on the Tools page.

I select 1997 for the starting year and 2016 for the ending year. I leave the default settings at the top of the screen alone for now. If I input 40% into the U.S. Stock Market, 40% into the Total U.S. Bond Market, and 20% into Cash, I have chosen a conservative allocation – 40/40/20. I click the Analyze Portfolios button and see that the return was a bit over 6% in the CAGR (Compound Annual Growth Rate) column. How likely am I to achieve 8% over the next 20 years? Not very likely.

I’ll input a moderate allocation of 60% stocks, 30% bonds and 10% cash. The result is an almost 7% annual return so I am getting close to my 8% but there was a nasty time when I lost 1/3 of the value of my portfolio. If I am 70 years old, how comfortable would I be if I watched my portfolio sink almost 33%? I think I would have some restless nights worrying whether I would have to go back to work. How up to date are my skills? Would my prospective employer allow me to take a short nap in the afternoon? I feel so rested and ready to rock and roll after a nap. Well maybe not.

Wait a minute, I tell myself. The past 20 years included the busting of a tech bubble, 9-11 and the 2008 financial crisis. Two of those were rather extraordinary events. So I pick a different 20 year time period, 1987 – 2006. That still includes some serious shocks like the tech bubble and its pop, as well as 9-11. My conservative allocation of 40/40/20 made 8-1/2% CAGR and the moderate allocation of 60/30/10 made 9-2/3%.

But I’m not happy with the risk. I could even decrease my risk and make my 8% return by choosing a very conservative allocation of 30% stocks, 50% bonds and 20% cash. My portfolio lost less than 10% in its worst year ever – the maximum drawdown. If I go to Vanguard’s risk return chart they estimate a 7.2% average return over 90 years, which included a horrible depression that lasted a decade and a world war. It’s to be expected that my 20 year period 1987 – 2006 would do a bit better than the 90 year average because the catastrophic shocks are not included.  I think my 20 year period is more representative of the risks I will face in the next 20 years.

I could have picked the 20 years from 1981-2000 and that would have been unrealistic. The conservative allocation earned more than 10% and the annual return on the moderate allocation was almost 12%.

So I have now set what I think is a realistic 20 year time frame that gave me the historical risk and reward that met my expectations. But that’s not realistic. Not yet. I am going to be taking money from this portfolio to supplement my retirement income. So now I go back up to the top of the screen where the defaults are and under “Periodic Adjustments” I select the “Withdraw fixed percentage” option and under that I input 4.0%. This is supposed to be the safe withdrawal percentage. The next row is the “Withdrawal frequency.” I’ll select Annual.

Since I am now taking cash out this portfolio, I will turn to the IRR column of the results because the Internal Rate of Return calculation considers cash flows. My very conservative allocation of 30/50/20 has an IRR of almost 8.5% with a drawdown of less than 15%. The column that says “Final balance” shows that I have more than double the money I started out with and I have been able to withdraw 4% per year. I would have liked to get the drawdown below 10% but I think I can live with 13-1/2%. I’ll be worried but I don’t think I will lose sleep over it. So now I have made what I think is a reasonable expectation of risk and reward based on historical returns.

There’s one last thing I need to do. I know that the 20 year period from 1929 to 1948 was bad but I can’t check that in Portfolio Visualizer because the year selection only goes back to 1972. So I select a really bad ten year period, 2000 – 2009. This was from the heights of the dot.com boom to a short time after the financial crisis. After taking 4% per year, the IRR on my very conservative allocation was 4% and I still had the money I started out with at the beginning of the ten year period. I could probably withstand a 20 year period like this as long as I stay true to my allocation.  But, the maximum drawdown (see here) was 21%, something that I am not comfortable with.

I am left with some hard choices.   In the case of another bad ten year period, I can lower my withdrawal percentage a bit or I can learn to have faith in the allocation process and accept the drawdown.  I have done this with a free tool. I could pay for more sophisticated tools that gradually transition from one allocation to another allocation over a 20 year period.  That would be more realistic still since I will probably get more risk averse as I get older. At least this gets me started.

We often can’t avoid the suprise events. Some surprises are both event and process like the diagnosis of a  life-threatening illness. We can understand and be alert to the process surprises that we may inflict on ourselves. Understanding involves some frank self-assessment and difficult questions. Am I prone to wishful thinking? Do I overestimate my tolerance for risk? How well do I live with the consequences of my decisions?

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CAPE

A few weeks ago I mentioned that I might calculate a 20 year CAPE ratio. The CAPE that Robert Shiller uses is a ten year period. As of the end of 2016 the 20 year CAPE was 31 vs the 70 year average of 21. Whichever calculation we use, the market is priced a good deal above average. The 20 year CAPE first crossed above the average in the late summer of 2009.

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California

Over the past 5 years California’s economy has grown faster than any other developed country except for China. Bloomberg article

Connector Jobs

May 7, 2017

Later in this article I’ll take a long term look at connector jobs and how they can help us understand the swings in the economy as a whole.  Last week I mentioned that I might figure and graph a 20 year CAPE ratio for the past few decades.  I will post that up next week. First let’s look at the whole economy.

The initial estimate of first quarter GDP was released this week. Another quarter of meager growth. Here’s a chart of real, or inflation-adjusted, GDP growth per capita. During this recovery there has been only one quarter when annual growth has crossed the healthy benchmark of 2.5%.

GDPPerCap201703

A working paper by economists at the NBER estimates a 2.1% growth rate in OECD countries (which includes the U.S.) for the next few decades. An aging population is the major contributor to the the 25% decline from the 2.8% growth of the post-WW2 era. Promised benefits to those in OECD countries will stretch national budgets in a lower growth environment.

The Trump administration has one mandate – stronger growth – and will be judged by how well it can maintain its focus on that goal. This current second quarter of a new administration is the first one that voters count. Voters and investors will be keenly watching to see if Republicans have anything of substance behind the campaign rhetoric.

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Labor Report

In contrast to the slow GDP growth comes the news that payroll growth is strong. The average of the BLS (includes government jobs) estimate and the ADP (private only jobs) was a 203,000 gain in April.

Here’s an indicator that has proved to be reliable for six decades. As long as the growth in construction jobs is greater than the percentage growth of all jobs, the economy is healthy. An investor who reduced their equity holdings when construction job growth declined faster than overall employment (blue line crossing below declining red line) and overweighted equities when construction job growth was faster (blue line crosses above rising red line) would have done quite well.

ConstVsPayems201705

This might seem like a puzzle to those who do not work in real estate or construction. How does such a small part of the economy – less than 5% – provide such a key indication of the health of an economy? Because construction jobs are connector jobs. Remember Tinker Toys? Construction jobs are the round hubs with the holes in them.

They connect working people who are buying and renting homes.
They connect businesses leasing offices and stores.
They connect politicians and taxpayers to build and repair infrastructure.
They connect investment money and businesses wanting to expand.

When construction jobs decline, we can guess that new home sales are weakening, that demand for office and retail space is slackening, that tax collections are diminishing and government budgets tightening.  Factory, retail and office building construction decline as caution plays a stronger hand among institutional investors.

New unemployment claims remain at historic lows. Continuing claims for unemployment insurance have not been this low since June 1969.

UnemplClaimsPctPayems201705

The number of people voluntarily qutting their jobs for another job (the quit rate) is near the highs seen in 2005 through 2007.

People working part time jobs because they can not find full time work have declined since their peak in September 2011 but are still high. Many employers in retail and restaurants use part time employees to meet daily peaks and ebbs in the customer flow. Benefit costs for part time employees are less than full time. Even in a booming economy like Denver, people in their 20s with a college or two year degree may have to put together two or more part time jobs to make ends meet.

Throughout most of this recovery the weekly earnings of non-government employees has struggled to grow at more than a 2.5% annual pace, far below the plus 4% growth of the middle of the 2000s. On an even more sobering note: the median real weekly earnings of full time black workers is 20% less than all full time workers.

For decades to come, both the financial crisis and the recovery will be studied and written about.  Scholars will try to understand the trend to part time jobs and the slackening wage growth.  The total cost of an employee includes benefit costs and mandated payroll taxes.  As medical insurance premiums continue to rise faster than inflation,  the total cost of an employee has increased faster than inflation.  Employers have compensated by reducing the growth of the wage component of total cost.  Secondly, they have reduced benefit costs by employing more part timers where possible.

Trump was elected on the campaign promise that this so-so rate of growth would not be the “New Normal” under his administration.  Walking that talk may be much harder than he thought, or that anyone thought.

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Today I heard some one say, “I’m afraid that if I don’t buy a house soon, I will be priced out of the market.” When have I heard that before? It was 2006, at the height of the housing boom.

The Cycle

April 30, 2017

This week I’ll look at the savings, retirement and asset cycle, which all have a similar lifetime. Let’s look first at asset pricing.

Long term moving averages can serve as a safety benchmark for asset prices, and a 50 month, or 4 year average, is one such average. If the price falls below that very slow moving average, there has already been a sizeable repricing of that asset and there may be more to come. It should prompt some caution or review.

Here’s a recent example.  In the summer of 2011, a basket of Brazilian stocks (EWZ) crossed below its 4 year average.  Six years later it is just nearing that long term benchmark. Its been a long hard slog for long term holders of Brazilian stocks, and supports the recommendation that an investor keep funds needed in the next five years out of the stock market.

Emerging markets (EEM, VWO, VEIEX) just crossed above their 4 year averages and are now at the same price as they were in August 2008.  This nine year “flatline” period came after a growth spurt from 2003 to 2007 when emerging market prices grew at 36% per year!  Even after nine years of no growth, an emerging market index has returned 10.5% annually in the the past 14 years.

The S&P500 has fallen below its 4 year average twice in the past three decades. Once was during the dot com bust in 2002 and the financial crisis in 2008. Each time, the index stayed below that benchmark for two or more years. During the 1969 – 1982 bear market, the SP500 fell below that benchmark four times! During that downturn, the index gained only 15% in 14 years. After adjusting for inflation, the loss was 40%,  or 3% per year.

Bond prices have been more stable and provide an anchor to a portfolio. Let’s compare the stock market to Vanguard’s total bond market index fund (VBMFX ). In the last three decades, the fund has NEVER fallen below its 4 year average. Dividend paying stock stalwarts like Johnson and Johnson (JNJ) can also serve as anchors since they fall below their benchmark less frequently than the SP500 index.  When these stable stocks do fall, the price rebounds more quickly than broader indexes because investors are attracted to fairly reliable sales and dividends.

So how does a casual investor without a charting program chart a 4 year average? Stockcharts.com has free charts available. In the example below, I input “SPY,” a popular ETF that tracks the SP500 into the “Enter A Symbol” box on the upper right portion of the screen, then I clicked the Go button. Stockcharts displayed a daily chart for this ETF with default 50 and 200 day averages. Above the chart, I clicked the selection box from Daily to Weekly and pressed the Update button. I left the default 50 and 200 averages alone. The red line is now the 200 week, or approximately 4 year average. The blue line is the 50 week, or one year, average. The chart below is an example.

SP500ROC201704

This particular screen shot includes a Rate of Change indicator in the pane below the chart. Set at 100 weeks, it shows the percentage gain over two years.  Both gold (GLD) and mining stocks (XME) are struggling to get back above their 4 year averages.  You can change the symbol and compare their graphs.

In the earlier example, emerging markets had a five year spurt upwards, then a nine year flatline. Let’s look at a broad index like the SP500 in inflation adjusted dollars and we will see a similar pattern. $100K invested in the SP500 index in January 1997 was worth $183K in real dollars, real buying power, in April 2000. That was almost a doubling in real value in a small time frame. Easy money!

In 2012, twelve bruising years later, that inflation adjusted portfolio value FINALLY rose above $183K. Here is a free chart from PortfolioVisualizer.com

SP500GrowthInflAdj1997-2016

In the past four years, we have had another 62% spurt upwards in real value. The length of these spurts and flat periods are unpredictable, but the flat periods last longer than the spurts.

Let’s go back to the previous twenty year period, from 1977 – 1997.  In the first four years, from 1977 – 1983, the SP500 flatlined. In the following 14 years, the index grew by 570%!  (Exclamation marks for these growth spurts.)

SP500GrowthInflAdj1977-1997
We can see now that the strong asset price growth from 1997 to April 2000 was in addition to the extraordinary price growth from 1983 to 1997.  But doesn’t this example disprove the point I made earlier that flatline periods are longer than the growth spurts?

Let’s look back to those years before 1977 and we will see one of the reasons for that long growth period of the 1980s and 90s.  The six year flatline from 1977 – 83 was the tail end of a much longer period of flat or declining asset prices that lasted for 14 years, from 1969 through 1982. The introduction of tax deferred IRA accounts brought many individuals into the stock market during the 80s and 90s and helped to lift stock prices.  The introduction of the internet in the early 90s helped fuel a boom in asset prices much like the development of radio did in the 1920s.

Let’s turn from the long term 15+ year cycle of the stock market to the savings and retirement cycles. We spend at least forty years working. We may have just the last twenty years of our working career to save up for retirement. We hope to spend fifteen to twenty years in some stage of retirement.

We do not control when we are born nor the timing of these long term asset pricing cycles.  An awareness of these cycles may help guide us to wiser allocation choices.

The Nobel economist Robert Shiller builds an inflation adjusted ten year P/E ratio (CAPE) that is meant to smooth the ups and downs of company earnings. If I get some time next week, I may construct a 20 year ratio that corresponds to the 20 year cycle of 1) saving for retirement, 2) spending in retirement, and 3) the long term ebb and flow in the stock market.

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Margin Debt

Investors meeting certain liquidity requirements can borrow money from their broker to buy assets, including stocks.  When stock prices start falling, investors without sufficient collateral in their brokerage accounts to cover the paper losses from falling stock prices may be subject to what is called a margin call.  The broker simply sells some of the client’s stock to replenish collateral.

Here’s an example and I will make the figures simple to avoid some of the complex rules involved.  An investor has $80,000 in stocks that she has bought and paid for.  She applies for a margin account with her broker who agrees to loan her $100,000 to buy other assets.  Thinking that the coming tax cuts will boost stock prices in the coming months, she buys $100,000 on margin in SPY, an ETF that replicates the SP500 index. Two weeks later, the European Union moves to disband in the coming months which makes investors very nervous and the stock market drops 20% in one day.  Yes, I told you I would make it simple.  The $80,000 in stocks that the investor owns outright is now worth $64,000 and the $100,000 of stocks she just bought on margin are worth $80,000.  The brokerage automatically sells $20,000 of the stock at the lower price to cover the shortfall in collateral. This is known as a margin call. One margin call does not create a selling wave.  Thousands of margin calls puts more downward pressure on stock prices and they continue to fall.  This again requires more selling to meet margin calls.

Because margin debt can ignite a selling frenzy in a crisis, the amount of margin debt is monitored.  Two years ago, the level of margin debt surpassed an earlier peak in 2000 at the height of the dot com bubble.  A graph from Doug Short at Advisor Perspectives shows the tight correlation between stock prices and margin debt.  After a brief decline, debt levels have again hit an all time high in real dollars.

There are a number of volatile situations around the world that could start a selling wave.  The level of debt will naturally accelerate that selling.  Now comes the news that there is a pool of margin debt that is not even reported and may add another 20 – 40% onto the reported total.  Here’s an article from Business Insider.

Guessing the Future

April 23, 2017

Human beings have an ability to foretell the future, or at least some people think so.  A more accurate description is that we predict the likelihood of future events based on past patterns.  Index funds average the predictions of buyers and sellers in a particular market.

During the recovery most active fund managers have underperformed their benchmark indexes. Standard & Poors, the creator and publisher of many indexes, provides a quick summary in their SPIVA spotlight. In the past five years, 88% of active fund managers have underperformed the SP500.  In a random world, I would expect that 50% of active fund managers would beat the index, and 50% of managers would underperform the index because the index is an average of all those buy sell decisions.

The 1% higher fees charged by active fund managers contribute mightily to this underperformance. Using long term averages, we expect that a third of active fund managers would beat their benchmark index.  The current percentage is only 12%. It is likely that the law of averages will eventually exert its pull.

Index funds mechanically rebalance regularly. Let’s look at a real life example.  The pharmaceutical giant Johnson and Johnson is a member of both the SP500 and the smaller group of core stocks that make up the Dow Jones index.  This week the company  reported first quarter revenues that were below expectations, and sellers promptly knocked 3% off the stock price.  Because most SP500 index funds are market weighted, index funds that mimic the weighting of the stocks in the index would buy and sell stocks in the index to capture these changes.

Because index funds are averaging the decisions of all stock investors, they should underperform. After all, the index funds are buying those companies that everyone else is buying, and selling companies that everyone else is selling.  Index funds are buying high and selling low, creating a drag on performance that is overcome by the lower fees charged by these funds.

In an article last fall in the Kiplinger newsletter, Steven Goldberg makes the case for a mix of both index and active funds.  Research shows that active fund mangers do better when an index does poorly.  It’s worth a read.

The index fund giant Vanguard is featured in a NY times article. John Bogle founded Vanguard based on his thesis that a passive approach to investing and low fees would reward most investors over the long term.

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Correlation, not Causation

When the stock market crashed in 1929, the unemployment rate was less than 3%.  A booming economy during the 1920s lifted demand for labor, while severe immigration restrictions enacted in 1924 reduced the supply of workers.

Unemploy1929-1942

The unemployment rate was 6% when the market crashed in October 1987 and again in September 2008. There seems to be a weak connection between unemployment and severe market crashes.  However, there is a consistent correlation between the change in number of unemployed and the start of recessions.

UnemployChange

A yearly increase in the number of unemployed on a percentage basis indicates a fundamental weakness in the economy.  Sometimes, the change reverses as it did in early 1996, at the start of the dot com boom, or in the mid-eighties after a downturn in oil and housing exposed a banking scandal. These two periods are circled in blue in the graph above.

Often the economy continues to weaken, more people lose their jobs, GDP falters and the economy slides into depression.

Because we cannot rely on just one indicator as a warning signal, we can chart the amount of production generated by each person in the labor force.  The civilian labor force includes both those who are working and those who are actively looking for work.  A growth rate below 1% indicates some weakness.  Using both the change in unemployment and the change in production helps filter out some of the noise.

While production growth may be faltering, the current unemployment level is not worrying.

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Pay Attention to the Pros

Institutional buyers and sellers of Treasury bonds will usually let the rest of us know when they are worried about a recession.  In a middling to healthy economy, Treasury buyers will demand a higher interest rate for a longer dated bond.  Subtracting the interest rate on a shorter term two year bond from a long term ten year bond should be positive.  In a “normal” environment, a 10 year bond might have an interest rate of 3% and a two year bond an interest rate of 1%.  The difference of 2% would be expected.  However, a negative result indicates that buyers want more interest from short term bonds because they are more concerned about short term risks.  As we can see in the chart below, a negative result precedes a recession by 12 to 18 months.  The current difference shows no indication of concern.

Guessing the future is not divination, nor is it perfect.  Retail investors may not have the time or expertise to estimate future risk, but we can study those who make it their business to manage risk.

The Long Game

April 16, 2017

Happy Easter!

Successful investing requires a far sighted vision. At the end of each year Vanguard sends its customers their long term outlook. This last one contained a few caveats: “the investment environment for the next five years may prove more challenging than the previous five, underscoring the need for discipline, reasonable expectations, and low-cost strategies.”

Vanguard’s ten year estimate of annualized returns is about 8% for non-US equities, 6.5 – 7% for the US stock market, 5% for REITs (real estate) and commodities, and 2% for bonds.

Vanguard’s team projects that a diversified portfolio of 60% stocks/ 40% bonds will return 5.6% annually over the next ten years. An agressive 80/20 mix they estimate at a 6.6% return, and a very conservative 20/80 mix at about 3.3%. Insurance companies typically adopt this safe approach. (Source)

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ANNUITIES vs. MANAGED PAYOUT?

Investors near or in retirement must often turn to their investments for supplemental income. Annuities are sold as a safe “set it and forget it” solution, but they come with upfront fees and currently pay low interest.

In early 2008, before the fianncial crisis, a 65 year old man could get an average annuity (the average of a 10 year and life) for 5.5% a year. That provided a guaranteed income that was more than the classic 4% “safe” withdrawal rate for retirees. That 4% withdrawal rule would normally ensure that a retiree did not run out of money before they died.

The average annuity rate for that same age is now half that interest rate (Source). For an investment of $100K, a 67 year old male living in Colorado can get a lifetime annuity of $7212 per year (CNN Annuity Calculator) For 14 years, the insurance company providing the annuity is essentially returning the investor’s money to them. If that male investor lived for 20 years till age 87, they would receive a total of $144K, an annual return of only 1.84%. If the retiree lived to 97, their annualized return would increase to 2.5% over the thirty year period. Clearly, an investor is paying for safety.

Wade Pfau is a CFP whom I have cited in previous blogs. Here he compares the advantages and disadvantages of investments vs. insurance. He makes an argument that an annuity that covers one’s essential needs allows a person to take more risk with the rest of their portfolio. The potentially higher return from the investment side of the portfolio can thus make up for the lower returns of the annuity, an insurance product. He does caution, however, that most annuities do not protect against inflatiion. A investor who needed $1000 extra dollars in monthly income in 2017, would need more than $2000 in 30 years at a 2.5% inflation rate.

Managed Payout?

One alternative is a managed payout fund. The Vanguard Managed Payout Fund VPGDX lists the fund’s holdings as 60% stocks with an almost 20% allocation to alternative strategies. Alternatives vary in volatility depending on the intent of the investment but let’s treat them as though they were mostly a stock, giving the fund a simple effective allocation of 75% stock, 25% bonds. This fund lost 43% from April 2008 through March 2009, less than the 50% loss of the SP500 index but not by much. A broad composite of bonds (BND) actually gained 3% in price during that time. Here is some info from the investing giant Black Rock on alternative investments.

The return of the fund since its inception in April 2008 is 4.28%. Vanguard’s broad bond composite fund VBMFX, with far less risk, had a ten year return of 4.12% and gained value during the financial crisis. Although some mutual funds have trade restrictions, the prospectus on this fund lists no such restrictions, so that one could set up a monthly withdrawal from the fund.

A Vanguard target date 2030 fund (VTHRX), which has an allocation of 70% stocks, 30% bonds, had a ten year return of 5.31%. That fund lost 45% during the eleven month downturn in 2008-2009, slightly more than the Managed Payout Fund.  The additional 1% annual return is the reward for that slightly greater drawdown. A 1/4 of that additional 1% return can be attributed to lower fees.

The advantage of a Managed Payout Fund – simplicity and regularity of income flows – does not outweigh the disadvantages of volatility and some tax inefficiency. An investor could conveniently set up a monthly withdrawal from a broad based bond fund and enjoy the same return with much greater safety of principal, lower fees, and control over the withdrawal amount, if needed.

When it comes to retirement income, most investors would prefer the simple arithmetic of our grade school years.  Both Social Security and traditional defined benefit pension programs use that kind of math.  Each year, a retiree gets ‘X’ amount that is adjusted for inflation.  No choices needed.  However, most employees today have defined contribution, not benefit, plans. A retiree owns their savings, the capital base used to generate that monthly income, and it is up to the retiree to  navigate the winding channel between risk and return.