Category: dividend stocks

Risky Biz

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December 13, 2015

How low can crude oil prices go?  Older readers may remember the Limbo, a party dance popular in the early 60s.  After breaking through the “limbo stick” of $40 per barrel, gas prices sank even lower when the IEA indicated that the supply glut will continue through 2016 (Story).

A popular energy ETF, XLE, has fallen 11% in nine trading days.  Yes, an entire sector of the economy has lost more than 1% per day this month. Some oil service companies lost more than 3% on Friday alone. The large integrated oil companies like Exxon (XOM) and Chevron (CVX) say they are committed to maintaining their dividends (Exxon now near 4%, Chevron near 5%) but investors are concerned that continuing price pressures will make that ever more difficult. This article provides a good overview of the structure, revenue and profit streams of large integrated oil companies.

So we lie around at night worried about our stock portfolio.  Why would we do that?  Because someone – who? – is going to pay us a little extra to worry about our stocks.  Or, at least, that’s the way it’s supposed to go, isn’t it? The extra return we are supposed to get for our worries is called a risk premium, or the plural – premia.  One measure of that premium is the total return on stocks minus the total return on a safe long term bond like a ten year Treasury bond.

In his book Expected Returns, An Investor’s Guide to Harvesting Market Reward,  Antti Ilmanen reviews the historical returns of several types of assets during the past century. He wrote a free summary of the book in 2012 (Kindle version  OR PDF version).  Mr Ilmanen presents an investing cube (pg. 3) as a visualization of the factors or choices that an investor must consider.   On one face are assets categorized into four types of investment.  On another face are four styles of investment.  On the third face of the cube are four types of risk.

A surprising find was that the risk premia of stocks over bonds was only 2.38% (p. 12) during the past fifty years.  Investors are not being paid much for their worry.  When the author compared the returns on stocks to longer term twenty year Treasury bonds (an ETF like TLT, for example), the risk premium has been negative for the past forty years.

The author emphasizes that “a key theme in this book is the crucial distinction between realized (ex post) average excess returns and expected (ex ante) risk premia.” (p. 15)  Historical averages of risk premia may be exaggerated by high inflation, which hurt the returns on bonds in the 1970s and part of the 1980s, and made returns on stocks that much better by comparison.  In a low inflation environment such as the one we have now the risk premia for owning stocks may be rather muted.

Ilmanen’s analysis of past returns reveals several historical trends that can help an investor’s portfolio.    Value investing tends to produce higher returns over time.  So-called Dividend stocks also generate additional return.

I was surprised at the relative stability of per capita GDP growth over 100 years.  We wring our hands in response to a crisis like the dot-com meltdown or the Great Recession but these horrific events barely show in the average aggregate output of the country over a person’s working years. Here is a table from the PDF summary.

A mutual fund QSPIX was formed last year based partly on the research in the book.  However, the minimum investment is $5,000,000.    The fund is currently 28% in cash.

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Social Security Strategies

A resource on the right side of this blog is Maximize My Social Security (MMSS), a personally tailored – and inexpensive – advisory service to guide older people to better informed Social Security choices.  The site does not use your social security number.  If you already have an online account with the Social Security Administration, you can complete the forms at MMSS and get some results in under twenty minutes.

Old people who used to talk about the latest Pink Floyd or Led Zep album when they were younger now talk about Social Security, Medicare and their aches and pains.  Always a popular topic:  hey, what do you think about waiting to file for Social Security?

Pros of waiting:

1.  Where else  can any of us earn a guaranteed 8% on our money each year?  Sign me up!  For each year we wait, our Social Security annual benefit increases by 8%.

2. Inflation adjusted:  On top of the additional 32% we get from SS when we start collecting SS at age 70, we are getting an inflation adjustment on that higher amount.

3.  If we need to borrow money to get by during the 4 years we wait, we may be able to borrow the money using our house as collateral.  Depending on our tax circumstances, the interest we pay on the borrowed money could be deductible, reducing the net cost of borrowing.

4.  If we are a guy, we will probably die before our spouse.  Wives who may have a lower benefit will get their benefit amount bumped up to what we were receiving.

Cons of waiting:

1.  We could die before the “payoff” age, between 79 and 82.  This is the age when the inflation adjusted benefits we receive by delaying our benefit matches the total we would have collected by claiming at an earlier age.  However, we often don’t factor in the advantage of the #4 Pro above in which our spouse collects a higher amount till her death.

2.  Congress could change SS payments and rules.  The institution does not have a good track record for keeping its promises.  The swelling ranks of the Boomer generation contributed far more than recipients of earlier generations took out in benefits. Congresses of the past few decades have spent all the extra money accumulated in the Social Security coffers.  After 2020 the system will come under greater cash flow pressure as the Boomers continue to retire and claim benefits.  If Congress does reduce benefits,  then those of us who waited to file for benefits will probably regret our decision.  By the way, MMSS allows users to estimate the long term impact of such a reduction.

3.  We may have to borrow to make ends meet while we wait to collect benefits.  Banks don’t usually loan money to retirees with no job income, necessitating some asset-backed mortgage. Older people may be averse to assuming any new debt.

4.  Withdrawing money from savings while we wait will reduce our savings for a time, which will lessen the “endowment” base of our lifetime wealth.  While the additional 8% per year from SS should more than offset that loss, we can never be certain.  As an example, let’s imagine a retiree at the beginning of 1995 who decided to draw down savings and wait four years to start collecting SS benefits.  The stock market had gone nowhere during 1994.  She sold some stocks and bought a 4 year CD “ladder” for the amount she would need to tide her over till she started collecting benefits.  During those next four years, the SP500 index rose from 459 to 1229, a 167% gain – more than 25% annually excluding dividends.  Even with the additional money our retiree was making each month in SS benefits because of her decision to delay, it was the worst time to get out of the stock market!

Out Of the Tent and Into the Forest

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May 12, 2013
We can take some steps to reduce our susceptibility to adverse events but if our primary aim is to reduce uncertainty as much as possible, our lives suffer in quality and our wallets suffer in quantity.  In our financial lives, we must try to find a balance between risk and reward.  There is a high demand for low risk, high reward investments.  Unfortunately, there is little supply of such investments and the few that are offered are usually scams.

There is a good supply of low risk, low return products. In the past ten years, conservative savers have taken a beating.  There have been only two periods where the interest on one year CDs has exceeded the percentage increase in inflation.

Challenged by low interest rates on CDs, savers have fled the market.

Older people who rely on their savings to generate income continue to search for yield, or the income generated by an investment.  The iShares High Yield Corporate Bond ETF, HYG, and the iShares Dividend Select Index ETF, DVY, have posted strong gains.  As more investors chase yield and drive up prices, the yields correspondingly become lower.   In December 2007, DVY paid out an annualized 4.7% yield on a price of about $53.  In March 2013, the yield was 3.4% on a price of $65 (Source)

Despite the fact that the Federal Reserve has held interest rates at historic lows, the amount of household savings continues to climb.  Some of this is due to an aging population which has more in savings and tends to be more conservative.

The Federal Reserve is essentially kicking people out of the tent and into the forest where the wild animals live.  It’s risky out there in the forest.  How come the banks don’t want our money?  Some people do not realize that a CD or savings account is essentially a loan to the bank.  Through the FDIC, the U.S. government insures most of these loans.  Loan your brother in law money for a  year and you might not get it back.  Loan your bank the money and you are assured that you will get it back.

In the simplified models of banking we learned in grade school, the bank pays us interest for the money we loan it (deposits) and loans that money out to other people at a higher rate of interest.  The difference in the two interest rates is how banks pay their employees and other business costs and make a profit. The reality is much more complex.  A bank does not take a $10 deposit from Mary and loan it to Joe.  The bank takes the $10 deposit from Mary and loans $100 to Joe.  Where did the other $90 come from, you ask?  It is created out of thin air in a process called fractional reserve banking, which allows a bank to leverage the $10 deposit by ten times, in this example.  Because banks are leveraging money, there is a labyrinth of financial metrics of stability to insure that the banks are not taking too much risk.  Some of these metrics include the risk weighting of assets (deposits, loans and securities, for example) and capital asset ratios.

In a 1985 paper by Federal Reserve economists, they note that “There is remarkably little evidence, however, that links the level of capital or the ratio of capital to assets with bank failure rates.”  This paper was written before the S&L crisis of the 1980s.

The financial crisis in 2008 led to a surge of bank failures, peaking at more than 150 in 2010.  In this past year, failures have dropped to a level that can be counted with two hands.

 During the recession, the amount of commercial and industrial loans declined but have risen to nearly the same level as 2008.

From a thirty year perspective, we can see just how severe the decline was.

While loans and interest bearing accounts, or assets, at the largest banks are nearing 2007 levels, assets at small banks have declined.

The banking industry has been consolidating, larger banks eating up the smaller ones.

This past Friday, the Chairman of the Federal Reserve, Ben Bernanke, expressed concern that some of the larger banks are still prone to failure.  The ever increasing size of the big banks has enabled them to have an even greater voice in the halls of Washington.  Bernanke’s remarks hint that he is a proponent of further regulations which would reduce the amount of leverage that banks can use to increase their profits.  Banking industry lobbyists are making the case that if they are required to reduce their leverage, it will hurt the economy by reducing the amount of loans they can make.

The banks are feeling squeezed and they are sure to let lawmakers know.  Their net interest margin, or the spread between what they pay to depositors and what they charge to borrowers, has fallen to pre-recession levels, putting pressure on banks to take more risk to increase their bottom line.

I am reminded of a comment made by Raymond Baer, chairman of Swiss private bank Julius Baer, in 2009 who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”  Let’s see: 2009 + 5 = 2014.  Hmmmm….

But we can’t live our lives waiting for the next catastrophe.  We must take some risk, be diversified and be vigilant.  As the stock market reaches new highs with each passing day, more investors will reassess their risk profile.  Some will curse their caution of the past few years and move money from safe but low yielding assets to the market, helping to fuel rising market prices.  The demand for yield creates a feedback loop that actually makes it harder to achieve yield.  If only we could live in a world where they didn’t have these darn feedback loops.