Category: portfolio allocation

The Un-Recovery Machine

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December 4, 2016

I’ve titled this week’s blog “The Un-Recovery Machine” for a reason I’ll explain toward the end of the blog as I look at the lack of growth in household income for the past 16 years.  Lastly, I will show how easy peasy it is to do a year end portfolio review. First, I’ll look at the latest job figures and a quick five year summary of a few key stats of stewardship under the Obama administration.

The economy added 180,000 jobs in November, close to estimates.  Obama will leave office with an average monthly gain of 206,000 jobs over the past five years, a strong track record. The president has a minor influence on the number of jobs created each month but each president is judged by job growth regardless.  We need to have a donkey to pin the tail on when something goes wrong.

The real surprise this month was the drop of .3% in the unemployment rate to 4.6%.  Some not so smart analysts attributed the drop to discouraged workers who dropped out of the labor force.  However, the number of dropouts in November was the same as October when the unemployment rate declined only .1%.  Seasonal factors, Christmas jobs and variations in survey data may have contributed to the discrepancy.  What is clear is that the greatest number of those who are dropping out of the labor force are the increasing numbers of boomers who are retiring every month. I’ll look further at this in a moment.

The number of involuntary part-timers has dropped from 2.5 million five years ago to 1.9 million, about 1.3% of workers. This is a lower percentage than the 1970s, the 1980s, and the first half of the 1990s.  It is only when the tech boom and housing bubble grew in the late 90s and 2000s that this percentage was lower.

Growth in the core work force is a strong 1.5%, a good sign.  These are the workers aged 25-54 who are building families, careers and businesses.  The change in the Labor Market Conditions Index (LMCI) turned positive again in October.  This is a composite labor index of twenty indicators that the Federal Reserve uses to judge the overall health of the labor market.  They have not released November’s LMCI yet.  This index showed negative growth for the first part of the year and was the chief reason why the Fed did not raise interest rates earlier this year.

The quit rate is back to pre-recession levels at a strong 2.1%.  This is the number of employees who have voluntarily quit their jobs in the past month and is used to gauge the confidence of workers in finding another job quickly. The highest this reading has ever been was 2.6% just as the dot com boom was ending in 2001.  Too much confidence. When the housing boom was frothing in the mid-2000s, the quit rate was typically 2.3%, a level of over-confidence. 2.1% seems strong without being too much.

Another unwelcome surprise this month was a .03 decline in the average hourly wage of private workers.  On the heels of a welcome .11 increase in October, this decline was disappointing. One month’s increase or decrease of a few cents is statistical noise.  The year-over-year increase gives the longer term trend.  For the past five years, the yearly increase in wages has been unable to get above 2.5%, which was the annual growth in November.

The greatest challenge that the incoming president will face is the ever growing ranks of Boomers who are retiring.  In 2007, the number of those Not in the Labor Force was 78 million.  These are adults who can legally work but are not looking for work, and includes retirees, discouraged job applicants, women staying home with the kids, and those going to college.  That number has now grown to 95 million, an increase of 2 million workers per year, and will only keep growing as the 80 million strong boomer generation continues to retire each month.   The millenials, those aged 16 to 34, are a larger generation than the boomers but will not fully offset the number of retirees till the first half of the 2020s.  If any president can explain this in very simple terms, it is Donald Trump, who has mastered the art of communicating a message in short bursts.

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Construction and Local Employment

Construction employment matters.  When growth in this one relatively small sector drops below the growth of all employment, that signals a weakness in the overall economy that indicates a good probability of recession within the year.  It’s not an ironclad law like the 2nd law of thermodynamics but has proven to be a reliable rule of thumb for the past forty years.  Fortunately, the economy is still showing healthy growth in construction employment that has outpaced broader job gains for the past four years.

The puzzle is why construction spending is an economic weathervane.  It has fallen from 11% of GDP in the 1960s to slightly over 6% of GDP today. (Graph )   Yet when this  relatively small part of the economy stops singing, there’s something amiss.

Real construction spending (in 2016 dollars) is currently at a healthy level of $175K per employee, 16% above the low of $151K in the spring of 2011.  Although we have declined slightly in the past year, the average is about the same level as late 2006 – 2007 and is above the spending of the 1990s.  As a rule of thumb in the construction industry, an employee is going to average 33% in wages and salaries. That doesn’t include the cost of employee benefits, insurance and taxes which will bring the total cost of the employee above 40% of the total cost.   So, if spending is $175K, we can guesstimate that the average worker is making about $58K.  When I check with the BLS, the average weekly earnings in construction is $1120, or almost $58K.  As a side note: that 40% employee cost is used by some contractors as a rule of thumb for a bid total when estimating a job.

During the recession many workers dropped out of the trades.  Older workers with beat up bodies cut back on hours, went on disability or took early retirement.  Younger workers who saw the layoffs and lack of construction employment during the recession turned their sights to other fields.  Workers who do come into the trades find that the physical transition takes some getting used to.  Even workers in their twenties discover that muscles and joints working 8 – 10 hours a day need some time to adapt.

The average workweek hours for construction workers hit at a 70 year high in December 2015 and is still near those highs at 39.8 hrs a week.  In some areas the lack of applicants for construction jobs is constraining growth.  In Denver, construction jobs grew by almost 20% in the past year and that surge is helping to attract  workers from other states.  The unemployment rate in Denver is 2.9%, below the 3.5% in the entire state.  (BLS Denver  Colorado)  This pattern is not confined to Colorado. Very often economic growth may be strong in the cities but weak and faltering in rural communities throughout the state.  For decades this has caused some resentment in rural communities who feel that politicians in the cities dominate policy making in each state.

Local employment

The Civilian Labor Force, those working and actively wanting work, is growing in all states except Alaska, Louisiana, Minnesota, New Jersey, New York, Nebraska, Nevada, Oklahoma and Wyoming (BLS here if you want to look up your city or state stats).  Some of the changes may be demographic.  I suspect that is the case in New York and New Jersey. The decline in some states are those related to resource extraction.  Employment in states with coal mining and oil production has taken a hit in the past two years.  In Colorado, the 11% gain in construction jobs has offset a 12% decrease in mining jobs.

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Household Income

On a more sobering note…In 1999 real median household income touched a high $58,000 annually.  Sixteen years later that median was $56,500, a decline of about 3%.  There’s a lot of pain out there.

For readers unfamiliar with the terminology, “real” means inflation adjusted.  “Median” is the halfway point.  Half of all incomes are above the median, half below.  Economists and market analysts prefer to use the median as a measure of both incomes and house prices to avoid having a small number of large incomes or expensive houses give an inaccurate picture of the data.

Both parties can take responsibility for this – two Republican administrations (Bush) and two Democratic (Obama) terms. There have been a number of different party configurations in the Presidency, House and Senate, so neither party can reasonably lay the blame at the other party’s feet.  The “new” more idealogically pure Republicans  in the House regard the “old” Republicans of the two Bush terms as traitors to conservative ideals.  Never mind that a lot of those “old” silly Republicans are still taking up room in the House.

Both parties have borrowed and spent a lot of money but little has flowed down to the American worker.  So much for the imaginativeness of trickle down economic theory.  When George Bush assumed office in January 2001, the Federal Public debt totalled $5.6 trillion.  When he left office in January 2009, the debt had almost doubled to $10.7 trillion.  Under Obama’s two terms, the debt nearly doubled again, crossing the $19.4 trillion mark in June 2016.  $14 trillion dollars of Federal borrowing and spending since early 2001 has not helped lift the incomes of American families.  It is a damning indictment of both major parties who have lost touch with the everyday concerns of many American families.

Can Donald Trump be the catalyst that miraculously turns the Washington whirlpool of money into an effective machine?  Doubtful, but let’s stay hopeful. 535 Congressmen and Senators, each with an outlook, a constituency, and an agenda funded by a coalition of lobbyists, are going to fight against giving up control.  Spend the money on my constituents. they will say.  Republicans throw out the phrase “limited government” to their base voters who whuff, whuff and chow down.  Once elected, many Republican politicians are as controlling as their Democratic counterparts, only in different areas of our lives. A Republican controlled government will push for more regulations on women’s health, regulations on people’s moral and social behaviors, a proposal to reinstitute the draft, and threats to private companies who move jobs out of the U.S.   Donald Trump recently enacted Bernie Sanders’ prescription for keeping jobs in America.  He no doubt threatened Carrier’s parent corporation, United Technologies, that they would lose defense contracts if Carrier moved all those 1000 jobs to Mexico.

So Donald Trump, the leader of the Republican Party, is following a socialist play book.  We are going to see more of this because Trump is the leader of the Trump party, not wedded to any particular ideology.  He is a transactional leader who plays any card in the deck to win, regardless of suit. Chaining oneself to ideals is a good way to drown in the political soup.

Republicans in Washington have consistently betrayed conservative ideals of financial responsibility and a smaller government imprint on the daily lives of the American people.  Democratic politicians cluck, cluck about progressive principles but Democratic voters find that their leaders have left them a pile of chicken poop. Unlike Republican voters, Democrats haven’t developed the organizational skills to make personnel changes in party primaries. Both parties are infected with old ideas, loyalties and prejudices.

Because of this, retail investors – plain old folks saving for their retirement – can expect increased volatility in the next two years.  We may look back with fondness at these last two years, a peaceful time of few accomplishments in Washington, and a sideways market in stocks and bonds.  A balanced portfolio will help weather the volatility.

Mutual fund companies and investment brokers track this information for us and we can access it fairly easily online at the company’s website.  Even if we have several places where we keep our funds, it is a relatively simple paper and pencil process to calculate our total allotment to various investments. We don’t need to be precise.  We are not launching a rocket to Mars.

If I have $198,192.15 at Merry Mutual and they say I have 70% stocks and 30% bonds, I can write down $140 in stocks, $60 in bonds.   Then over to my 401K at the Ready Retirement Company to find out that I have $201,323.39 balance, with 80% stocks and real estate funds and 20% bonds.  I write down $160 for stocks and $40 for bonds.  Then over to my savings account at Safety Savings where I have $39,178.64, which I include with my bonds.  I write down $40.  Finally, over to my CDs at the First Best Bank in my neighborhood where I have $32,378.14 in CDs of various maturities.  I include those with my bonds and write down $32. Maybe I have an insurance policy with some paid up value that I want to include in my bonds.

So, adding it all up, my stocks (more risk) are $140 + $160 = $300.  My bonds/cash (less risk) are $60 + $40 + $40 + $32 = $172.  $300 + $172 = $472 total portfolio value.  $300 stocks / $472 total = .635 which is about 64%.  So I have a 64% / 36% stock / bond split and I have figured this out without expensive software, or an investment advisor.

Depending on my comfort level, knowledge and expertise I may want some software or some advice from a professional but I know where my allocation lies.  I am on the risky side of a perfectly balanced (50% / 50%) portfolio and how do I feel about that?  If I do talk to an advisor or a friend I can tell them up front what my allocation is and we will have a much more informed conversation.

Pool and Flow

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October 2, 2016

A few weeks ago, I introduced two concepts: stock and flow. I’ll develop that a bit to help the reader analyze their portfolio with a bit more clarity.  To avoid confusion between stocks, as a type of investment, and the concept of a stock as in a reservoir or pool of something, I’ll refer to the concept as a pool and stocks as a type of investment.

Leverage

Each month we might check our investment and bank statements to find that the value has gone up or down.  In any one day only a tiny portion of stocks and bonds trade, yet these transactions determine the value of all the unsold assets, including the ones on our statement.  As I mentioned a few weeks ago, the flow from a reservoir of water determines the value of all the water in the reservoir.  It is like the butterfly effect, the idea that the fluttering of a butterfly’s wings in Mexico can cause a typhoon in southeast Asia.  In financial terms, when a small event has a large influence it is called leverage. A flow, a transaction, is the  catalyst for a transfer of value from one asset to another.

Let’s look at an example.  We buy a 1000 shares of the XYZ biotech firm for $10 a share, for a total investment of $10,000.  The next day the FDA announces that, contrary to expectations, they will allow a drug trial to proceed to Phase 3.  XYZ’s stock price rises 10% in response to the news.  The market price of our investment is now worth $11,000.  Where did the other $1000 come from?

Transfer of Value 

An asset value rose, so the value of another asset pool fell as the value is transferred from one asset to pool to another. Yesterday $10,000 of cash was worth 1000 shares of XYZ.  Today, that $10,000 of cash is worth only 909 shares of XYZ.  This is a different way of looking at cash – not as a liquid medium with  a stable value – but as an asset with an erratic value.

Cash = Investment 

What is cash?  It is an investment of faith in the United States.  We might give it a stock symbol like CASH and I’ll use that stock symbol to distinguish cash when it acts as an asset.  Stockcharts.com allows users to track the relationship between two stocks, or to price one stock in terms of another. We do by typing in the a stock symbol ‘A’ followed by a colon and a second stock symbol ‘B’.  Stockcharts will then show us the value of A priced in B units.  Below is the chart of Google (GOOG) priced in Apple (AAPL) units, or GOOG:AAPL.

On the left side of the chart in early 2014, Google’s stock was worth about 6.25 “Apples.”  By mid-2015, Google’s stock had fallen to 4.25 Apples.  Did Google’s value fall or Apple’s value rise?  Let’s imagine that we live in a world without money, as though we had taken the red pill as in the movie “The Matrix.”  Without a fairly constant measure like cash, we simply don’t know the answer to that question.  Imagine that each investor gets to choose which asset they want their monthly statement priced in and that our choice is Apple.  Over a year and a half, we see that we have lost about a third of the value of our portfolio of Google (6.25 / 4.25 = about 2/3).  We can’t stand the continuing losses anymore and sell our Google stock and get 4.25 units of Apple. It is now September 2016 and we still have 4.25 units of Apple because Apple is our measure of value.  Had we continued to hold the Google stock, we would have 7.29 Apple units.

What is CASH worth?

Now let’s turn to a slightly different example.  We are going to price CASH in Apple units, the inverse or reciprocal of how we normally do things.  When we say that Apple’s stock is $100, for example, we are pricing Apple stock in CASH units, or AAPL:CASH.  Instead we are going to look at the inverse of that relationship: pricing CASH in Apple units.  Remember, we are no longer in the matrix.

We begin with the same portfolio, 6.25 Apple units in early 2014.  We think that this CASH asset is going to do better than Apple, so we sell our Apple units for CASH and get 68 cash units for each Apple unit, a total of 425 cash units.  In mid-2015, we find that our CASH units are now worth only 3.5 Apple units.  We have lost about 45% in a year and a half!  We sell our CASH units and get 3.5 Apple units which is what we still have in this latest statement 15 months later.

Our losses are even worse than that.  Each year, Apple gives the owners of its shares another 2/100ths of a share as a dividend.  The owners of CASH get only 1/100th of a cash share each year.  Apple pays those dividends from its profits.  For owners of CASH, a financial institution pays the dividends from its profits. While the Federal Reserve, a creation of the Federal Government, doesn’t directly “set” interest rates it effectively does so through the purchase of bank securities.  Each dollar bill is equivalent to a share in an entity called the United States and it is ultimately the U.S. government that largely determines the dividend rate that is paid on safe investments like savings accounts.

Stock dividends compete with cash dividends

To remain competitive with safe investments, Apple only has to pay a little more than the very low dividend rate that savings accounts are currently paying.  If interest rates were 5% instead of the current 1%, Apple would have to devote more of its profits to dividends to appeal to income oriented investors.  By keeping interest rates low, the Federal government effectively allows Apple to retain more of its profits.  Where does Apple keep that extra money?  Overseas and out of the reach of the IRS.  That’s only part of the irony.  If Apple had to pay more of its dividends to the share owners, the share owners would pay taxes on the income. So the U.S. government loses twice by keeping rates low (See footnote at end of blog).

So CASH is effectively owning the stock of an entity called the United States, which doesn’t make a profit.  In the long run, owning the stocks of companies that do make a profit generates much more return to the owner.  Let’s look again at the leverage aspect of stocks and cash.  Earlier I noted the huge leverage involved in stock and other non-CASH asset transactions.  A tiny number of transactions affects the value of a large pool of assets.  On the other hand, millions of CASH transactions take place each day and have little effect on the nominal value of CASH.  So we price highly leveraged assets – stocks, bonds, etc. – in terms of an unleveraged asset – cash.

The functions of cash  

Cash plays several roles. First, as a medium of exchange, it acts as a measuring stick of economic flow in a society. This first role has a symbol – $.  Secondly, as an asset pool, CASH acts as a holding pond, a reserve in the waiting, the first in the asset reservoir to be tapped. Lastly, it acts as an insurance on the principal of other assets, like stocks and bonds.  Let’s call that INS.

Insurance

As an insurance, let’s consider a portfolio of $900 in stocks, $100 INS.  A 10% fall in stocks is reduced to a 9% fall because of the INS position.  Let’s consider the exact same portfolio, except that the investor’s intention is that the $100 is a CASH investment, a reservoir of asset buying power.  The same 10% fall in stocks is now a trigger for additional purchases.  In the first case the $100 is an anxiety reduction fee; in the second, a prediction of a market correction.

An investor might blur the distinction between the functions. Retired people who want to preserve the nominal value of their savings may tend to keep the majority of their nest egg in cash without distinguishing the different functions.  Cash = safety and liquidity. Because cash is used as a yardstick, its nominal value is kept constant.  But what that cash can buy, its purchasing power, changes.  When they need some of that CASH ten years from now, the purchasing power of that asset may have fallen by 30% but the nominal value is the same as it was ten years earlier.

Cash Analysis

As noted before, companies must make a profit or go out of business. Not so the U.S. government. Over time, the rate of a company’s profit growth must exceed the inflation rate, so that stocks give the best investment return in the long run.  Investors would benefit by separating their cash position into its functions, $ and CASH and INS, to understand more clearly what their intentions and needs are for the coming year.  This can be as simple as a piece of paper that we review each year.

Analysis Example 

An example – Cash needs:
1) income for the next year including emergency fund – $50K – $ function.
2) stock market seems awfully high and it has been a while since there has been a 10% correction – $100K CASH function.
3) $30K INS function to help me sleep at night in case there is more than a 10% correction.
Total: $180K.

Why write it down?  Believe it or not, we forget things.

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As a footnote:

Offsetting the tax losses to the government is the fact that some of Apple’s cash consists of cash-like equivalents like Treasury bonds which pay a very low dividend.  Apple loses income because of the low dividend and the U.S. government gains by being able to borrow money from Apple at low rates.

Global Portfolio

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May 15, 2016

Picture the poor investor who leaves a meeting with their financial advisor followed by a Pig-Pen tangle of scribbled terms. Allocation, diversification, small cap, large cap, foreign and emerging markets, Treasuries, corporate bonds, real estate, and commodities. What happened to simplicity, they wonder?  Paper route or babysitting money went into a savings account which earned interest and the account balance grew while they slept.

For those in retirement, it’s even worse. The savings, or accumulation, phase may be largely over but now the withdrawal phase begins and, of course, there needs to be a withdrawal strategy.  Now there’s a gazillion more terms about withdrawal rates,  maximum drawdowns and recovery rates, life expectancy, inflation and other mumbo jumbo that is more complicated than Donald Trump’s changing interpretations of his proposed tax plans.

Seeking simplicity, an investor might be tempted to put their money in a low cost life strategy fund or a target date fund, both of which put investing on automatic pilot.  These are “fund of funds,” a single fund that invests in different funds in various allocations depending on one’s risk tolerance. There are income funds and growth funds and moderate growth funds within these categories.  For a target date fund, what date should an investor use?  It is starting to get complicated again.

Well, strap yourself into the mind drone because we are about to go global.  Hewitt EnnisKnupp is an institutional consulting group within Aon, the giant financial services company.  In 2014, they estimated the total global investable capital at a little over $100 trillion as of the middle of 2013. Let’s forget the trillion and call it $100.

Could an innocent investor take their cues from the rest of the world and invest their capital in the same percentages?  Let’s look again at the categories presented by the Hewitt group.  The four main categories, ranked in percentages, that jump off the page are:

Developed market bonds (23%),
U.S. Equities (18%),
U.S. Corporate Bonds (15%),
and Developed Market equities (14%).

The world keeps a cushion of investable cash at about 5% so let’s throw that into the mix for a total of 75%.   Notice how many categories of investment there are that make up the other 25% of investable capital!

In the interest of simplification let’s consider only those four primary categories and the cash. Adjusting those percentages so that they total 100% (and a bit of rounding) gives us:

Developed Market bonds 30%,
U.S. Corporate Bonds 20%,
U.S. Equities 25%
Developed Market equities 19%,
Cash 6%.
Notice that this is a stock/bond mix of 44/56, a bit on the conservative side of a neutral 50/50 mix.  Equities make up 44%, bonds and cash make up 56%.

I’ll call this the “World” portfolio and give some Vanguard ETF and Mutual Fund examples.  Symbols that end in ‘X’, except BNDX, are mutual funds. Fidelity and other mutual fund groups will have similar products.

International bonds 30% –  BNDX, and VTABX, VTIBX
U.S. Corporate Bonds 20% – BND and VBTLX, VBMFX
U.S. Equities 25% – VTI and VTSAX, VTSMX
Developed Market equities 19% – VEA and VTMGX, VDVIX

According to Portfolio Visualizer’s free backtesting tool this mix would have produced a total return of 5.41% over the past ten years, and had a maximum drawdown (loss of portfolio value) of about 22% during this period.  For a comparison, an aggressive mix of 94% U.S. equities and 6% cash would have generated 7.06% during the same period, but the drawdown was almost 50% during the financial upheaval of 2007 – 2009.

There have been two financial crises in the past century:  the Great Depression of the 1930s and this latest Great Recession.  If the balanced portfolio above could generate almost 5-1/2% during such a severe crisis, an investor could feel sure that her inital portfolio balance would probably remain intact during a thirty year period of retirement.  During a horrid five year period, from 2006-2010, with an annual withdrawal rate of 5%, the original portfolio balance was preserved, a hallmark of a steady ship in what some might call the perfect storm.

Finally, let’s look at a terrible ten year period, from January 2000 to December 2009, from the peak of the dot com bubble in 2000 to the beaten down prices of late 2009, shortly after the official end of the recession.  This period included two prolonged slumps in stock prices, in which they lost about 50% of their value.  A World portfolio with an initial balance of $100K enabled a 5% withdrawal each year, or $48K over a ten year period, and had a remaining balance of $90K. Using this strategy, one could have withdrawn a moderate to aggressive 5% of the portfolio each year, and survived the worst decade in recent market history with 90% of one’s portfolio balance still intact.

Advisors often recommend a 4% annual withdrawal rate as a conservative or safe rate that preserves one’s savings during the worst of times and this strategy would have done just that during this worst ten year period.  Retirees who need more income than 4% may find the World portfolio a conservative compromise.

{ For those who are interested in a more granular breakdown of sectors within asset classes, check out this 2008 estimate of global investable capital.}

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Productivity

In a recent article, Jim Zarroli with NPR compared productivity growth with the weak growth of only the wages component of employee compensation.  He did leave out an increasingly big chunk of total employee compensation: Federal and State mandated taxes, insurances and benefits.  Since these are mandated costs, the income is not disposable. A term I have never liked for this package of additional costs and benefits is “employer burden.”  The burden is really on the employee as we will see.

In the graph below are two indexes: total compensation per hour and output per hour.  At the end of the last recession in the middle of 2009, the two indexes were the same.  Seven years later, output is slightly higher than total compensation but the discrepancy is rather small compared to the dramatic graph difference shown in the NPR article. As output continues to level and compensation rises more rapidly, we can expect that compensation will again overtake output.

Over the past several decades, employees have voted in the politicians who promised more tax-free insurances and benefits.  While the tax-free aspect of these benefits is an advantage, some employees may think they are freebies.  Payroll stubs produced by more recent software programs enable employers to show the costs of these benefits to employees, who are often surprised at the amount of dollars that are spent on their behalf.  While these benefits are welcome, they don’t pay school tuition, the rising costs of housing or repairs to the family car.

Many voters thought they could have it all because some politicians promised it all: more tax-free insurances and benefits, and higher disposable income.  Total employee compensation, though, must be constrained by productivity growth. In the coming decade, legislators will put forth alternative baskets of total compensation.  More benefits and insurances means less disposable income but a politician can not just say that outright and get re-elected. More disposable income means less insurances and benefits, which will anger other voters.  In short, the political discourse in this country promises to only get more contentious.

Portfolio Stability

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February 14, 2016

Disturbed by the recent volatility in the stock market, some investors may be tempted to trade in some of their stock holdings for the price stability of a CD or savings account.  After a year of relatively little change, stock prices have oscillated wildly since China began to devalue the yuan at the beginning of the year.

Just this week, the price of JPMorgan Chase (JPM), one of the largest banks in the world, fell almost 5% one day then rose 7% the next.  Such abrupt price moves in a large multi-national company are driven less by fundamentals and more by fear.  As the price of oil fell below $30, hedge fund and investment managers began to doubt the safety of bank loans to energy companies, particularly those smaller companies whose fortunes have risen recently during the fracking boom.  Even if these types of loans were a miniscule portion of JPM’s total loan portfolio, investors remember that the financial crash began in 2007 with growing defaults of home loans that started a financial chain reaction of derivatives that blew up.  Sell, sell, sell, then buy, buy, buy.

Price stability is a term usually associated with measurements of inflation like the Consumer Price Index (CPI). A basket of typical goods is priced each month by the BLS and the changes in those prices are charted.  Each of us has a basket of investment goods that have varying degrees of price stability.  Stock prices vary a lot;  bond prices less so; house prices even less.  Cash type instruments like savings accounts and CDs have no nominal variation.

Each of us desires some degree of stability as we chug through the waters of our lives.  Like a ship we must make a tradeoff between speed and stability.  A stable ship must compromise between the depth and breadth of its keel, that part of the ship which is below water.  A deep keel provides stability but puts the ship at the risk of running aground in shallow water.  A broad keel is stable but increases the water’s drag, slowing the ship. (Cool stuff about ships)

It is no surprise that stocks provide the power to drive our investment ship.  Few investors realize that housing assets provide more power and stability than bonds.  We judge stability by the rate with which the price of an asset changes.  The slower the price change, the more stable the asset.  Over decades, residential housing has better returns and steadier pricing than bonds, although that might surprise readers who remember the housing bubble and its aftermath.

Many investors include the value of their home in their net worth but not necessarily in their investment portfolio and may underestimate the stability of their portfolio. Let’s imagine an investor with $750,000 in stocks, bonds, CDs, savings accounts and the cash value of a life insurance policy.  Let’s say that $375K is invested in stocks, $375K in bonds and cash equivalents.  That appears to be a middle of the road allocation of 50/50 stocks/bonds.  I will use bonds as a stand in for less volatile investments.

Let’s also assume that this investor has a house valued at $215K with no mortgage.  If we add in the $215K value of the house, we have a total portfolio of $965K and a conservative allocation closer to 40/60 stocks/bonds, not the 50/50 allocation using a more standard model.

We arrive at a conservative estimate of a house value based on the income or rental value that the house can generate, not the current market value of the house, which can be more volatile.  In previous posts, I have noted that houses have historically averaged 16x their annual net operating income, which is their gross annual rental income less their non-mortgage operating expenses. For real estate geeks, this multiplier is 1 divided by the cap rate.

Let’s use an example to see how this multiplier works.  Let’s say that the going rent for a modest sized house is $1600 per month and we guesstimate an average 30% operating expense, leaving a net monthly income of $1120.  Multiplying that amount by 12 months = $13,440 annual net operating income.  Multiply that by our 16x multiplier and we get a valuation of $215K.  Depending on location, this house might have a market value of $260K but we use  historic income multiples to calculate a conservative evaluation.

Our revised portfolio provides a more comprehensive perpective on our investment allocation and the stability of our “buckets.” During the past year, we may have seen a 5 – 10% increase in the value of our home, offsetting some of the apparent riskiness of a 10% or 20% move in the stock market.  Adjusting our portfolio assessment to allow for a home’s value might reveal that our stock allocation is actually a bit on the low side after the recent market decline and – quelle horreur! – we should be selling safer assets and buying stocks to maintain our target portfolio balance.  But OMG, what if stocks fall further?!  Then we might have to buy even more stocks to meet our target allocation percentages!  This is the essential strategy of buying low and selling high, yet it is so counterintuitive to our natural impulses.  We buy some assets when we are fearful of them.  We sell other assets when we think they are doing well.

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For anyone interested in housing as a business, the Wall St. Journal published a comprehensive guide, Wall St. Journal Complete Real Estate Investing Guidebook by David Crook in 2006. Recently, Moody’s noted that apartment building cap rates had declined to 5.5%, resulting in a multiplier of 18x that is above historical norms.

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Glootch or Glut?

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March 15, 2015

Retail

Indicators of business activity and confidence have all been strong.  The Purchasing Managers Index, the monthly employment report, and the NFIB small business index have shown exceptional strength in the past several months.  A week after a strong employment report came the worrisome news that retail sales declined for the third month.

A 2% drop in auto sales was the primary driver of February’s decline but the lack of demand is evident in the broader economy.  Excluding auto sales this is the second three month period of declining sales since the recovery began.  Following the slump in 2012, the SP500 sagged about 7%.  The market’s response to this slump has been muted so far.

American businesses had hoped that their customers would spend the dollars saved at the gas pump but consumers may be tucking away some of that cash. The slowdown in retail sales may be partly due to the harsh winter in the east, or a lack of income growth.  The strong dollar has made American products more expensive to export so businesses are especially dependent on domestic demand. Since last summer, prices at the wholesale level have declined steadily.  Commodities other than oil are also showing slack demand.

The inventory to sales ratio has climbed abruptly in the last half of the year.  Businesses make their best guess in anticipating future demand.  A capitalist economy is based on the decision making of millions, not a central committee of a few.  If inventories continue to mount, we can expect that businesses will adjust to the new environment and rein in production and expansion plans.

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Retirement

Twenty years ago I read articles on portfolio diversification like this one and was glad that I wasn’t old enough to be concerned about that kind of stuff.  Then one morning I was shaving and noticed that I was developing a slight turkey wattle in my neck, the same thing I had noticed in my Dad. OMG! I was getting old!
A Bankrate.com blog post features a chart of savings goals that a person at each stage of life should have accumulated to ensure that they can maintain their living standard in retirement.  The benchmarks are based on one’s current income.  Many Americans do not even meet these modest goals.  According to the chart, a person making $60K  who retires at 67 should have $500K in savings and investments.  
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Apple
Telephone and radio were the high tech firms of the early 20th century.  In 1916, ATT was added to the Dow Jones Industrial Average (DJIA), acknowledging that the company had become a pillar of the American economy. 
At the close of trading on March 18th, almost a hundred years later, ATT will be dropped from the DJIA and replaced by Apple, a high tech firm of the 21st century.  Apple’s projected earnings growth for this year may cancel out the anticipated negative earnings growth of the DJIA but Apple is a more volatile stock than stodgy ATT so daily price changes in the index are likely to be a bit more dramatic.
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Budgeting
Last week, economist Greg Mankiw wrote a piece in the New York Times explaining the recent change from static to dynamic budget scoring in the new Congress.  These are two different methods for estimating the effects of proposed tax changes on the budget over the following ten years.  Static scoring, the previous system, has been in place for decades and assumes no changes to the economy resulting from the proposed tax changes.  Dynamic scoring estimates changes in GDP and revenues resulting from the tax changes. Several examples illustrate differences between the two types of scoring.  The article is well written and easy to understand without the use of complicated economic models.

Dance Partners

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January 18, 2015

When investors are grumpy, good news is not good enough or it is too good.  Confidence among small businesses climbed to levels not seen since late 2006 and the positive sentiment was broadly based, including new hiring and plans for expansion.

On the other hand…December’s 9/10% decline in retail sales was a surprise after a strong November.  However, a closer look at the retail figures shows some real positives.  The year-over-year gain was 2.6%, above the 1.7% core inflation rate, indicative of modestly  growing demand.

Excluding retail gas sales, retail sales gained 4.8% over last year.

Now, let’s put gas sales in some historical perspective.  In January 2007, the price of a gallon of gasoline was $2.10, about the same as it is now.  On average, we are driving more fuel efficient vehicles than in 2007, yet total retail gas sales are 25% higher now.

Every six weeks, the Federal Reserve releases their Beige Book survey of economic conditions around the country.  They also reported moderate growth in employment and sales.  They noted that flat wage growth and low inflation reduces any urgency in raising rates.  Friday’s release of the CPI confirmed the low inflation rate.  Including gas and food, the yearly increase was only .7%.  Core inflation, which excludes gas and food prices, rose 1.7%.  Consumer sentiment is nearing the levels of the early to mid-1980s, the beginning of a period of strong growth.

For now, stocks and oil prices are dance partners.  In a week of negative sentiment, traders were watching the 1975 level on the SP500.  This was mid-December’s bottom, a short-term key level of support.  After Thursday’s close near 1990, stocks rallied on the strong consumer sentiment and a report from the International Energy Agency that lower prices are causing some oil production cuts. Fourth quarter earnings season has just begun but if volatility in oil prices remains strong, this may drive market sentiment at least as much as earnings reports.

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Job Openings (JOLTS)

November’s job openings showed a slight increase, getting ever closer to the 5 million mark and nearing an all time high set in the beginning of 2001 as the dot-com boom was ending.  This summer open positions surpassed the mark set in June 2007 at the end of the housing boom.

The  economy grows stronger on many fronts – labor, retail, housing and industrial production – and is near multi-year high marks without the help of a widespread boom in any one sector of the economy.  The surge in oil  shale production is confined to a few states.

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Portfolio Allocation

As the market remains somewhat volatile, it’s time to revisit a familiar theme – allocation.  Let’s look at a selection of portfolios with moderate allocation. How much difference has there been between a portfolio with 60% stocks and 40% bonds (60/40), and one with 40% stocks, 60% bonds (40/60)?

Earlier in the year, I mentioned a site  that can backtest a pretend portfolio.  In the free version, the re-balancing rules are fairly simple but it does allow us to make some comparisons of long term trends.

All of the following tests include the years 2000 – 2014, a period which covers two downturns.  The first, from 2000 to 2003, was a protracted decline after the dot com bubble.  The second, from late 2007 to 2009, was severe.

The test includes an annual re-balancing to get to the target percentages, and assumes a modest investment of $100 each year into a $10,000+ portfolio.  Because of the two downturns, it’s no surprise that the portfolio weighted toward bonds did better than the portfolio weighted toward stocks.

The difference between the 60/40 and 40/60 was about 7/10% in annual return.  If we were to use intermediate term bonds as a proxy for the bond component of the portfolio, the difference would be even less.  In the middle range of allocation models, the differences in returns over a long period of time are probably smaller than what we worry about.

The importance of moderate allocation is illustrated by the following two examples.  Let’s consider the period from 1995 – 2014, which includes three market rises and two downturns.  Note the ratio: three up to two down.  If we compare a portfolio of all stocks to a balanced portfolio of 50% stocks and 50% long term bonds, we see that it is only in the past five years that the all stock portfolio finally meets the return of the balanced portfolio.

Long term bonds are especially sensitive to changes in interest rates so let’s look at a balanced portfolio of stocks and intermediate term bonds.

In this case, it is only in the past two years that the total return of the all stock portfolio has outperformed the balanced portfolio.  One of the those years included an unusual 30% gain in one year.  In short, it is hard to argue against a balanced portfolio over a long period of time.

Lastly, the example below shows a slight advantage to re-balancing a portfolio.  However, the additional .2% gain each year should not cause us to lose sleep if we forgot to do this for a few months.

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Oil Prices

Oil suppliers are pumping down their inventories as global demand for oil weakens.  More product, less demand = lower prices. In a standard economic model, customers want more of a good at a lower price.  Suppliers are less willing to supply a good at a lower price.  Eventually, suppliers and customers reach an equilibrium at a certain price.

What happens in a price war does not follow this simplified textbook model.  Suppliers with deep reserves try to drive out other suppliers by flooding, or at least over supplying, the market, thus driving the price down.  More units are bought but at lower prices, so the value of gross sales may be lower even though the units sold is higher than before.  The profit on each unit sold, or marginal profit, gets lower and may get negative for a time till the more vulnerable suppliers leave the market.

The governments of Venezuela, Russia and Nigeria depend on oil revenues for much of their income.  Should oil prices stay below $50 for half a year or more, these countries will be pressed to curtail social benefit programs and infrastructure projects.  The interest rates on their bonds will increase as investors price in a greater risk of default.

Sudden changes produce fractures.  Fractures produce frictions. Frictions dissipate in a cascade of minor adjustments or suddenly in a violent upheaval.