Place Your Bets

January 6, 2019

by Steve Stofka

This will be my tenth year writing on the financial markets. As I’ve written in earlier posts, we’ve been sailing in choppy waters this past quarter. In 2018, a portfolio composed of 60% stocks, 30% bonds and 10% cash lost 3%. In 2008, that asset allocation had a negative return of 20% (Note #1). We can expect continued rough weather.

If China’s economy continues to slow, the trade war between the U.S. and China will stall because a slowing global economy will give neither nation enough leverage. Will the Fed stop raising interest rates in response? If there is further confirmation of an economic slowdown, could the Fed start lowering interest rates by mid-2019? Ladies and gentlemen, place your bets.

Thanks to good weather and a strong shopping season, December’s employment reports from both ADP and the BLS were far above expectations (Note #2). Wages grew by more than 3%. Will stronger wage gains cut into corporate profits? Will the Fed continue to raise rates in response to the strong employment numbers and wage gains? Ladies and gentlemen, place your bets.

The global economy has been slowing for some time. After a 37% gain in 2017, a basket of emerging market stocks lost 15% last year. Although China’s service sector is still growing, it’s manufacturing production edged into the contraction zone this past month (Note #3). Home and auto sales have slowed in the U.S. What is the prospect that the U.S. could enter a recession in the next year? Ladies and gentlemen, place your bets.

The partial government showdown continues. The IRS is not processing refunds or answering phones. If it lasts one more week, it will break the record set during the Clinton administration. Trump has said it could go on for a year and he does like to be the best in everything, the best of all time. Could the House Democrats vote for impeachment, then persuade 21 Republican Senators (Note #4) to vote for a conviction and a Mike Pence Presidency? Ladies and gentlemen, place your bets.

When the winds alternate directions, the weather vane gets erratic. This week, the stock market whipsawed down 3% one day and up 3% the next as traders digested the day’s news and changed their bets. Interest rates (the yield) on a 10-year Treasury bond have fallen by a half percent since November 9th. When yields fell by a similar amount in January 2015 and January 2016, stock prices corrected 8% or so before moving higher. Since early December, the stock market has corrected by a similar percentage. Will this time be different? Ladies and gentlemen, place your bets.

Staying 100% in cash as a long-term investment (more than five years) is not betting at all. From a stock market peak in 2007 till now, an all cash “strategy” earned less than 1% annually. A balanced portfolio like the one at the beginning of this article earned a bit less than 6% annually. Older investors may remember the 1990s, when a person could safely earn 6% on a CD. Wave goodbye to those days for now and place your bets.

///////////////////////////

Notes:

  1. Portfolio Visualizer results of a portfolio of 60% VTSMX, 30% VBMFX and 10% Cash
  2. Automatic Data Processing (ADP) showed 271,000 private job gains. The Bureau of Labor Standards (BLS) tallied over 300,000 job gains.
  3. China’s manufacturing output in slight contraction
  4. The Constitution requires two-thirds majority in Senate to convict an impeached President. Currently, there are 46 Democratic Senators and Independents who caucus with Democrats. They would need to convince 21 Republican Senators to vote for conviction to get a 67 Senator super-majority. 22 Republican Senators are up for re-election in 2020 and might be sensitive to public sentiment in their states.

Stormy Seas

December 23, 2018

by Steve Stofka

For the past two months, the stock market’s volatility has doubled from late summer levels. The Fed announced its intent to continue raising interest rates in 2019 at least two times, and the market nosedived in response. It had been expecting a more dovish policy outlook from Chair Jerome Powell.

What does it mean when someone says the Fed is dovish, or hawkish? Congress has given the Fed two mandates: to manage interest rates and the availability of credit to achieve low unemployment and low inflation. That goal should be unattainable. In an economic model called the Phillips curve, unemployment and inflation ride an economic see-saw. One goes up and the other goes down. To rephrase that mandate: the Fed’s job is to keep unemployment as low as possible without causing inflation to rise above a target level, which the Fed has set at 2%.

There are periods when the relationship modeled by the Phillips curve breaks down. During the 1970s, the country experienced both high unemployment and high inflation, a phenomenon called stagflation. During the 2010s, we have experienced the opposite – low inflation and low unemployment, the unattainable goal.

Convinced that low unemployment will inevitably spark higher inflation, the Fed has been raising interest rates for the past two years. The base rate has increased from ¼% to 2-1/2%. The thirty-year average is 3.15%. Using a model called the Taylor Rule, the interest rate should be 4.12% (Note #1).  After being bottle fed low interest rates by the Fed for the past decade, the stock market threw a temper tantrum this past week when the Fed indicated that it might raise interest rates to average over the next year. Average has become unacceptable.

FedFundVsTaylorRule

In weighing the two factors, unemployment and inflation, the Fed is dovish when they give greater importance to unemployment in setting interest rates. They are hawkish when they are more concerned with inflation. The Fed predicts that unemployment will gradually decrease to 3.5% this coming year. Unemployment directly affects a small percentage of the population. Inflation affects everyone. The Fed’s current policy stance is warily watching for rising inflation.

The stock market is a prediction machine that not only guesses future profits, but also other people’s guesses of future profits. As the market twists and turns through this tangle of predictions, should the casual investor hide their savings in their mattress?

These past five years may be the last of a bull market in stocks; 2008 – 2012 was the five-year period that marked the end of the last bull period that began in 2003 and ran through most of 2007. Here are some comparisons:

From 2014-2018, a mix of stocks returned 7.7% per year (Note #2). A mix of bonds and cash returned 1.96%. A blend of those two mixes returned 4.91% per year.

From 2008-2012, that same stock mix returned just 2.66% per year. The bond and cash mix returned 5.5%, despite very low interest rates. A blend of the stock and bond mixes returned 5.26%.

For the ten-year period 2008 thru 2017, the stock mix earned 7.7%. The bond and cash mix returned 3.54% and the blend of the two gained 6.35% annually. On a $100 invested in 2008, the stock mix returned $13.5 more than the blend of stocks and bonds. However, the maximum draw down was wrenching – more than 50%. The $100 invested in January 2008 was worth only $49 a year later. Whether they needed the money or not, some people could not sleep well with those kinds of paper losses and sold their stock holdings near the lows.

The blend of stock and bond mixes lost only a quarter of its value in that fourteen-month period from the beginning of 2008 to the market low in the beginning of March 2009. The trade-off between risk and reward is an individual decision that weighs a person’s temperament, their outlook, and the need for to tap their savings in the next few years.

A rough ride in stormy seas tests our mettle. During the market’s rise the past eight years, we might have told ourselves that our stock allocation was fine because we didn’t need the money for at least five years.  If we are not sleeping because we worry what the market will do tomorrow, then we might want to lower our stock allocation. Sleeping well is a test of our portfolio balance.

///////////////////

Notes:
1. The Atlanta Fed’s Taylor Rule calculator
2. Calculations from Portfolio Visualizer: 30% SP500, 30% small-cap, 20% mid-cap, 20% emerging markets. Bond mix: 70% intermediate term investment grade bonds, 30% cash. The blend of the two was half of each percentage: 15% SP500, 15% small-cap, 10% mid-cap, 10% emerging markets, 35% bonds, 15% cash.

Spring Cleanup

March 11, 2018

by Steve Stofka

Today time springs forward. Tufts of grass turned green, and some trees are beginning to bud. It was still light after 6 P.M. even before the time change. Great flocks of cranes fly north. In the springtime evening we can hear the siren call of the booby headed tax deadline.  2017 IRA contributions are due by April 15th.

This is a good time to check our game plans. Are we saving enough? In the accumulation, or pre-retirement, phase, 10% or more of our income is a good savings goal. 5% is an absolute minimum. Savings should be used to pay down any debt that has an interest rate more than 5%. High interest rate loans are a weight we must drag around with us. Consider working part time for a while and using that money to pay down high interest rate debt.

New car loans now average over $30K with an average maturity (length of payment period) of 67 months. The average interest rate is 4.21% but anyone with less than a FICO score of 690 is paying 5% or more. This article has breakdowns by credit score, lending institution, length of loan, and other factors.

Of the money we have saved – any annual portfolio realignments to be done? This is a good time to not only think about it but to do it.

In the distribution phase of a portfolio, we begin to withdraw funds from the portfolio that we have accumulated through a lifetime of saving.  Using Portfolio Visualizer, I’ve compared two portfolios with a 60/40 mix – 60% stocks, 40% bonds and cash.  These backtests include an annual rebalancing that may be more difficult for funds in a taxable account because buying and selling may generate taxable capital gains.

Let’s pretend a person retired in May of 1998 at the age of 68 and just died last year. During this twenty years, there were two times when the stock market fell 50%. The beginning year 1998 is near a high point in the stock market. The ending year 2017 was the 8th year of the current bull market. The test begins and ends at strong points in the market cycle, a key feature of a test like this.  Beginning a backtest with a trough in the market cycle and ending with a peak only distorts the results.

Portfolio

At the time of retirement, our retiree had a $1 million portfolio, although the amount could have been $100,000 or $10 million.

Portfolio6040

Although the stock allocation is the same for both portfolios, Portfolio 2 is totally simple. Put all the money in Vanguard’s Total Stock Market fund and forget about it. Portfolio 1 manually diversifies the 60% stock portion of the portfolio among four classes: Large capitalization, mid cap, small cap value stocks in the U.S., and European large cap stocks. Think of Goldilocks sitting down to a table with four bowls of soup – big, medium, small and European.  If that person retired today, a diverse stock portfolio would include an emerging markets index fund like Vanguard’s VEIEX.  In 1998,  emerging markets were not part of a core portfolio as they are today.  For this test, I left out emerging markets.

The bond portion of the portfolio is an index fund of the total bond market. Both portfolios hold 10% in cash for emergencies and living expenses.

Income

A portfolio is like snow in the Rocky Mountains that melts and flows toward the Pacific Ocean. Will the water make it to the ocean? Each year this retiree withdrew 4% of their portfolio balance for expenses. That percentage is considered safe during most twenty-year retirement periods. Note that some advisors are using a thirty-year retirement period to test a portfolio mix. As the years go by and the purchasing power of a $1 erodes, will 4% be enough to meet a retiree’s income needs? The more diverse portfolio allowed the retiree to withdraw a larger amount every year, and the annual withdrawal did keep up with inflation.  Secondly, the ending balance was about the same as the beginning balance after adjusting for inflation.

PortfolioWithdrawal6040

Return

The more diverse Portfolio 1 (marked complex in graphic below) has a better return over this twenty-year period. See the Internal Rate of Return (IRR) column, which adjusts for the withdrawal amounts each year.

PortfolioReturns6040
The drawdown, or greatest decline in value, in the time series is a critical test of a portfolio mix. The retiree needs that portfolio to generate a certain amount of income every year. If the portfolio falls to zero, the income stream has dried up. In the chart below, look at the dip in the portfolio value during the 2008 Financial Crisis. The more diverse Portfolio 1 (blue line) dipped below the starting $1 million figure, but not by much. The investor who was 100% invested in the stock market, the 500 Index portfolio (yellow line), fared the worst during most of the twenty-year period.  In a sign that the bull market has matured, the 500 Index has overtaken the simple 60/40 mix (red line) and is about to overtake the diversified 60/40 mix (blue line).

PortfolioGrowth6040
The diverse portfolio is not complex. There are no gold or commodity assets, no energy or natural resource funds, and no real estate REITs to manage.  If emerging markets were added to the Goldilocks mix, there would now be five equal bowls of soup, each of them taking 12% of the portfolio. This portfolio would have earned 4/10% better each year.

PortfolioEM6040

We could add a Pacific stock index like Vanguard’s VPACX to the mix, but when do we stop adding indexes? In this time period, that index had a slight negative effect on returns. As the number of indexes grow, we are less likely to adjust our allocation.

Our portfolios can get cluttered and too complicated to be effective and easily managed.  Can we simplify?  It’s worth a look see. In taxable accounts, de-cluttering and re-balancing can generate taxable capital gains, so it might not be advisable to make any changes.

Stress Test

February 11, 2018

by Steve Stofka

The recent market correction, defined as a 10% decline, has been a real time stress test for our portfolios. There hasn’t been a stock market correction since the 11% drop in December 2015 to January 2016. Because the end of January was near the height of the stock market, you can more easily find out how much your portfolio declined relative to the market. As of the close Friday, the SP500 had fallen 7.2% since the end of January. That is your benchmark. Later in this blog, I’ll review a few reasons for the decline.

You can now compare the decline in your portfolio to that of the market.  If you use a personal finance program like Quicken, this is an easy task. If you don’t, then follow these steps:
1) Write down your January ending balances at your financial institutions, including any savings accounts or CDs that you own.
2) Write down the current balances and calculate the difference in value since the end of January.
3) Divide that difference by the balance at the end of January to get a percentage decline.

For instance, let’s say your balances at the end of January added up to $100K and your current balance is $95K (Step 1). The difference is $5K (Step 2). Your portfolio has declined 5% (Step 3) compared to the market’s 7.2%, or about 70% of the market. If the market were to fall 50% as it did from 2000-2002 and 2007-2009, you could expect that your portfolio would fall about 35%. Are you emotionally and financially comfortable with that? A safety rule of investing is that any money you might need for the next five years should not be invested in the stock market.

The next step is to compare the gains of your portfolio in 2017 to the market’s gain, about 24%. The gain should be approximately the same as the loss percentage you calculated above. If the gain is slightly more than the losses, you have a good mix.

The chart below compares two portfolios over the past ten years: 1) 100% U.S. stock market and 2) 60% stocks/ 40% bonds (60/40 allocation). Notice that the best and worst years of the 60/40 portfolio are nearly the same while the best year of the 100% stocks is 10% less than the worst year.

StressTest2008-2017
The 60/40 portfolio captured 80% of the profits of the 100% stock portfolio ($101,532 / $128,105) but had only 60% of the drawdown, or decline in the portfolio. Compare that with the chart below, which spans only nine years and leaves out most of the meltdown of value during the Financial Crisis. There is no worst year! La-di-da! Investors who are relatively new to the stock market may underestimate the degree of risk.

StressTest2009-2017
The 60/40 portfolio captured 58% of the profits of the 100% stock portfolio ($152,551 / $262,289) but the drawdown was 63% (11.15% / 17.84%).  If the drawdown is more than the profits, that doesn’t look like a very good deal for the 60/40 portfolio, does it?  That is how bull markets entice investors to take more risk than might be appropriate for their circumstances.  Come on in, the water’s fine!  An investor might not see the crocodiles. Markets can be volatile. This has been a good reminder to check our portfolio allocation.

///////////////////

Why?

So, why did the market sell off? Let me count the ways. It began on Friday, February 2nd, when the monthly labor report showed an annual gain of 2.9% in hourly wages. For much of this recovery, economists have been asking why wage growth was sluggish as unemployment fell. Economists who like their idealized mathematical models don’t like it when reality disagrees with those models. Finally, wage growth showed some healthy gains and the market got spooked. Why?

As wages take more of the economic pie, profits decline. Companies respond by raising prices, i.e. higher inflation. As interest rates rise, there are several negative consequences. Companies must pay more to borrow money. Fewer consumers can afford mortgages.  Homebuilders and home improvement centers like Home Depot and Lowe’s may see a decline in sales. Car loans become more expensive which can cause a decline in auto sales. There is one caveat: even though hourly wages increased, weekly earnings remained stable because weekly hours declined slightly.  Next month’s reports may show that inflation concerns were overestimated.

This past Monday, ISM released their monthly survey of  Non-Manufacturing businesses and it was a whopper. 8% growth in new orders in one month. Over 5% growth in employment. These are two key indicators of strong economic growth, and confirmed  the fears stirred up the previous day’s labor report. Inflation was a go and traders began to sell, sell, sell.

For the past year, market volatility was near historic lows. Volatility is a measure of the predictability of the pricing of SP500 options. A profitable tactic of traders was to “short” volatility, i.e. to bet that it would go lower. There were two exchange traded funds devoted to this: XIV and SVXY. Traders who bought XIV at the beginning of 2017 had almost tripled their money by the end of the year. When volatility tripled this past week, the whole trade blew up. People who had borrowed to make these bets found that their brokers were selling assets to meet margin calls.  Within days, XIV was closed and investors were given 4 cents on the dollar. SVXY may soon follow. Investors had been warned that these products could blow up. Here’s one from 2014.

The stock market is both a prediction of future profits and a prediction of other investor’s predictions of future profits! The prospect of stronger interest rate growth caused traders to reprice risks and returns. Much of the impact of the selling this past week was in the last hour on Monday and Thursday, when machine algorithms traded furiously with each other. The last hour of trading on Monday saw an 800 point, or 3% , price swing in just a few minutes. In the closing ten minutes of that hour, Vanguard’s servers had difficulty keeping up with the flow of orders.

Contributing to the decline were worries over the government’s debt.  The new budget deal signed into law this week will likely increase the yearly deficit to more than $1  trillion.  There was soft demand for government debt at this week’s Treasury bill auction.  Even without a recession in the next ten years, the accumulation of deficits will increase the total debt level to about $33 trillion.

This correction is an opportunity for the casual investor to make some 2017 or 2018 contributions to their IRA. Profit growth is projected to be strong for the coming year. The correction in prices this week has probably brought the forward P/E ratio of the SP500 to just below 20, a more affordable level that we haven’t seen in few years.

 

Ten Year Review

January 14, 2018

by Steve Stofka

To ward off any illusions that I am an investing genius, I keep a spreadsheet summarizing the investments and cash flows of all my accounts, including savings and checking. Each year I compare my ten year returns to a simple allocation model using the free tool at Portfolio Visualizer. Below is a screen capture showing the ten-year returns for various balanced allocations during the past several years.

10YrReturn20180112
The two asset baskets are the total U.S. stock market and the total U.S. bond market. A person could closely replicate these index results with two ETFs from Vanguard: VTI and BND. Note that there is no exposure to global stocks because Portfolio Visualizer does not offer a Total World Stock Asset choice in this free tool. An investor who had invested in a world stock index (Vanguard’s VT, for example) could have increased their annual return about 1.3% using the 60/40 stock/bond mix.

I include my cash accounts to get a realistic baseline for later in life when my income needs will require that I keep a more conservative asset allocation. An asset allocation that includes 10% cash looks like this.

10YrReturnStkBondCash20180112
In the trade-off between return and risk, a balanced portfolio including cash earns a bit less. In 2017, the twenty-year return was not that different from the ten-year return. From 2009 through 2011, ten-year returns were impacted by two severe downturns in the stock market.

//////////////////////

The Hurt

Falling agricultural prices for seven years have put the hurt on many farmers. This decade may turn out to be as bad as the 1980s when many smaller farms went belly up because of declining prices. Remember the Farm Aid concerts?

The Bloomberg Agriculture Index has fallen about 40% over the past five years. While farmers get paid less for their produce, the companies who supply farmers with the tools and products to grow that produce are doing reasonably well. A comparison of two ETFs shows the divergence.

DBA is a basket of agricultural commodity contracts. It is down 33% over the past five years.
MOO is a basket of the stocks of leading agricultural suppliers. The five-year total return is 31%.

The large growers can afford to hedge falling prices. For family farmers, the decline in agricultural prices is a cut in pay. Imagine you were making $25 per hour at the beginning of 2017 and your employer started cutting your pay bit by bit as the year progressed? That’s what its like for many smaller farmers. They work just as hard and get paid less each year.

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?

/////////////////////

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.

//////////////////

California

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

Global Portfolio

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.}

////////////////////////////

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.