Comprehensive Money Management

Bill's Blog

Broken Eggs

We face a looming retirement crisis that will impact millions of elderly and soon-to-be elderly Americans, as well as our children and grandchildren who will have to bail out those generations.

The Facts:

Overall Population

·        78% of Americans live paycheck to paycheck.

·        1 in 4 don’t set aside anything for savings each month.

·        Nearly 3 in 4 say they’re in debt, and over ½ say they think they will always be.

·        Nearly 8 in 10 of Americans are “extremely” or “somewhat” concerned about affording a comfortable retirement while two-thirds believe there is some likelihood of outliving retirement savings. (Northwestern Mutual) 

Pre-Retirees

·         48% of households in America headed by individuals at least age 55 have no retirement savings. 

·        In order to maintain our standard of living post-retirement, we need to have saved at least 11 times our income by age 65. That means saving 15 percent to 17 percent of income across your working life. (Research done by Aon Hewitt and the University of Georgia)

·        60% of pre-retirees in America aren’t on track to achieve even 8 times projected income, a very conservative estimate of bare bones retirement preparedness (National Institute of Retirement Preparedness) 

·        We face a looming retirement crisis that will impact millions of elderly and soon-to-be elderly Americans, as well as our children and grandchildren who will have to bail out those generations.

·        By 2035, and for the first time in U.S. history, Americans over the age of 65 will outnumber our children.  With increasing deficits as far as the eye can see, its unlikely that our kids will be up to that challenge. 

·        The US government is currently spending $1 trillion more every year than it takes in.  With the bulk of that going to defense, social security, Medicare and interest on our $22 trillion in debt, it’s a mathematical certainty that taxes will be higher for future generations than they are today.

·        Even those who think that they are okay may be at risk.  More Americans in history have placed their retirement nest eggs in a single basket – US stocks.  The current bull market is now the second longest in US history and US stocks have never been this expensive by almost any measure.  That begs the question.  What will happen to their nest eggs when a recession strikes and they have no time to recover?

How Did This Happen: 

·        Steadily growing life expectancies is one reason.  Someone who retired in the 1950s probably didn’t expect to live beyond their late 60s or early 70s, but odds are now about 50-50 that someone retiring today will live into their 90s.

·        There has been a dramatic widening of the wealth gap between the top 20% and the rest of America.  While America as a whole has been getting richer, the vast majority of Americans have not.  The 540 billionaires in the US now control 64% of all US wealth.  These 540 people, which could easily fit in an average size movie theater, now have more wealth than the bottom 240 million Americans combined. 

·        For the majority of those 240 million people, the cost of living has risen much more dramatically than incomes.

Average Americans are treading water:  “Despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”  --  Pew Research Center 

But the problem isn’t just the cost of living due to inflation; it’s that the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.

Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $65,000 was found to be the optimal income for “feeling” happy. In other words, this was a level where bills were met and there was enough “excess” income to enjoy life. (However, that $65,000 was based on a single individual. For a “family of four” in the U.S., that number was $132,000 annually.) 

Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58,000.

Skewed by the 1%

The issue with the Census Bureau’s analysis is that the income numbers are heavily skewed by those in the top 20% of income earners. For the bottom 80%, they are well short of the incomes needed to obtain “happiness.” 

The chart below shows the “disposable income” of Americans from the Census Bureau data. (Disposable income is income after taxes.)

So, while the “median” income has broken out to all-time highs, the reality is that for the vast majority of Americans there has been little improvement. So, if you are in the Top 20% of income earners, congratulations. If not, it is a bit of a different story.

No Money, But I Got Credit

As noted above, sluggish wage growth has failed to keep up with the cost of living which has forced an entire generation into debt just to make ends meet.

While savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of “disposable income” for that same group. As a consequence, the inability to “save” has continued.

So, if we assume a “family of four” needs an income of $58,000 a year to “just get by”, that becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.” 

The “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3300 annual deficit that cannot be filled.

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth and historically low unemployment rates.

The mirage of consumer wealth has not been a function of a broad increase in the net worth of Americans, but rather a division in the country between the Top 20% who have the wealth and the Bottom 80% dependent on increasing debt levels to sustain their current standard of living.

Nothing brought this to light more than the Fed’s own report on “The Economic Well-Being Of U.S. Households.” The overarching problem can be summed up in one chart:

More Money

Of course, by just looking at household net worth, once again you would not really suspect a problem existed. Currently, U.S. households are the richest ever on record. The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.

However, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans. 

Despite the mainstream media’s belief that surging asset prices, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy, it has really been anything but. Given the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same – “if you are wealthy – life is good.”

The illusion by many of ratios of “economic prosperity,” such as debt-to-income ratios, wages, assets, etc., is they are heavily skewed to the upside by the top 20%. Such masks the majority of Americans who have an inability to increase their standard of living. The chart below is the debt-to-disposable income ratios of the Bottom 80% versus the Top 20%. The solvency of the vast majority of Americans is highly questionable and only missing a paycheck, or two, can be disastrous.

While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.

It is hard to make the claim the economy is on the verge of acceleration with the underlying dynamics of savings and debt suggesting a more dire backdrop. It also goes a long way in explaining why, as stated above, the majority of Americans are NOT saving for their retirement.

“In addition, many workers whose employers do offer these plans face obstacles to participation, such as more immediate financial needs, other savings priorities such as children’s education or a down payment for a house, or ineligibility. Thus, less than half of non-government workers in the United States participated in an employer-sponsored retirement plan in 2012, the most recent year for which detailed data were available.”

But more importantly, they are not saving on their own either for the same reasons.

“Among filers who make less than $25,000 a year, only about 8% own stocks. Meanwhile, 88% of those making more than $1 million are in the market, which explains why the rising stock market tracks with increasing levels of inequality. On average across the United States, only 18.7% of taxpayers directly own stocks.”

With the vast amount of individuals already vastly under-saved, the next major correction will reveal the full extent of the “retirement crisis” silently lurking in the shadows of this bull market cycle.

This isn’t just about the “baby boomers,” either.

Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents.

In turn, parents are now part of the “sandwich generation” who are caught between taking care of kids and elderly parents.

But the real crisis will come when the next downturn rips a hole in the already massively underfunded pension funds on which many American’s are now solely dependent.

For the 75.4 million “boomers,” about 26% of the population, heading into retirement by 2030, the reality is that only about 20% will be able to actually retire.

The rest will be faced with tough decisions in the years ahead.

What Can We Do?

·        First, individuals and families must make saving for retirement a priority. It can be difficult to think about your 401(k) or IRA when you're living paycheck to paycheck, but putting a little bit away each month will make all the difference. The earlier you start saving, the better off you'll be 

·        The long-term solution lies in the adage "time is money," or at least the opportunity to make money.  If you put in a little bit in savings each year starting at a young age, it will add up to a lot of money by the time you're 65 years old – and much more than if you start saving for retirement when you're 40 or 50 years old. 

·        A recent CNBC.com article showed the benefits of starting saving for retirement at 25 or 30 years old.  A $650 monthly deposit into a 5 percent compounding account will yield $1 million after 40 years.  A little over $10 dollars a day (the price of an average dine-in lunch) would yield half a million dollars.  Run those same numbers over a 20-year period, and the results are $267,000 and $132,000, respectively.  

·        The answer is obvious: start saving early, even if it's a small amount, and get regular tax-free savings.

·        The last day for 2018 contributions to your Roth IRA is April 15th.

   Congress must act as well. 

·        This retirement crisis is not news for policy makers. 

·        Senators Tom Cotton (R-AR), Cory Booker (D-NJ), and Todd Young (R-IN) have developed a bipartisan package of common-sense bills that would help boost retirement security for individuals and families. It was strongly endorsed by the Bipartisan Policy Center. I hope these bills are reintroduced in Congress this session because they are needed.

·        Congress needs to invest in hard working families by helping make sure they can save for retirement now, so they will be set up for success in later years. But it also must be careful to avoid further complicating an already overly-complicated retirement savings system.

·        The dirty little secret is that government can provide all the incentives in the world for workers and families to save for retirement. But none of it will matter unless those workers and families make saving for retirement a priority as well.

·        Lastly, and perhaps most importantly, inequities in our tax system – which were compounded by the Tax Cuts and Jobs Act of 2017 – made a huge problem even worse.  Fixing those inequities will need to become a priority if we hope to avoid serious economic consequences and social unrest.   

Prefer the cartoon version?  “Meet the Broken Nest Egg”:  https://youtu.be/kmtjJVC_niI?t=32

 

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What Do I Own and Why Do I Own It? 2019 Update

In times of economic turmoil and financial market upheaval, it’s a good idea to take a deep breath and reflect on this question.  Understanding what you own and why you own it is the first step toward building confidence and conviction.  Confidence and conviction are always tested during periods of market volatility.  The more you understand about the design of your portfolio, the better you’ll sleep at night when the world around us appears to be coming unglued.  

Before we look inside your portfolio, let’s first review a few principles.  It is important that you first have this foundation to fully understand what you own and the role it serves in your portfolio:

Principle #1: None of us can accurately predict the future.  This might come across as common sense, but deep down none of us really believe it.  We are all human beings who tend to follow our “gut”.  That in turn is heavily influenced by media reports, crowd psychology and an unfortunate human tendency to extrapolate recent trends well into the future.  If one of our investments drops unexpectedly, fear sets in and we emotionally project that it will go to zero.  When another investment rises to new highs, greed takes over and our gut tells us it will keep going to the moon. The truth is that nobody can reliably and consistently predict the future, but that never stops us from trying!

Principle #2: Human emotions always trump logic when they are at their most extreme.    Our gut feelings offer a false confidence that is heavily driven by consensus opinions that were likely formed by reading, listening and watching what the masses are saying.  It’s hard to go against the consensus.  Even if the consensus proves to be right, any advantage you might gain by following it was lost as the markets have long since re-priced to reflect consensus.  The expected result is already baked in.  Going against consensus, when you are right, can be quite rewarding.  

Principle #3: Attempting to ‘Beat the Market’ is a Fools Game.  The market is by definition the sum of all investors, each of which has multiple votes based upon the size of their financial commitment.  The sum of all investors set a price for each investment based on all the known information about that investment and all other known environmental factors.  The price is determined and constantly fluctuates in a tug of war between those who are bullish and those who are bearish, with the big players who have the greatest knowledge and resources dominating the game.  The rest of us are just casual observers.  It is foolish for any of us to think we can correctly guess the winner, not just once or twice, but time and time again.     

Principle #4: Diversified Portfolios = Safety.  If none of us can consistently and accurately predict the future, and if the prices of all investments already reflect all the known information that is available, the ONLY reasonable strategy is to spread our money around and not make any big bets.  Putting all of your eggs in one basket is a get rich quick strategy that rarely works other than for a very lucky few, most of whom later lose it all in the next round.  Diversification is known in investment circles as the only true “free lunch”.  It is a strategy to mitigate risk and to slowly and steadily move forward one step at a time, with only a few steps back every now and then.  It’s a strategy that avoids big losses and improves your likelihood of reasonable gains over the longer term.

Principle #5: Over time, the law of averages prevails.  Investors who stick with managers, allocation strategies and a rebalancing plan achieve better risk-adjusted returns and will end up richer.  Putting all your eggs in the stock market is great when it’s on a tear, but don’t be fooled by short-term results.  It’s the old fable of the tortoise and the hare.  Steady, disciplined and consistent always win over time.

Principle #6: Don’t obsess over the losers.  Diversification means that some of your investments will do very well and others may do less well or even poorly.  That is by design.  It’s impossible to know the outcomes in advance.  Expect this to happen and don’t obsess over the losers.  And whatever you do, don’t dump those that go down!  They are likely tomorrows winners as they are now out of favor and bargain-priced.  It’s a peculiarity of human nature that we feel better buying things that are now expensive and dumping things that are now cheap!  

Principle #7: The smartest guys in the room build disciplined models and follow them religiously.  Two of thesmartest in the universe are David Swenson who manages the $27 billion Yale endowment fund and Jack Meyer who does the same for Harvard’s $36 billion fund.  Their strategies are quite similar, so much so that many investors now refer to what they do as “The Ivy Portfolio”.  The Ivy Portfolio is famous for its simplicity and discipline.  It equally weights a large number of asset classes and regularly rebalances back to those equal weights.  Each asset class is chosen due to its lack of correlation to the other asset classes, not to the investment manager’s predictions for how well that asset class will do in the future.  In less formal terms, some are likely to zig while others are likely to zag.  Each asset class will respond differently to changing economic conditions, government policies and investor psychology.  Equal weighting is designed to combat our human tendency to tell ourselves stories about why one will do better than the other (predicting the future).  Equal weighting allows the markets to set prices based on all the known information.  Equal weighting acknowledges that to favor one asset class over another is another way of saying that you know better than the markets.  We do not.

Principle #8: Volatility is our new best friend.  Following a disciplined process reduces our reliance on emotion and prevents us from making bad decisions in periods characterized by the emotional extremes of greed and fear.  In fact, the volatility that brings out these emotions becomes our best friend.  Big drops in any one asset class require us to accumulate more while it’s temporarily cheap.  Big increases in any one asset class force us to take some of our chips off the table before it comes back down to earth.  

Principle #9: Learn from how the smart guys on the block manage their money.  Our current model portfolios embrace the Yale and Harvard methodology.  All of our model portfolios embrace diversification and require disciplined rebalancing back to the target percentages.  However, the design of the old models did occasionally make bigger bets in one direction or another (inflation versus deflation, dollar strength versus dollar weakness, etc.).  Sometimes that worked to our advantage, sometimes not.  Our newer models equally weight twenty different asset classes as the base case, with modest deviation from those targets based only on individual investor considerations.  The portfolio is highly diversified across asset classes (breadth) and highly diversified within each asset class (depth).  The strategy relies on a disciplined rebalancing process to maintain our weightings over time.  We sell what goes up and buy more of what went down.  We let the markets set the appropriate price without second guessing our equal weightings.  We let rebalancing do the work for us and make our buy sell decisions.  It is the opposite of a “predict the future” strategy.  We don’t have to constantly guess if the markets have it right or have it wrong.  

10 Twenty – Diversified Investment Portfolios with a Plan.  

Ten model portfolios are available for my diverse set of clients, each of which includes twenty distinct asset classes.  A chart comparing the models is attached as the last page.  Each asset class was chosen with an eye toward reducing correlation to the other asset classes.  The goal was to have some asset classes in the mix that would respond favorably to almost any potential future scenario.  The default model is called “Balanced” and requires an equal 5% weighting to each asset class.  The other models are more or less conservative or aggressive and make adjustments to account for individual investor risk tolerance, need for return, and other circumstances.  Rebalancing is performed primarily in tax deferred retirement accounts when possible.  We also look to harvest losses in the taxable portfolio to offset other positions that have taxable gains.

The asset classes are divided into the categories of equities, fixed income and real assets with all asset classes assigned to one or the other.

Equities – aka the “Engines”

Equities do especially well in periods of better than anticipated economic growth.  They do poorly when growth falls short of expectations.  Notice that it is the difference between the expectation of growth and the actual growth that drives the price of equities.  Equities can do poorly in periods of strong growth when their prices had already discounted strong expected growth.  Likewise they can perform well in periods of weak growth and when the economy is doing poorly as long as they perform somewhat better than the lowered expectations.  There are 8 asset classes in our model that fall under the category of equities:

Broad-based Companies

1.       Large U.S. companies (5%): U.S. large capitalization stocks have been the best performing asset class in the world in recent years after coming off a decade of flat performance that generated a measly 2% average return per year during the period from 2000 to 2010.  The strong recent performance is largely due to flight capital from Europe and Asia looking for greater safety in the U.S. dollar and our historically more stable economic and political systems.  By some accounts, this rally is long in the tooth as U.S. stocks (like Johnson & Johnson and Exxon for example) are at least 30% more expensive than their European counterparts (like Bayer and Royal Dutch Shell).  This defies logic since these companies have relatively equal prospects given that they sell similar products to the same customers all around the world.  The U.S. companies that make up the S&P 500 are trading at a price that equates to a 2% dividend yield, whereas the 500 largest European companies trade at a price that produces a dividend closer to 3%. Overemphasizing this asset class while its trading at premium valuations relative to others is making a big bet that U.S. companies will continually and consistently grow faster than the markets already lofty expectations.  That seemingly ignores the headwind of a higher U.S. dollar that will make U.S. exports more expensive to the rest of the world.  Meanwhile, international companies in similar business will see their exports to the U.S. surge as their prices become more competitive compared to their U.S. counterparts.  The allocation decision isn’t about patriotism; it’s about the laws of economics.  Rubber bands stretched too far tend to snap back, as do valuations of any one asset class when pushed to extremes. 

 

2.       Small and Medium size U.S. companies (5%):  Smaller companies tend to outperform larger companies over time, and value-oriented small stocks tend to outperform growth-oriented small stocks over time.  Those are well established truisms that have been accepted for decades.  We include small and medium sized companies in our portfolio to take advantage of these probabilities.  We also follow a value tilt when portfolio size justifies a larger number of separate investment assets in the mix.

 

3.       International developed market companies (5%): Currently priced at a 30% discount compared to their U.S. competitors, this asset class looks to be a better bet relative to U.S. equities at current prices. 

 

4.       Emerging market companies (5%): Despite greater instability and volatility, it is important to have some exposure to the portions of the world that are growing.  And some are on fire.  Literally and figuratively!  Latin America has added more citizens to its middle class in just over two years than Texas has residents.  Mexico, despite all its bad press, is a rising manufacturing power.  Frontier markets like the Philippines, Indonesia and Africa may well be the next big boom.  But right up front I will say we shouldn’t toss around the phrase “BRIC” – Brazil, Russia, India and China – as an investable class.  The acronym should stand for “bloody ridiculous investment concept”.  Those four countries couldn’t be more different in terms of education, history, natural resources, economic policies, work culture, respect for rule of law, demographic, or market outlook.  Russia and Brazil thrive on high energy costs; India and China suffer from them.  If treating that small group as homogeneous is silly; treating the other 150 or so developing and frontier markets as a unit is downright absurd.  The various countries of the world will follow their own unpredictable paths.  We will focus on the more stable “global blue chips” that know their markets better than any U.S. company could.  We also favor ETFs that focus on companies that closely tied to emerging market consumers.  Young populations of upwardly mobile consumers are part of the demographic trends that favor growth for these consumer-focused companies.

Natural Resource Companies.  Heavily leveraged banks and insurance companies come and go.  Software and other tech companies are only as good as their continued ability to innovate.  Retailing and the fashion industry is littered with winners and losers.  Natural resource companies, by comparison, are unique for their mundane, predictable and relatively stable businesses and strong stable and growing dividends.  They also provide a degree of inflation protection that most other equities do not.  These unique characteristics set them apart.  For these reasons, we carve them out from the universe of broad-based equities and give them a category of their own. 

5.       Energy companies (5%): Developed economies need energy to transport goods, feed people and provide all the benefits of modern lifestyles.  It takes ten times more energy to produce a meat diet than a diet based on rice alone.  Producing and delivering energy is a stable business that generates strong and growing dividends over time.  There is a reason that Exxon has grown to become one of the largest companies in the world. Unlike other industries, the original players are all still around in one form or another. We can’t say that about almost any other industry.

 

6.       Food and Farmland companies (5%): The big argument for it is easy to guess: the demand for food will continue to skyrocket as frontier and developing economies progress, and as rising middle classes of China, Africa and the Middle East demand better and more reliable sources of protein.  By one measure, if every person in China ate two extra eggs a week, it would require all the grain Canada currently produces just to feed the chickens!  And, food aside, farmland is also in demand for biofuel production.  Annual returns from farmland have been very strong in recent years, somewhere in the mid-teens when you include cash rents, profit-sharing income, and appreciation.  The inflation benefits are obvious, for both the annual income stream and, more importantly the residual value.  That leads some people to call farmland “gold with a coupon.”  The bad news is that there has already been a big move in prices, especially for the best located: prime Iowa acreage may be in a bubble, with prices reaching as high as $20,000 acre earlier this year.  On the other hand, the worldwide ratio of arable land per person keeps dropping, from almost three acres per person in 1960 to about one now, while developing demand for its output is nearly certain to rise.  

 

7.       Timber Companies (5%):  Timber companies provide strong income streams along with inflation protection.  The headline here is simple: Harvard has a $3 billion dollar allocation to timber, an enormous 10% of its endowment.  After tremendous success in the US woodlands market, buying from paper mills that needed cash and then selling out to other endowments and pension plans that awakened to the value, Harvard headed to Romania and New Zealand and reloaded.  It’s now stomping around the forests of Brazil looking for even more.  Timber is special.  It is perhaps the only asset class that can do four distinct jobs:  It’s an outstanding hedge against inflation.  It throws off a steady income stream with only modest effort.  It is a fundamental way to play the expansion of the world’s economies.  Finally, it’s a surprising play on green technologies as new and unexpected markets for wood products are continually developed.  Somewhat counter-intuitively, “green” regulations are creating a push toward timber as a “renewable energy resource.

 

8.       Water and Environment Companies (5%):

 

Water: All evidence seems to indicate that people really do enjoy water.  Too bad, because only about 1% of it on the entire planet is potable.  You already know that the supply is under incredible and growing pressure from increasing populations.  The exact reason that’s true, however, is a bit surprising.  It’s not so much that people drink more water, or even use it for other purposes like bathing.  It’s that as the demand for protein food sources increases, the need for fresh water to create it explodes:  from this point of view, in fact, eating a hamburger is the same as taking a 12 hour shower.  Given exponential growth needs, water may the ultimate liquid investment!

 

Environmental Services: More people on the planet living a middle-class lifestyle means more waste and more pollution, pure and simple.  Companies that clean up the planet will be in demand for eons to come. 

Fixed Income – aka the “Brakes”

Fixed income in the form of cash and bonds adds stability to portfolios.  They also provide much needed liquidity in times of market turmoil, becoming the fuel that we need to purchase other assets when they happen to be down.

9.       Cash (5%):  Cash is the first fuel we use when rebalancing.  It also provides liquidity for distributions for those who are retired from the workforce.  It grows naturally from accumulated dividends.  

 

10.   U.S. bonds (5%):  U.S. bonds offer deflation protection, but can be hurt significantly in periods of rising interest rates and increased inflation expectations.  For that reason, we have shortened the maturity (known as duration) of our bond holdings in general.  We also emphasize short and medium-term inflation protected bonds over nominal bonds that lack inflation protection.

 

11.   International developed market bonds (5%):  International bonds currently offer higher yields than their U.S. counterparts.  We limit our portfolio primarily to foreign government bonds and inflation-protected foreign bonds to mitigate default risk and inflation risk.  Foreign bonds also offer diversification away from the U.S. dollar which can at times be a plus and at other times a minus.  For that reason, we favor a mix of 50% currency hedged and 50% non-currency hedged international bonds.  

 

12.   Emerging Market bonds (5%): There are many reasons that emerging market debt instruments bear so much higher rates of interest than U.S. obligations.  Partly it’s the perceived safety of U.S. instruments, and partly, it’s fear of inflation in the issuing country. And then there’s the currency risk that you’re taking on in those foreign jurisdictions.  But it’s very hard to ignore four or five extra percentage points of interest these days.  Besides, these are not your father’s emerging markets.  Emerging market countries are actually in much better shape financially than their developed country counterparts.  Most are creditors, not debtors.  Additionally they have younger populations and fewer retirees to support, which should enhance their growth prospects when compared to the west. We favor 50% dollar denominated emerging market bonds and 50% in local currencies.  

Real Assets – the “Diversifiers”

Real assets are physical, as opposed to financial.  Even in periods of modest inflation, currencies (and the financial assets measured by them) lose value, real assets hold theirs.  

Real Estate and Infrastructure: 

13.   U.S. Real Estate (5%):  REITs are tax advantaged pass-through vehicles that collect rent and mortgage payments from every part of the real estate world including residential and commercial, with subcategories like health care, luxury resorts, shopping malls and even self-storage.  REIT dividend rates are higher than bond yields, which makes them susceptible to rising interest rates.

 

14.   International Real Estate (5%):  International REITs operate exactly like US REITs except that they own property outside the U.S.  They are currently paying significantly higher dividend yields than U.S. REITs due to the perception of greater safety in the U.S. than in European and Asian markets.  

 

15.   Global Infrastructure (5%):  In many parts of the world, infrastructure such as bridges, power plants and even airports are owned by public companies.  These generate returns over long periods of time from user fees, royalties, rents, and shares of government tax income.  The good news, and the bad, is that you usually have a governmental partner:  That can provide monopoly power, but also some uncertainty… politicians have been known to change their mind on occasion.  Outside the U.S., many smart folks believe infrastructure is the very best way to profit from the developing economies of Asia, Latin America, Eastern Europe and Africa.  Immature economies will suffer from fits and starts as they adjust to capitalism and therefore can be a roller coaster.  Long-term infrastructure projects might be safer, with water and energy infrastructure the surer bet.  

 

16.   U.S. Oil and Gas MLPs (5%): Master Limited Partnerships or MLPs are a unique and very underappreciated asset class.  Congress created special vehicles back in the ‘80s to spur energy infrastructure construction, and could almost say that they went overboard bestowing investor incentives to kick-start that effort.  MLPs trade publicly, do not pay entity-level tax, pay out nearly all of their net income directly to unit holders, and can actively manage energy businesses to grow distributions.  The most interesting sort of MLP for most investors are those active in the “midstream” sector.  These companies provide pipelines, storage facilities, and other plumbing to move energy products around the country.  That should keep revenue growth cooking and help this group maintain its long history off increasing distributions by something like 5% to 10% per year.  The yields they generate for investors are tax-favored since they are treated as a “return of capital”.  A 6% yield suddenly looks more like 8% or 9% after considering this tax benefit.  The annoying thing is that it’s harder to figure out how to buy each MLP.  Pure MLPs generate a K-1 and can be a little messy around tax time.  MLPs in the form of ETFs are much simpler to work with but do lose part of their tax advantage. 

 

Commodities and Alternative Strategies

17.   Precious Metals (5%):  Is gold a good investment?  I don’t know: Is insurance?  In both cases you’re spending dollars to protect against something you very much hope doesn’t happen.  Obviously, the one great and undeniable advantage of gold is that, over many centuries and indeed throughout human history, it has generally retained its value against the vagaries of paper currencies.  There is quite an active little argument about whether gold “is money”.  It certainly has some fantastic characteristics that make it a natural candidate for that role; it’s difficult to produce, there are limits on the supply, it is incredibly durable (98% of all gold ever found in civilization is still kicking around), its fungible, easily divisible, measurable, and transportable.  But it has also proven time and time again to be quite volatile.  So gold is insurance in our portfolio, nothing more.   Whether it qualifies as an investment, or merely a smart thing to do, is just semantics.  But do remember that nobody would recommend paying lavish insurance premiums without something to insure.  Same with gold.  It protects your financial assets from confiscation through devaluation at a time when many central banks are experimenting with unprecedented money printing on a scale never before seen.  Gold has risen by as much as 100% per year, and has fallen by as much as 25% per year, in just the few years that we’ve owned it.  I’ve come to believe that 5% in gold and other precious metals is enough insurance for most portfolios as too much can make for a bumpy ride. 

 

18.   Commodities (5%):  Physical commodities tend to behave differently than stocks and bonds, which is a good thing when you’re looking for diversification.  There have been many times in history when stocks and bonds were both declining in value, while commodities did the reverse.  Energy commodities were terrific performers during the 1970’s and early 1980’s even while world economies were stagnant.  Over time, energy should become more and more expensive as demand will increase with a growing middle class and the costs of extraction continue to rise.  There may still be plenty of oil and gas left in the ground, but it’s getting harder to find and more expensive to extract over time.  That suggests that energy prices should rise over time at something more than the rate of inflation.  

Commodities in general are a great diversifier.  They exhibit a low correlation to almost every other asset class.  That alone is enough of a reason to include them in our portfolio.  Increasing demand for agricultural and other food products, not to mention potential currency depreciation, add to their allure.  This category is also where we park other alternative strategies that may be appropriate from time to time including private equity, long short funds, merger arbitrage, and other hedging strategies.

19.   Thematic Strategies: We are entering a decade when technological innovation and powerful demographic trends are likely to significantly impact our world.  Companies are struggling to adapt to these new realities.  Some will be successful and others not.  Traditional investing focuses primarily on geography (US vs International) and company size (large, medium and small cap) as differentiators of performance.  A thematic approach shifts the focus to investments that stand to benefit from rapidly evolving demographic and technological changes.  We are heading toward a future that includes self-driving electric vehicles, genomic alteration that will extend life expectancy, robots that more efficiently and accurately perform functions than their human counterparts, and artificial intelligence that offers implications beyond our imagination.  Think of how Uber, Amazon and Facebook have already changed our lives.  There is much more to come.  Thematic strategies focus on identifying disruptive innovators with the potential to create exponential growth and profitability.  Such companies demand at least a modest allocation in any diversified portfolio.

 

20.   Hedge Strategies: For years, hedge fund managers have engineered financial strategies to protect portfolios from the bear markets that occur from time to time. These strategies come in a variety of flavors, but their common element is a goal of providing positive returns that are uncorrelated with stocks and bonds.  Common hedge strategies include 

a.       “long-short” equity strategies that take long positions in stock that are expected to appreciate and short positions that are expected to decline.  

b.       merger arbitrage strategies, also known as risk arbitrage, seek to profitably speculate on the successful completion of announced mergers by taking advantage of inefficiencies in the market prior to closing a transaction.

c.       relative strength/momentum investment strategies focus on buying stocks that are rapidly appreciating and quickly exiting the moment that they stop rising in value.

d.       private equity seeks to invest in privately held companies before they go public, hoping to cash in on their rapid growth before it is fully priced in the public markets.

Historically these highly engineered growth enhancing and risk mitigation strategies were only available to ultra-high net worth investors who often paid their hedge fund managers “2 and 20” (2% annual fee plus 20% of profits).  That has changed with the introduction of a low cost, high quality ETFs that replicate many of these strategies.  Our modest allocation to hedge strategies offer investment returns that are uncorrelated with public equity markets and can therefore enhance returns and reduce overall portfolio risk over time.  

Considerable thought has gone into the creation of our ten portfolio models.  The principles under which they were constructed are based on strong academic research that provides sound empirical evidence of a tendency toward superior performance and risk reduction in the real world.  If you’d like to read more about the research that underlies our strategy, I can suggest the following resources:

The Investors Manifesto by Dr. William J. Bernstein

The Ivy Portfolio by Mebane T. Faber, CAIA, CMT and Dr. Eric W. Richardson

7 Twelve – A Diversified Portfolio with a Plan by Dr. Craig L. Israelson

The Alternative Answer by Bob Rice, Bloomberg TV’s Alternative Investment Editor

Unconventional Success by David Swenson, Chief Investment Officer, Yale University

The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation – Dr. A. Gary Shilling

The Crash Course – The Unsustainable Future of Our Economy, Energy and Environment by Chris Martenson, PhD.

 

 

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Confessions of Your Investment Manager: I’m preparing for a Market Crash

As we enter the eleventh year of economic expansion, valuations in the US stock and bond markets have reached all-time highs.  Real estate construction is booming.  Cranes fill the skyline in every major city in the US and many around the world.  Unemployment is low.  Inflation is moderate.  Optimism is high. 

Meanwhile, consumer, corporate and government debt are extraordinarily high and rising, salaries are stagnant and tax revenues are falling.  These are unusual and unexpected occurrences for an economy in the later stages of a strong, central-bank-driven, economic expansion. 

Ten years after the “Great Recession”, we are witnessing the longest bull market in history, approaching ten years (or nearly 3,650 days). 

As market risks rise, complacency is in the air

After eleven years of mostly rising US stock prices, “expected future returns” (based on today’s current lofty valuation levels) are falling.  The demographics of an aging population and high levels of debt make it unlikely that future investment returns will be as strong as they have been in the past.  This is not news to those of us who are serious students of the economy and the markets. 

Each year four American institutions publish their long-term strategic economic views and market return expectations for the next 5 to 10 years.  Their predictions rely on an understanding of economic cycles, market valuation metrics, and behavioral science.  While forward looking projections into an uncertain future are rarely perfect, all four have accumulated a solid track record that adds to their credibility.  My quarterly emails always include a copy of the “Ivy Portfolio Index”, which provides historical returns of the assets classes we invest in, alongside the future “expected returns” for each of these four institutions.  This offers both a crystal clear “rear-view mirror view” of where we have been and a less clear but well-reasoned “front-windshield-view” of where we appear to be heading.   

Past and future returns

Historically speaking, a well-diversified portfolio that equally weights most major asset classes has returned between 6% and 8% for the past ten years.  However, all four institutions that publish their economic and market forecasts expect future returns to be significantly lower than that historical average:

·        Northern Trust expects a 60/40 global stock/US bond portfolio to average 5.25% for the 5 years.  

·        PIMCO expects a multi-asset portfolio to average 4% over the next 10 years.

·        JP Morgan Chase expects a well-balanced portfolio to average 5% over the next 10 years.

·        AQR Capital Management (a research firm that provides data utilized by pension plans) expects that a balanced portfolio will average 4% over the next 10 years.

There is no escaping the fact that these institutions are quite sanguine about future forward looking returns.  That reflects the current high starting prices.  In their commentaries, each institution references similar realities that impact their forecasts.  These include slowing economic growth based on aging world populations (especially in Japan, China and Europe), the end of economic stimulus and “extraordinary measures” by central banks, and (especially) the very high levels of debt around the world at a time of rising interest rates.  

Lower expected future economic returns will not be linear

It is likely that the next 5 to 10 years will witness both bull and bear markets.  There are likely to be some double-digit positive years as well as significant negative years.  That is consistent with these institutional projections – which are long term averages.  

One of my most important jobs as your financial advisor is to help reduce the negative impact of the next bear market or market crash, without exiting the markets entirely (an alternate solution that few of us can afford).

Risk management is now more important than ever

Diversification doesn’t pay off during bull markets.  It keeps you from having all your eggs in a single high performing basket.  However, diversification pays off big time when markets turn negative, as they inevitably and unexpectedly do from time to time.  

Diversification helps to limit the size of the losses when these downturns occur.  After a sizeable market loss, it can take nearly twice the percentage gain as the percentage loss incurred, just to get back to where you started.  A smaller loss guarantees a much more rapid recovery on the other end.  A smaller loss also allows you to sleep better at night when others are tossing and turning.  And it reduces the likelihood that you’ll bail out altogether.  

Minimization of losses is the most important factor in achieving strong long-term returns.  At this point in the economic cycle, wise investors and their advisors are focused primarily on risk, and should not be stretching for higher hoped for returns. 

Only one future will come to pass, but many are possible

Crashes most frequently occur after lengthy periods of economic success, when valuations are extended, optimism is high, and complacency is the norm.  After many years of strong returns, markets have become priced for perfection.  That’s nothing new.  Bear markets typically occur every 8 to 12 years when prices get ahead of themselves and investors become complacent.  Then, inevitably, something unexpected happens.  The immediate triggers vary.  Then paradigm shifts and the herd suddenly changes course.  

This is part of who we are as a species.  We move along the continuum between greed and fear at least once a decade or so.  It’s been a consistent story since time immemorial.  We’re taught this as children through stories like “The Emperor has No Clothes!” when a young boy clearly sees obvious facts that the herd chooses to ignore.  It’s illustrated in the childhood game of musical chairs when more and more players join the game only to lose their seat when the music suddenly stops.  An awareness of these all-to-human frailties is the first step in ensuring that you are prepared when old perceptions and new realities suddenly and violently come into conflict.          

Taking a few chips off the table

Of course, it would be foolish to think that I (or any investment manager) will be able to exit the markets the day before the next crash.  What I do aim to do however, is prepare and protect your portfolios as the probabilities of negative surprises rise.  It’s time for many investors (and especially those who have accumulated the majority of their total lifetime wealth) to take a few chips off the table.

After a market crash, journalists are fond of asking “What are you doing now?”  A better question might be “What did you do ahead of time to prepare?”  What a portfolio manager does ahead of a market changing event will have a much greater impact than their reaction after the fact.  The ability to successfully react and take profitable action after the event is limited (like grabbing a chair when the music stops).  

Despite our efforts, the economic cycle has not been repealed.  Nor has the ongoing battle between greed and fear.  Crashes will inevitably occur from time to time…

Crashes exist precisely because human beings are wired to become greater risk takers and increasingly complacent after long periods of strong market performance.  When logic suggests that we should take a few chips off the table, greed and complacency set in and many investors instead choose instead to double down.  This can cause the music to keep playing longer than expected.  Frankly, it may continue for some time.  As valuations become increasingly stretched and expectations rise to unsustainable levels, markets become increasingly vulnerable to unexpected negative events.  And then it ends.  How much sand can you add before the last grain of sand collapses the entire pile?       

Are we there now?  Perhaps not, but we’re definitely closer than yesterday.  At the crux of this debate is the fact that every bear market is different.  Soul searching, regulation and legislation is imposed after each episode, never before the crash occurs.  Post-crash models are developed to perfectly spot (with hindsight) the last crash, but often the focus point is no longer correct for the next crisis.  

The global system is complex and dynamic.  I’m confident that the next crash will result from a separate set of vulnerabilities than the last.  That said, the lessons of history are not to be dismissed out of hand.  I’m convinced that it’s important to study and understand market valuation tools and the history of economic cycles to help us prepare.

How will we know when a bear market is just around the corner?  

Economists cite four main indicators that can signal changing probabilities.  Right now, all four are flashing red or yellow.

The four main indicators:

·        Corporate behavior – Mergers and acquisitions, initial public offerings and corporate stock buy-backs are always good to keep an eye on.  There is strong evidence that most of the gains in the US stock market in recent years have been a direct result of financial engineering via stock buybacks.  Generally, markets do a pretty good job of determining prices.  That assumes there is a fairly diverse group of buyers and sellers and that each act in its own economic self-interest.  In real life, however, this is not always the case.  In recent years there has been a mind-boggling increase in corporate buy backs.  Corporations tend to buy back stock regardless of economic value, thereby distorting stock prices.  Buybacks offer a quick way to boost executive bonuses, regardless of the risks and rewards passed on to shareholders.  They can push up prices beyond their market determined true economic value.  

 

Between 2012 and 2015, US companies acquired $1.7 trillion of their own stock, with many companies going deeply into debt to purchase their shares on the open market.  More recently buybacks have been funded by corporate tax cuts and repatriated foreign cash.  This rocket fuel was in plentiful supply after the recent tax cut, but may now be largely spent.  With interest rates rising, the price of this rocket fuel is also going higher.  With leverage ratios high, and interest costs rising, stock buybacks are likely to be fewer and less frequent in the future than we’ve seen in the recent past.  If you want to understand why US stock prices are rising much faster than they are around the world, the first thing to look at is this “elephant in the room”.  http://www.areteam.com/blog/the-elephant-in-the-room-share-repurchases

 

·        Profitability metrics – Corporate profit margins are at all-time highs.  Theoretically at least, outsized profits eventually lead to greater competition as new entrants join the market to share in the riches.  Eventually these new competitors and employees themselves demand a greater share of the pie, thereby bringing margins back down to earth.  Those are factors that have, until recently, kept profit margins relatively consistent over long periods of time, always eventually reverting back to the mean.  If history is a guide, future profit margins will decline from these currently lofty levels.  The price-to-earnings ratio is a key valuation tool.  If earnings fall or are expected to fall, stock prices will likely follow.    

 

We also know that high stock market valuations do have a negative impact on future stock market returns.  Expensive valuations should still be considered as a warning sign.  Today, Schiller’s cyclically adjusted price-to-earnings ratio (CAPE) remains the highest it’s been in all of US history at 32.70 (i.e. US companies are currently valued at 32.7 times their ten year average earnings; a record high).  This indicates the U.S. equity market is quite rich by historical standards.  That begs the question—are we near the end of this bull market or will it go higher still?  Markets do have a way of defying logic from time to time, and attempts at timing rarely work out.  

 

While CAPE is not a short-term timing tool (according to Professor Schiller’s own admission), it does help us to shape our expectations for the future.  It narrows the funnel of doubt.  Professor Schiller is on record as stating that today’s market reminds him of the Roaring 20’s and the Tech Boom of late 1990’s, both all of which ended with significant economic pain.  https://www.cnbc.com/2018/10/01/bull-run-has-echoes-of-1920s-nobel-prize-winning-economist-shiller.html

 

·       Balance sheet and credit metrics – High debt levels are rarely a good thing!  It depresses investment and places a future drag on economic activity.  Consumer debt, corporate debt and government debt in the US are all setting new records.  If growth slows, that couldn’t come at a worse time.  Central banks around the world are reducing or reversing their extraordinary accommodative policies and interest rates are beginning to rise around the globe.  They have few tools left should economies falter.  

 

The US federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or social programs.  The massive run-up in debt of the past decade combined with newly rising interest rates creates a one-two punch.  

 

A growing budget deficit, made worse by the recent tax cuts, in combination with steadily rising interest rates, will put a crimp on future growth and asset prices.  With less money coming in and more going toward interest, political leaders will find it harder to address pressing needs like fixing crumbling roads and bridges or to make emergency moves like pulling the economy out of future recessions.  Within a decade, more than $900 billion in interest payments will be due annually, easily outpacing spending on myriad other programs.  Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.  I thought that fact deserved both bolding and underlining!https://www.nytimes.com/2018/09/25/business/economy/us-government-debt-interest.html

 

·        Positioning – Knowing where you are in the crowd is a very useful thing.  I always attend at least a few webinars each week and listen how other managers are positioned to ascertain what the herd is saying.  Right now, the herd is mostly “all in” and somewhat euphoric.  Even well-informed and anxious advisors are afraid to pare back their equity valuations, for fear of missing out.  The final stage of a bull market can be quite lucrative to investors.  It’s also quite dangerous to advisors who can be punished in the short term by their clients if their exit (in retrospect) turns out to have been premature.  In the game of musical chairs, nobody enjoys sitting alone in a chair while the music continues to play.     

The four main indicators are all flashing red or yellow.  What now?

The four indicators provide both kindling and fuel for a bear market. But, the list isn’t exhaustive.  Something is missing, i.e., the spark to ignite the fire is needed.  The spark in 2000 was the collapse of a handful of massively overvalued start-up Dot Com companies with no earnings (i.e. “the emperor had no clothes”).  The spark in 2008 was one too many no-down-payment mortgages (the “last grain of sand”) and the last renter on earth suddenly became a homeowner and there was no one left to buy at the new record high prices (i.e. “too few chairs when the music suddenly stopped”).  Could this be where we are with the US stock market today as the baby boomers continue to liquidate holdings to finance their retirement?

How bad can it get?

None of us can say for sure what the next catalyst will be or when it will occur, but the massive and growing size of consumer, corporate and government debt in the face of rising interest rates will likely make it more severe than most people currently expect.  History offers a sobering assessment:

·        On July 8, 1933, the Dow was down to 41.22, a 90% loss from its record-high close of 381.2 on September 3, 1929.  

·        The NASDAQ Composite fell 78% over the three weeks from it’s all time high on March 10, 2000.    

·        Recall that a 50% drop requires a 100% gain to get back to even.

How many people do you know that are mostly invested in highly priced US stocks?  Have they been bragging lately about how much better they are doing than you in the markets, with your globally diversified, lower risk (and currently lower return) portfolio?  Do they understand the risk they are taking for an extra few percentage points?

My final confession today: There is no perfect answer.

Having an awareness of the lessons of history can help us prepare for the next bear market.  It gives us an idea of what we need to monitor.  As markets rise beyond expectations, we can lean away from expensive assets while being mindful of the danger.  We can regularly rebalance out of the asset classes that are rising the fastest and into those that are falling or rising less quickly.  Those actions can significantly mitigate the losses when they arrive unexpectedly.  I’m currently leaning away from expensive US growth stocks in favor of less expensive value stocks that offer greater downside protection.  We also have lower exposure to US stocks than do most US investors.

It’s likely that none of us will be able to spot the exact turning point.  This is a fact that should be accepted.  But, I believe that a good process should have investors leaning out of risk assets as valuations rise and future expected returns decline, before the exuberant market psychology changes, and before the volume of debt and corporate stock buybacks collapse under their own weight.  

The best solution:  Diversify, diversify and diversify some more.  And pay off as much debt as you can.

Yes, that’s something we’re already doing.  We invest in a very wide variety of asset classes with a history of little correlation (or better yet, negative correlation) to the others.  It does little good to diversify among asset classes if they all go up and down together at the same time.  The underperformance of the laggards is the price we pay to avoid the really big double-digit declines that occur from time to time.  Diversification provides greater stability and predictability in long term returns with considerably less volatility.

True diversification also requires that we include a healthy dose of “real assets” that should do well when inflation returns.  Inflation is especially harmful to stock and bond prices.  It is a risk that is often ignored.  

Real estate, infrastructure, commodities, precious metals and inflation-protected bonds offer protection from this monster.  If you’re looking to finance your retirement over 30 or more years, inflation is the wild card that can derail even the best financial plan.  

And lastly, which is heresy for an investment manager to say:  Your best “risk adjusted return” may simply be to pay off debt.  Talk about shooting oneself in the foot!  Isn’t that a little like Macys telling shoppers to go to Gimbels (or Amazon to bring that analogy up to date?).  Perhaps.  But I’d rather sleep at night knowing that I’ve offered you the best possible advice even if it results in less assets under management for my firm.

Paying off a 5% mortgage or a 7% car loan is the same as a guaranteed 5% or 7% investment return.  When the best minds on Wall Street are projecting 5 to 10 year expected returns at 4% to 5% (and with the possibility of short-term loss), doesn’t paying off higher rate debt sound reasonable?

What’s next?

I’ll be making modest changes in your portfolio in the 4th quarter.  

These Include:

·        Adding more inflation-protection.  I’ll be rebalancing fixed income portfolios away from nominal bonds and toward inflation-protected securities, particularly those with shorter durations carrying less market risk.

·        Lowering portfolio costs.  I’ll be adding new ultra-low cost, no-transaction fee funds from State Street and others.  Under new arrangements with TD Ameritrade, many of the newest and lowest cost ETFs in the world are now available with no transaction fees.  I’ll work to lower your portfolio costs by replacing existing funds with these new funds, especially in tax-deferred retirement accounts where capital gains taxes are not a consideration.

·        Tax loss harvesting.  The recent downturn in international stocks and bonds relative to US assets offers an opportunity to harvest losses in these asset classes even as we keep allocations unchanged.  I’ll be selling investments in asset classes that have losses and replacing them with similar investments with identical performance characteristics, generating tax loss carryforwards.  That’s the equivalent of a “free lunch”.  It may not be as tasty as a free lunch made by Chef Jae, but it puts free money in your pocket thanks to the extra efforts of Chef Bill.    

·        Increased use of alternative assets.  Your current investment policy includes an allocation for “Soft commodities and Other Alternatives”.  Other alternatives include long/short funds, market neutral funds, S&P 500 put/write strategy funds and “thematic investments”.  Many of these funds are designed to produce positive returns regardless of the direction of stock prices.  Thematic investments include investments in companies that are likely to outperform most others during a market downturn.  These include innovative companies that offer new disruptive technologies, health care and biotech companies that benefit from an aging population, and those who are focused on high growth areas such as robotics, artificial intelligence and cyber security.  I’ll be increasingly adding new ETFs that specialize in “Other Alternatives” later this year.

·        Reviewing your asset allocation.  After years of cheap money and strong investment returns, it may now be time to take some chips off the table.  We can do this by making incremental changes to your allocation model.  That involves reducing exposure to highly priced equities and increasing exposure to fixed income and real assets that typically offer more stable and/or inflation-protected returns.  I’ll contact you before year-end if I believe that changes are in order given my knowledge of your financial resources, risk tolerance and long-term goals.

All my best,

Bill

 

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Thriftville & Squanderville -- A True Story

Thriftville and Squanderville: Our generation's greatest investor and big picture thinker--Warren Buffett--came up with these names in an article in Fortune magazine published in October of 2003.  As our politics deteriorate and our nation becomes increasingly fixated on culture wars--few seem to notice the huge asteroid (figuratively speaking) that is heading our way.

This asteroid may not be quite existential, but it may bring to humanity almost unimaginable consequences, though perhaps not as dire as those that faced by the dinosaurs. Like our predecessors, it may catch many if not most of us unaware. 

The asteroid I’m speaking of is our national debt, which is now spiraling uncontrollably upward--after a poorly timed tax cut--and amid the rapidly rising interest cost of servicing our massive debts. It is giving the US economy a temporary sugar high, even as the rest of the world begins to slow.

We narrowing escaped a smaller asteroid in 2008, thanks to extraordinary measures taken by central banks around the world.  Few saw that coming at the time and even fewer are prepared for the fact that may be coming again.   

More now than ever, Buffett's warning has the potential of becoming a greater reality quite soon.  Below is an excerpt from Buffett's 2003 piece:

Our trade deficit has greatly worsened, to the point that our country's "net worth," so to speak, is now being transferred abroad at an alarming rate.

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time, that's how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there's a quid pro quo--but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which, at their core, represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off--or simply service--the debt they're piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying. They want quick and painless solutions to make Squanderville great again.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So, the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land and Squanderville companies. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat--they have nothing left to trade--but must also work additional hours to service their debt and pay Thriftville rent on the land and companies so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

It can be argued, of course, that the present value of the future production that Squanderville must forever ship to Thriftville only equates to the production Thriftville initially gave up and that therefore both have received a fair deal. But since one generation of Squanders gets the free ride and future generations pay in perpetuity for it, there are--in economist talk--some pretty dramatic “intergenerational inequities”.

Let's think of it in terms of a family: Imagine that I, Warren Buffett, can get the suppliers of all that I consume in my lifetime to take Buffett family IOUs that are payable, in goods and services and with interest added, by my descendants. This scenario may be viewed as effecting an even trade between the Buffett family unit and its creditors. But the generations of Buffetts following me are not likely to applaud the deal (and, heaven forbid, may even attempt to welch on it).

Think again about those islands: Sooner or later the Squanderville government, facing ever greater payments to service debt, would decide to embrace highly inflationary policies--that is, issue more Squanderbucks to dilute the value of each. Worse yet, they might even give themselves a tax cut!  After all, the government would reason, those irritating Squanderbonds are simply claims on specific numbers of Squanderbucks, not on bucks of specific value. In short, making Squanderbucks less valuable would ease the island's fiscal pain.

That prospect is why I, were I a resident of Thriftville, would opt for direct ownership of Squanderville land and companies rather than bonds of the island's government. Most governments find it much harder morally to seize foreign-owned property than they do to dilute the purchasing power of claim checks foreigners hold. Theft by stealth is preferred to theft by force.

The biggest issue alluded to by Buffett is the unsustainable trade deficit.  We (the US) have been getting too good of a deal for too long. Not the other way around!  Other countries have given us increasing supplies of valuable goods in exchange for more and more squanderbucks and squanderbonds of dubious value.

This deficit has created warehouses stuffed of dollars and dollar-based debt at America's most important trading partners. The dollar reserves are especially large in Asia, where export-oriented countries like China and Japan have run large trade surpluses with the U.S.

Demanding that their people buy more goods from us is a little like pushing water up hill.  You can’t force Thriftville residents to buy expensive Squanderville products when other nations produce them more cheaply.

The solution is not threats of tariffs on foreign produced goods. Even elimination of all tariffs on US goods has minimal effect.  We just have very little to export at the right price points to the thriftier nations of the world.  To the contrary, we ourselves are a consumer nation addicted to low priced goods and services offered by others who can typically build better, faster and cheaper than can the aging supply of American workers.  Immigration of low wage labor has kept us competitive in some industries like agriculture, but it is unlikely that we’ll be able to add enough immigrants fast enough to keep our goods and services competitive over time.  We desperately need more low-cost immigrant labor to compete, but that seems unlikely in the current political environment. 

The real problem: The reality of the trade deficit is that Americans spend too much and save too little.  We’ve been doing that for a long time, having accumulated massive debt and fully stuffed closets and garages which serve as circumstantial evidence. 

Threatening tariffs to beat up on our lenders and toughening immigration policies that discourage low wage workers from coming here only make our problem worse. The baby boom generation of Americans have become fat and happy thanks to our addiction to low cost foreign goods. Today, virtually everything sold in WalMart comes from overseas. Even without new tariffs, inflation is likely inevitable. Add a 20% tariff on top of the already rising prices, and it can ignite an upward spiral in prices last experienced during the stagflationary period of the 1980’s.  Tariffs are nothing more than a tax on the American people. When you’re addicted to cheap goods and up to your eyeballs in debt, adding tariffs is akin to pouring gasoline on a fire. 

The U.S. is still considered one of the most stable countries in the world and one of the most desirable place to own real assets such as real estate and businesses. Why would our trading partners only want U.S. Treasuries (squanderbonds), especially as we become more hostile to our lenders. Selling assets to foreigners offers at least a possible way out.

For the past fifty years, our trading partners around the world have been trading things of real value (goods and services provided with scarce materials and human labor) for pieces of green paper with no intrinsic value.  It is we, not they, who have been the greatest beneficiaries of this Faustian bargain. This has been a great boon to the current generation of Americans as they have enjoyed a lifestyle well beyond their means. But the clock is ticking as we head to a tipping point when the next generation must pay the bill. Tariffs and reductions in immigration are more likely to accelerate that process than delay it further. Pouring gasoline on a fire is not a reasonable solution. 

I do not see any short-term remedy for this situation for America. The reality we are in is upsetting and you might not want to believe me, but maybe you'll believe Warren Buffett. As the baby boom ages, and immigration declines, the gross domestic product of the US (by definition) must slide.  Simply put, GDP is the # of workers x productivity of workers. As the baby boom leaves the workforce, GDP will decline unless the workers are replaced by new immigrants.  This is Japan’s problem since their culture discourages immigration altogether.  In short, we need massive new immigration just to prevent a decline in economic activity.

Will current efforts to restrict immigration and threats of tariffs against our bankers push us to a tipping point?  Nobody knows when or how that will occur. When does the last grain of sand cause the pile to collapse?

The risks are high.  Investors would be wise to diversify into real assets with intrinsic value (real estate, infrastructure, farmland, water, timber, energy and inflation-protected bonds).  CMMS clients are already there, but some may wish to add to their holdings of real assets for even greater protection over the coming months and years.

All of us should cut our spending and increase savings to prepare for a long period of perpetual rain.  A storm is coming that few seem to notice, so there is still time to make adjustments and better prepare.

Eventually our debt collectors from around the world will be knocking at our doors. Rising interest rates on an already massive and growing debt (national, corporate and household), combined with increasingly hostile policies and angry rhetoric, make me very nervous.

Where is the tipping point, or the point of no return?  That’s the $71 trillion dollar question.  http://www.usdebtclock.org/

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Politics and Investing Don’t Mix

When it comes to your investment portfolio, should you ignore the noise coming out of the White House? Or should we be making changes?  What does Trump mean for your investments? 

Here are the most common questions I’ve faced on this topic in recent months and my answers:

No. 1. How will Trump affect the economy and the stock market?

We start with an overlooked truth: Presidents, regardless of party, get too much credit for when things go right and too much blame when they go wrong.

The president is but one part of the government, which accounts for less than a quarter of the economy, though obviously it has a huge impact on markets and the broader economy through foreign policy, regulations, tax policy and spending.

Yes, Donald Trump can and will affect the economy and the markets. But we should not put all of our focus on the marginal impact of the president while giving short shrift to more important things such as corporate revenue and earnings, the Federal Reserve, interest rates, inflation, congressional spending, employment, retail sales, Supreme Court decisions, and, of course, valuations.

Like all presidents, if he does good things it will be supportive of the markets; if he commits major errors – such as starting a trade war or gets the U.S. into a serious shooting war – it will be detrimental.

No. 2. Why is the market rallying when some predicted stocks would fall if Trump were elected?

One explanation for the market’s post-election enthusiasm for Trump was based on expectations of tax reform, tax cuts, infrastructure spending and deregulation.  However, that was a post-hoc narrative.  The simple fact that markets in Germany, France and Japan rose more than in the U.S. since the election suggests that something else is at work.

My explanation is that the global recovery from the financial crisis continues apace, slowly repairing and rebuilding from that event. If you insist on singling out an explanation for why global markets are rising, look no further than the robust recovery in corporate earnings, especially in Europe.

As for forecasts of a Trump crash, that – like mostothers – was simply wrong – at least so far.

 

No. 3. How can you say politics doesn’t matter to markets?

Let me be precise: Politics can and occasionally does matter to markets – especially in the short term – but just much less than many people assume.

If I told you the president was going to be impeached, and the markets will continue to power higher for a few years, you might think I was batty. But that is what happened when Bill Clinton was impeached in 1998.  The next year, the Standard & Poor’s 500 Index rose more than 21 percent, and the Nasdaq Composite Index gained more than 85 percent. Yes, it would all end badly the next year, but the impeachment was irrelevant to the dot-com bubble popping.  

So too was the accusation that President Barack Obama was a Kenyan-born Marxist who was hell-bent on “Killing the Dow”.  When he left office early last year, the Dow was about 15,000 points and nearly 300% higher than the day he took office.

And when President George W. Bush introduced unfunded tax cuts, many economists assumed that the deficit would balloon, inflation would soar, and jobs would be wiped out.  Two of those three things never happened, and the market rose 94 percent.

If you let your political ideology get in the way of your investing decisions, the results are never pretty.

 

No. 4. The Trump news flow is overwhelming.  What should we do?

I think we all hoped that once the election was over, we could go back to our normal lives without the incessant parade of campaign news.

No such luck.

Investors need a way to sequester the noisy news flow out of the White House.  It is too easy to let the relentless and disturbing headlines throw off well-designed long-term financial plans.  Investors must read the news, but not let it interfere with thinking clearly.

Look, let’s be honest about the commander-in-chief: He is the world’s leading Twitter troll, a man whose main goal is to interrupt your thinking, misquote and insult other people, engage in rhetorical sleight of hand, and impugn the integrity of those trying to do honest work. What all trolls want is a reaction, something Trump has achieved to great success.

The first rule for sanity on the internet is “Do not feed the trolls”.  No one can really ignore the president of the United States, but it’s probably best to view much of what he says or tweets as minor background noise.

No. 5. You keep saying not to worry about who is president; but surely you do worry about him, right?  

Yes, as a citizen I do worry about the president’s rampant prevarications and the degraded culture he has created.

The search for facts and reliable information is the bedrock of modern civilization and well-functioning markets.  Agnotology (culturally constructed ignorance) is dangerous and worrisome.  Exaggeration is one thing.  Living in an alternate universe is another.  I have no interest in returning to the dark ages before the Enlightenment.  However, that seems to be the direction in which we’re headed, and some people seem to think it will make them the most money.  

It likely won’t, and now more than ever, truth remains the best disinfectant. 

No. 6. But I’m really worried about the increased polarization of social media, the propagation of “alternative facts”, increased tribalism, a decline in civil discourse and the resulting damage being done to our institutions and our democracy.  What should I do?

First, listen dispassionately.  One of the reasons I engage on social media is to seek out people who disagree with me.  If they can make an intelligent argument about another point of view, it is time well spent. I used to think that 140 characters cannot possibly enough to have an intelligent discussion. While that may still be the case for some topics, for the most part, I now believe that if you cannot express it in 140 characters, you are on a rant. And by all means, there’s the right time for long form analysis; given that you have read up to this point, I presume you agree.

Let me quote from a Financial Times article that, in my assessment, goes to the core of human behavior: 

“We humans are social creatures. Given a choice between being right on a partisan question (abortion, guns, globalization, climate change) and having mistaken views that our friends and neighbors support, we would rather be wrong and stay in the tribe. ... in surveys of views on climate change: college-educated Republicans and Democrats are further apart on the topic than those who are less educated.”

Second, strive to keep an open mind and genuine curiosity.  Aside from the hot button issues listed, I would add to that many of our democratic institutions have been vilified for partisan purposes:  The FBI, the CIA, the judiciary, and the Federal Reserve.  It’s easy to self-select social media friends, select internet sites or cable news channels that reinforce our biases and deepest fears.  Fear can lead to ignorance and conspiratorial thinking.  This media can be manipulated to exploit a person’s political views in order to instill fear and sell grand conspiracy theories.  Fear and ignorance can destroy our democratic institutions in the face of conspiratorial boogey men such as the current Breitbart, Alex Jones/InfoWars and Fox News narrative of an evil “Deep State” that will take away our freedoms.  Much of this panders to the fears of the “browning of America” and stokes anger among the intellectually disabled while masquerading as alternative news. 

... the evidence suggests that curious people are less subject to the temptations of partisanship. When the national conversation becomes polarized, we need to encourage curiosity about how things work rather than them-and-us tribalism.

I'm here to tell you, politics and investing don't mix.

This is a statement that rocks one of our most fundamental and most cherished beliefs. Like many of you, I too have very strong political convictions that affect how I see the world.  Whether you sit on the left or on the right, I have some bad news:  Your politics can kill you in the markets.

As a student of investment theory, I’ve learned that understanding behavioral psychology, statistics, cognitive biases, history, data analysis, mathematics, brain physiology, even evolution can help us make better investing decisions.  Indeed, these are all key to learning precisely what not to do.  While making good decisions can help your portfolio, avoiding bad ones is even more important.

We humans make all the same mistakes, over and over again. It's how we are wired, the net result of evolution. That flight-or-fight response might have helped your ancestors deal with hungry saber-toothed tigers and territorial Cro-Magnons, but it drives investors to make costly emotional decisions.

And it's no surprise.  It's akin to brain damage.

To neurophysiologists, who research cognitive functions, the emotionally driven appear to suffer from cognitive deficits that mimic certain types of brain injuries. Not just partisan political junkies, but ardent sports fans, the devout, even hobbyists.  Anyone with an intense emotional interest in a subject loses the ability to observe it objectively: You selectively perceive events.  You ignore data and facts that disagree with your main philosophy. Even your memory works to fool you, as you selectively retain what you believe in, and subtly mask any memories that might conflict.

Studies have shown that we are actually biased in our visual perception – literally, how we see the world – because of our belief systems.

This cognitive bias is not an occasional problem – it is a systematic source of errors.  It's not you, it's just how you are built.  And it is the reason most people are terrible investors.

How does this play out in the world of investing?  Let me share two examples. I don't pick favorites: Both Democrats and Republicans are implicated.

Back in 2003, the dot-com crash had about run its course. From the peak of the market in March 2000 to the March 2003 trough, the Nasdaq had gotten crushed, losing 78 percent of its value.  Yes, Seventy Eight Percent!

As Federal Reserve chief Alan Greenspan took rates down to 1 percent, the Bush administration passed $1 trillion in tax cuts. As someone else once said about the stock market, "Give me a trillion dollars, and I'll throw you one hell of a party."

Yet many of my Democrat friends on Wall Street – fund managers, traders and analysts – were highly critical of the tax cuts.  At the time, I heard all the reasons why they were so bad: They were deficit-busters, unlikely to create jobs, giveaways to the wealthy.

While those critiques may have been true, they were also irrelevant to equities.  As armchair policy wonks obsessed over these issues, they missed the bigger picture: Liquidity is a major factor in how the economy and stock markets perform.  Trillions of dollars in fresh cash was very likely to goose equities higher.  (Sound familiar?)  Indeed, the impact of the tax cuts did just that. Combined with Greenspan's ultra-low rates, you had the makings of a cyclical bull market rally.  From 2003 to 2007, the Standard & Poor's 500-stock index – the usual benchmark for equities – gained 100 percent.

And my politically active friends on the left missed most of it.

Fast-forward six years to the credit crisis in 2008. The S&P 500 had fallen 58 percent. By March 2009, op-eds in the Wall Street Journal were already blaming the crash on President Obama (took office two months earlier).

But conditions were forming that would hasten the end of the sell-off.  Markets were deeply oversold. Once again, the Fed chair was cutting rates – this time, it was Ben Bernanke, and he took rates down to zero.  In a panic, Congress forced the accounting rule-making body to be more accommodative to the banking sector. FASB 157, as it is known, ended mark-to-market accounting – essentially allowing banks to hide their bad loans.

All these factors suggested that a substantial rally from the market lows was coming. Historically, average gains in post-crash bounce-backs were 70 percent.  The easy money to the downside had been made, and it was time to stop betting that the markets were heading south.  If history held true, we were looking at the mother of all bear market rallies.

By that March, I was explaining this to clients.  But the greatest pushback this time around came from across the political spectrum.  My GOP family and friends were lamenting the occupant of the White House.  I heard things like "Obama is a Kenyan, a Muslim, a Socialist.  He is going to kill business."

What followed was the single most intense six-year rally in Wall Street history.  By the end of the Obama administration, the US stock market had more than tripled!  

And some of my politically active friends on the right missed most of it.

Remember, the cycle of booms and busts are surprisingly regular occurrences.  What some people call a "100-year flood" actually happens far more frequently – since 1929, there have been 18 crashes.

It's just as important that an investor participate in the cyclical bull markets, capturing the rally as well.  All things considered, missing the downside and catching the upside makes for a pretty decent investment strategy.  If only…

You need not be a mathematical wizard to learn this lesson.  When you are in the polling booth, vote however you like; But when you are reviewing your investing options, it is best to do so with a cold, dispassionate eye and stick with a well-designed investment plan designed for both good times and bad.

Summary:

Whatever fears you have based on the current state of our politics, you are not alone. These fears and the risks involved are already baked into market prices.  

There are many variables that drive market prices.  US government policy is but one of dozens of factors.

Your portfolio is constructed like a well-built car.  It is 60% engines (for growth), 20% brakes (for safety) and 20% seat belts and air bags (for crash protection).  Like your car, your investment portfolio is designed to get you to your chosen destination, as quickly, efficiently and safely as possible.  Don’t let politics interfere with the job its designed to do.   

Bill

 

Credit to Alex Merk, President and CIO of Merk Investments for many of the words and ideas included in this month’s blog.

 

 

 

 

 

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Comprehensive Money Management Services LLC (“CMMS”) is a Registered Investment Adviser located in Coral Gables, Florida. The firm is registered with the State of Florida Office of Financial Regulation. CMMS and its representatives are in compliance with the current filing requirements imposed upon Florida-registered investment advisers and by those states in which CMMS maintains clients.

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