Category Archives: Blog Post

Where the Wild Things Are in the Economy

One takeaway from 2008 – 2009 is that sometimes diversification does not work as planned. Most investment asset classes declined in the credit crisis.  Cash is the conspicuous exception.

As noted in last Friday’s post, reserving for liquidity is even more important than usual (given my perception) of the elevated prospects for a market convulsion, as we make our way back to the old normal.  There’s a lot to be said for cash as an alternative to bonds.  If interest rates or inflation spikes and bond prices plunge, and if cash is available to scoop up the bargains, losses on long positions can be mitigated.

Holding cash means accepting a negative rate of return on an inflation adjusted basis.  Long-term, this is a losing strategy.  As a tactical allocation, it means not being greedy.  And if you need liquidity, it’s just common sense.

Finally, if the US dollar falls in a currency crisis, the price of imports will rise.  Perhaps the best way to hedge against the currency risk of cash, is an expanded international allocation denominated in foreign currency.  But if the “correction” is global, then the US dollar will be as good as other currencies and might prove to be a safe haven.  If this seems like a circular argument, that shows how interconnected things have become.

Bubbles

During the past 20 years, we suffered 2 vicious corrections, 2000 and 2009. Attribution is simple. In 1999, tech stocks took off to the moon on the back of internet hype. Then, the combination of low interest rates, a love of real estate born of the prior equity bubble, mortgage securitization, and other factors led to soaring house prices. By 2007, houses were generally highly leveraged and overpriced. The collateral damage of the housing and mortgage crisis spread throughout the economy in ways few had imagined.

Which brings us to today. Allow me ask the obvious, what is overpriced today and which dominoes might prove vulnerable in a correction? Our artificially low interest rates and corresponding bond valuations seem the most likely candidates for disruptive movements.

The factors driving interest rates are complex, and countless financial instruments are tied to interest rates. This is not to predict economic Armageddon, but the dominos are set. There are paths to unwind QE without disruption, but we have not been down this path before. We can hope the path to normal will not be too disruptive. I am acutely aware of what I don’t know, but I have an idea where it might come from. This is fat tail risk.

When liquidity is important, it is important to reserve for it. If managing volatility is important, you might pay a steep price to hedge. Much like the crisis of 2000 and 2009, this one, if it occurs, will likely pass within a few years. I suggest reserving for liquidity needs anticipated within 3 to 5 years, and staying the course with the balance. Manage risk, don’t try to avoid it (you can’t).

A Simple Perspective on Equity

People often trade stocks as if they were baseball cards. They know when a company (player) is doing well and they speculate that if performance continues, they will be able to sell the stock (card) for more money.

What if Congress passed a law that prohibited the sale of stock. You could buy it, but you couldn’t sell it (never mind the inconsistency). As in musical chairs, the music stopped. How would you feel about what you own if you were stuck with it? If you made investment decisions based on the principal that the value of an investment is a function of the cash it can give you back, this probably would not be a big deal. You made wise capital allocation decisions.

If you have speculated on the greater fool theory, assuming someone will pay more for something without intrinsic value, you might be in a bad spot.

Business owners usually run their business to generate cash and profits. Maybe they plan to sell someday, but they know that future valuation will be based on profitability and/or liquidation value, not speculation.

When buying stock, consider whether you’d want to own the whole company if you could afford it.

Tax Day

Although the fiscal cliff crisis was resolved a year ago, the price of the tax increase was not clear.  Now that April 15th, tax day, is here, the impact can be assessed.  In the first quarter of 2014, tax receipts from individuals were up about 15%, for an additional $35 billion of Government revenue.  This is money that was not spent to help business create jobs.  This fiscal drag is reflected in consumers postponing purchases, and in many cases selling stock to raise the cash to pay their tax bill.  In contrast, last year tax refunds were up 15%, which might explain last year’s better than expected consumer spending and market performance early last year.

Last year’s fiscal cliff settlement raised payroll taxes and marginal tax rates for high-income earners.  Many exemptions and deductions continue to be phased out, and the maximum tax rate on capital gains was raised.  For many who pay estimated taxes, or pay through withholding, the increase was not collected during the year.  Finally, now in the first quarter of 2014 and the days leading up to April 15, the bill has come due.  The impact of the fiscal cliff is finally being felt with a one-year lag.

Moving forward, the worst may be behind us.  Consumer spending, first-time filings for unemployment benefits, (and the weather), continue to improve.  As the economy continues its upward trend and tax induce stock selling abates, the market may continue to track upward driven by improving corporate earnings.

A Tactical Approach to Tax-Free Income

Municipal bonds offer an interesting proposition for high income bond holders. Although muni yields are generally less than their corporate counterparts, for those in upper income tax brackets, the tax adjusted yield is often higher. What’s not to like about tax-exempt?

For one, there’s more than one way to generate tax-free income. For those with Traditional IRA’s, the income limitation on conversions has been eliminated. I think the most important variable in the Roth conversion analysis is the owner’s tax rate. If one assumes that income tax rates will increase, or that they will be in a higher tax bracket, they should probably convert. If they expect to be in a lower tax bracket, either due to lower income in retirement or a general reduction in income taxes, they probably should not convert from Traditional to Roth.

If the tax rate assumption does not move you, or if you think rates will stay the same, consider these other Roth advantages. Do not underestimate the added liquidity factor of the Roth. If an account has been open for at least five years, all contributions can be withdrawn without additional tax or penalty, since contributions have already been taxed. Additionally, there are no Required Minimum Distributions for Roth IRA’s. Considering these advantages, unless you expect your tax burden to diminish, you might consider a Roth conversion.

Now what about those muni bonds? If the idea of a Roth conversion intrigues you, ask yourself, why would anyone invest in municipal bonds for tax-exempt income and receive a lower tax rate, when they could have tax-free income from higher yielding corporate bonds in a Roth IRA account? Adding tax diversification to your portfolio is still another reason to consider that Roth conversion.

I expect this conversion to get more air time as interest rates increase and the notion of bond income in retirement gains relevance.

Investing involves risk of loss of principal. Please consult your financial advisor before investing. State tax exemption might depend on state of residence.

The Taper

Today the Fed announced the beginning of the end of QE, aka “Taper”. I applaud this move. One key ingredient we need to return to “normal” is a market-based interest rate. Interest rates ration money to the most productive projects by raising the hurdle rate. The Quantitative Easing bond-buying program has served to artificially depress lending rates and spur economic activity. As economic activity accelerates, the Fed needs to allow interest rates to normalize and resume the role of pricing money to avoid capacity constraints and ensuing inflation. If economic activity remains weak, then demand for money will be weak and rates will stay low anyway (albeit maybe not on the floor).

I don’t get the sense that there’s a lot of lending activity outside of mortgages that will be stifled if rates drift back to the range of historical norms. As long as economic activity continues its slog to normal, I see the long-awaited tapering as welcome confirmation that recovery is intact.

Animal Spirits

I’d rather experience a bull market fueled by improving fundamentals and leading economic indicators than one premised on upside risks due to potential progress on entitlement spending and the possibility that QE stimulus withdrawal might prove benign.  While the future remains uncertain, the herd is on the move.   Whether they get spooked in another direction is a risk of running with the bulls.  In 1997, I thought stocks were expensive.  They doubled in 2 years.  Then they got cut in half.  I think a tactical approach can serve a portfolio well in this type of market.  Enjoy the ride.

Equity Markets

Markets can be unpredictable and irrational, in case you haven’t noticed.  Sometimes they are driven by fundamentals, and sometimes by momentum stemming from fear or euphoria. In the late 90’s we witnessed a bubble based on speculation about the internet economy.  In 2008-09 we stared into the abyss and thought the end had arrived.  With the benefit of hindsight, the market overreaction seems clear.S&P 500 Graph

If you want equity returns, you need to accept the irrational turns in the market.  In the long-term, meaning 5 years or more, fundamentals matter.  Any investment is worth the present value of the future cash flows.  The problem is, expectations of cash flows can change in a hurry, but time resolves most big questions.

Plan and set aside your cash needs for several years, and keep those funds in a safe place.  But don’t let fear keep you on the sidelines.  You could find yourself in a bear trap for a long time, waiting for the market to come back.

Chart source: Yahoo Finance, period July 2, 1990 to October 1, 2013. S&P 500 Index.  Investing involves risk of loss.  Past performance is no guarantee of future returns.

Boutique vs Enterprise Wealth Management

I run a boutique wealth management practice.  There is a trend toward bigger firms using a team approach with relationship managers, investment specialists, financial planners, attorney’s and tax professionals on staff. They bring vast resources to the table.  More expertise and experience must be better, right?  Maybe not.  These large advisory firms are not built to enhance the relationship between client and advisor.  Rather, they are designed as scalable models of efficiency to build and manage ever-growing piles of assets.  An advisor’s ego is directly correlated with the amount of assets his firm manages.  It is the measure of success in the industry.

I believe a firm of specialists compartmentalizes the firm’s view of the client. 

The challenge for the client is finding a financial advisor competent in the areas they need.  Investment management and financial planning are my specialties.  If tax or legal assistance is required, I have seasoned relationships that may serve clients better than restricting the choice to whoever a large firm brings on staff. If the investment advisor and the financial 

planner are not in the same body, something will get lost in their communication.  Maybe not in the quantified financial planning report, but in the emotional tone or body language the client showed in the planning interview.

Who’s really calling the shots and who answers the phone when you call?

Fiscal Dysfunction

It looks like Congress will kick the can again, raising the debt ceiling and keeping the Government open.  That’s nice, since the failing to pay U.S. creditors is the equivalent of Russian roulette.  The potential consequences of default are difficult to imagine.  But if I had to imagine a scenario that could compare to the mortgage crisis, with all the unforeseen and little understood interrelationships, a Treasury default would be a good place to start.  So, that’s the good news. It looks like the risk of imminent crisis is diminished.

But kicking the can is not solving the underlying problem.  We have to contain our spending problem.  There is a tipping point, when servicing the U.S. debt crowds out our ability to fund programs we are accustomed to.  If Congress doesn’t take the initiative, the markets will do it for us.

Eventually interest rates will go up, and the cost of servicing our debt will grow even if we don’t raise the debt ceiling.