Sunday, March 26, 2017

Bonds Can Hurt Retirement Capital


Running out of money is the single biggest fear of all investors and should be of their portfolio managers and other fiduciaries. Unfortunately far too many focus on a perceived capital amount to meet their long-term funding needs. Unfortunate because they do not include allowances for taxes, inflation, and mistakes both in terms of investments and unplanned expenses. Thus their retirement or legacy needs are often understated. Because of these understatements/reasonable errors I believe payout of accumulated capital over 3% annually may lead eventually to the depletion of capital  in part or completely.

Universal Problem

There are apparently a number of perceived missing elements in every country's constitution. The global rise in populism is based on the belief that our society, in other words our government, owes each able bodied person gainful employment, and for the others some form of support. To the best of my knowledge the economic structure of no country is set up deliver on these perceived, unwritten promises. Thus this is the first big problem facing us.

Retirement Capital

However there is a second and perhaps even bigger problem that is accelerating ahead of us. Any quick review of national statistics will show that the need for retirement capital is actually growing faster than the need for jobs. To some degree the need for jobs is being addressed in the much reduced growth in population around the world, except in Africa and some parts of the Middle East. The existing unemployment and under-employment is creating a growing class of people that have little to nothing in the way of retirement capital even if they qualify for the under-funded social security.

Demographically there will be others such as the disabled and currently incarcerated who will enter the retirement stage with little or no capital. Add to these a much larger group of people entering their senior stage when they have not built sufficient retirement capital. All of these people (unlike some of the unemployed) can vote and are more likely to do so than in the past.

The risk to those who believe that they have sufficient retirement capital may be  a gross miscalculation. Eventually our societies will react to these needs. While hopefully they may make investing more profitable by lowering expenses and taxes, the odds are that governments will spend money. In some combination the money will impact taxes on (a) those that have money, (b) inflation for all, and (c) deficits which will drive interest rates up and the value of currencies down. It is these prospects plus the current low real interest rates, after inflation, which makes investing in high quality bonds risky if they have to be sold to make payments. 

Currently the Proper and Improper Use of Bonds

After a long struggle to build sufficient retirement capital with due consideration to the growing needs of present and future beneficiaries, an individual or institutional investor may wish to reduce the risk of losing meaningful amounts of retirement capital, one could properly invest in high quality bonds. This assumes that the current interest rates are above the after-tax inflation rate. Such an investor is both extremely rare and lucky. All other bond owners are speculating as to the future. 

At current interest rates adjusted for inflation and taxes it is difficult to see how bonds can be used to actually build retirement capital as distinct from maintaining it. Many if not most bond holders do so in the belief that there is less price risk in owning bonds than owning stocks or other forms of equity. Historically they are right in that most market declines bonds decline less than the stocks. Thus, I believe the proper way to look at the allocation of assets to bonds is a longer term index of fears of stocks than the VIX or other measures of short-term volatility.

Bonds Could be Worthwhile

As with all investment strategies there is a time that they are correct and other times when they are wrong. Unfortunately, I can perceive that once again interest rates will be driven so low that they can make bonds attractive to new purchasers. For those who have owned bonds for sometime, the offset is that during such a period if they have to sell their bonds the odds are the prices will be below (and perhaps significantly below) their purchase prices. There have been periods in history when purchasing high quality bonds with highly elevated yields produce in time big price appreciation benefits. My only problem with this strategy is that most of the time by the end of these market recoveries, one would have been better buying equities.

Equity Risk in Some Bonds

High yield bonds and to some extent high interest loans have been called stocks with coupons. This means while these credit instruments are called bonds and loans they have imbedded in them risk of late and/or incomplete repayment as scheduled. Unfortunately many individual and institutional investors have focused on the bond-like attributes of this kind of paper and have enjoyed the performance comparisons of high yield paper out-performing high quality bonds. Perhaps they didn't notice that in most of these periods stocks in general out-performed both high yield and high quality bonds, but they could claim that they were more conservative because they owned bonds and loans and not those risky stocks.

Spending Too Much of the Income

One of the real disadvantages of high yield paper is that most investors spend all of the interest payments as if they were from a high quality source. Note that in many periods the price performance of these assets is below the total return performance results by more than the paid interest . The missing difference is the impact of the defaults on a minority of these bonds. The major credit rating groups regularly publish their estimates of the forthcoming default rates of this asset  To the extent that investors want to spend the payments off of high yield paper, I would recommend that they put into some reserve account at least the current default estimates on the category. Often when defaults rise all of these types of paper fall to some degree in sympathy to the defaulting issues.

Bond Market Liquidity is Illusive

The liquidity in the bond market is considerably less than in the stock market which makes it difficult to sell during periods of unrest. This is particularly true in the high yield market. In one recently recorded instance that is part of a law case, the nominal bid for a bond was 65 ($0.65 per dollar of face value.) A large professional seller encountered the following situation: 60 to sell $1 million, 50 to sell $2-5 million and 31 for more. What is the worth of this account's net asset value with a nominal quote of 65?

The Problem with Bonds are the Bond Buyers

As with most things the problem with various instruments; e.g., guns or fast cars, are not inherent in the instruments themselves, but the people who use them. Utilizing Schroders* Global Investors Study 2016 one can see individual and institutional investors bring the wrong attitudes to investing in securities and funds. The desired income broken down by location was instructive. Europeans wanted 7.9%, Asians 9.7% and those in the Americas 10.4%. One should not be surprised to learn that the Europeans in aggregate hold a higher allocation to bonds than those in America, but with an older population and more proportion of  debt than those on this side of the pond. Thus they are growing their retirement capital deficit faster as well as having higher unemployment and underemployment which helps to explain their more socialist oriented government. What is most interesting is that those surveyed thought they would live a long time in retirement. In addition, 74% thought they would live sixteen to thirty years in retirement. Contrast that image with their practice of owning particular securities 3.2 years and their advisors recommending holding for on average 4.3 years. In effect what the study is showing is that investors with a long-term need for retirement income plan to trade around five times during their retirement years. While not a perfect comparison, long-term studies of US Mutual Funds suggest those that on average trade less, perform better.
*Held personally

Bear all of this in mind with the surge of global money going into bond funds at the same time that they are significantly under-performing the average equity fund.

US Investors May Do Better

According to the trade association for mutual funds, ICI, 60% of defined contribution assets are invested in equity funds.  With a significantly older weighted population, 54% of Individual Retirement Accounts are in equities. Roughly half of the money in these two main retirement accounts are in mutual funds. Typically defined contribution and IRA accounts don't trade much. To the extent that they don't trade and invest for longer periods of time they will build retirement capital sums. They could be augmented if the tax people allow these accounts to grow without mandatory redemptions way beyond the current 70 ½ years old.  

If the current US Administration and Congress really want to increase employment, perhaps they will focus on small companies being the largest contributors of new jobs - despite the fact that the number of publicly traded companies has dropped by 3000 over the last twenty or so years. We are down about 1/3 from our previous total.

Investment Conclusions 

At the current time, high quality bonds don't make a lot of sense for most retirement accounts. Also the average US investor, excluding currency, is likely to perform better than their European counterparts. This is particularly true if smart job generating tax programs are put into place.
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A. Michael Lipper, C.F.A.,
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Sunday, March 19, 2017

Six Contributors to Future Performance


Delivering on funding goals is more important than ego satisfaction. 

Investors and their managers want to be winners, or at least feel like winners. That is why there are daily price movements published, which is the same reason that most US race tracks have eight to ten races a day. The one clear observation on both presentations is that it is almost impossible to be a winner in every investment and every wager, every day.

One of the lessons I learned at the track and investing for our clients is to be highly selective as to which contests that I choose to put money into.

My style of both investing and other wagering is to focus on what contests are important to win. This has led to the development of the TIMESPAN L Portfolios® which looks to meet critical payment needs broken into various time periods. With that as a guiding principle, I tend to sort the enormous amount of daily inputs we all are besieged with, by assigning them to different timespans. In that way, the information is put into period-based categories where the information is most useful to aid in achieving goals.

Six Timespan Sorts

What follows is how I sort the flow of information (and perhaps misinformation) into the most useful timespans.

1. Present trading environment-A quick look at the price indices for the three major US stock indices have very similar  patterns. In the recent burst of enthusiasm all three had upward price gaps which lasted for a few weeks. One of the rules of thumb is that eventually all gaps have to be filled by an equal and opposite reaction. This has been done. Soon after filling the gap, upward momentum stalled and now the price patterns appear to be in a top formation. The "bulls" would characterize it as a consolidation awaiting further, hopefully positive, developments. After all there has not been as much as a 1% decline in the value of the S&P500 in any single day since October 11th, 2016. (Barron's has noted that after the last period of 100 days without a single day drop of 1%; was followed a year later, when the index was up +75%.)
2. Current economic picture-While central banks tend to speak in terms of government sourced economic statistics, they are starting to react to the signs coming from the commercial world. Around the world many businesses are getting better with the only short term concerns is finding qualified help. We personally know of US businesses hiring and the apparent replacement of old help wanted ads with new ones at higher initial wages offered. Growth is spa radically  picking up globally selectively in Europe and significantly in Indonesia and Singapore. While not always accurate, The Economist has an article headlined “The global economy enjoys a synchronized upswing.” 

3.  China remains both the short-term and long-term wild card. US Secretary of State Rex Tillerson is in Beijing meeting with his counterpart. This is a ‘getting to know you’ meeting, trying to find areas of future cooperation. Combine this with the speech of Apple's* CEO on Saturday in Beijing and his meetings early next week with the leading political and economic leaders of China, which can further clarify the nature of Chinese progress to becoming an even bigger player on the world stage. While the current government of China has apparently managed its economy best in the world of large nations, a recession or even a major slow down in its growth would be destabilizing to the US and much of the world. This possibility does not appear to be priced into the global stock markets. 

4.  Market leadership and structure changes could be disruptive or opportunities. Charles Schwab* has issued an intelligent study that portrays that the superiority of small caps compared to large market capitalization stocks is going to be reversed due to both market liquidity concerns and valuations. This view could be supported by The Financial Times which reports a study that predicts that one-third of City (UK's Wall Street) analysts will lose their jobs due to regulatory disclosure practices. They note that this could produce more underpriced securities which will tend to be in small to mid caps. We have seen for sometime similar trends within the US which is one of the reasons that US small caps have performed so well as captured in a number of mutual funds. A Quarterly Institutional Review by Dimensional Fund Advisors demonstrates that the superior performance of many small caps comes from value and core funds not small cap growth funds. Our investment funds and portfolios will almost always have different mixes of Large Cap and Small Cap funds.

*Stocks owned either personally or in the private financial services fund I manage

5. The march of what is called “popularism” will probably continue despite this week's Dutch election. While that particular populist party did not come out as the feared leader, it did add to its number of seats while the victorious establishment party lost a much larger number of seats. Despite the sense of relief by the establishment's financial inherent leaders in France, the FT noted in a headline "Financiers lineup to engage with LePen." I speculate that unless the various establishment parties launch new programs that effectively address the levels of dissatisfaction being expressed globally, it is only a matter of time before there will be a political leadership change. (I am not suggesting that those that are not part of the governing bodies will themselves provide solutions, but have the advantage of the old slogan "throw the bums out." 

6. Final Worry-According to my old firm's research, on a global basis  investors have put $1.1 Trillion into Bond funds in the last three years compared with $750 Billion into Money Market funds, $569 Billion into Equity funds and $123 Billion into Mixed Asset funds. At some point with the built-in rise of interest rates and signs of inflation, bond prices will decline and put investors further behind in their needs for retirement capital. The bond market participants include not just slow moving investors, but also trading entities, including ETFs and hedge funds -  some of which borrow heavily against their portfolios. If bond prices collapse due to the lack of market liquidity one could see significant counterparties’ risks which could hurt the stock market regardless of the economic outlook. These counterparties may have to sell their equities at any price to meet their margin-called debts.  


My special Blog Post of March 15, entitled “We Cannot Escape Being Global” discussed the visit of Chinese President Xi Jinping’s to meet President Trump in Palm Beach.  The correct dates of the meetings are April 6 & 7. 

Click here to read my special blog post.
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A. Michael Lipper, C.F.A.,
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Thursday, March 16, 2017

We Cannot Escape Being Global


I think about this blog every day, culminating in my weekly “Monday Morning Musings.”  Very occasionally events occur during the week that I would like to share as soon as possible. 

One of the approaches I use in this Blog is to relate current information to historical context.  This post is an example.  

Our Needs are Global

Almost all of our own economic activities, much of the food we eat and many of our social attitudes are influenced beyond our national borders. The whole concept of ‘national states’ presumed that the bulk of the population had a large number of common interests which were sufficiently different than our neighboring national states that created a specific legal identity. We were different than our neighbors. We choose to have "us" govern our national state which in the past represented our world.

“One World”

This belief is no longer true and matter of fact has not been true regardless of our laws and taxes for a number of generations. When Franklin Delano Roosevelt defeated Wendell Willkie for US President in 1940, he did something that no other  President has ever done before or since. (My late Mother was a political aide to Mr. Willkie.)

FDR sent Willkie around the World to meet with foreign leaders including some that were not presently within their governments as a way to build the critical alliances needed to defeat the Axis. As an outgrowth of this wartime trip came Wendell Willkie's book, "One World" which to a large degree predicted the reality of today’s increasingly close dependency of one national state with others. Almost every major international trend since at least WWII has reinforced these dependencies.

President Xi’s Visit

This week, due to the snow storms in the Northeast US, Ruth's and my return from Florida meetings has been extended due to extensive flight cancellations. In a classic example as to the impact of the broader world on our personal lives, we are staying at a Palm Beach hotel within about a mile of Mar-A-Lago, the unofficial winter White House of President Trump. Traffic and other security measures are strict and will be tightened even further for the April 6 & 7 visit of the leader of China to the US President.

Perhaps by the following Monday the pundits will be declaring who won, lost, or achieved a draw.  My guess is that over time, the pundits’ judgments will be proven at least to be incomplete and probably wrong.  China and the US share many of the same problems: ISIS, aging population, bloated bureaucracies and the re-definition our global roles. At best the two leaders will identify their similarities and differences.  The meeting may be as  important as the meeting at Yalta.

Recognize our Co-Dependence with China

The meeting of the leaders of the two largest economies in the world reinforces to me our co-dependence. China is the world's largest consumer of many traded commodities. These commodities are traded globally with daily fluctuating prices. These prices often represent inflationary pressures that eventually impact producer and consumer price indices that the central banks use in setting their monetary policies. I am particularly conscious of the Chinese impact on technology as it assiduously protects the largest consumer marketplace in the world and is still a major exporter of technological product. The drive of the present government to increase the portion of its internal economy devoted to services has a direct impact on the US as the largest exporter of services.

Investing successfully in China is difficult whether through joint-ventures or publicly traded shares. We are exposed to both in investing international funds and multi-national companies. Luckily we have other exposures, as investing in China has not today produced much in the way of cash dividends and who knows in the way of earnings. Nevertheless, I believe that all investors and many people will be affected by what happens in China. Thus, we need to recognize our co-dependence in thinking about both our portfolios and our lives. 
Did you miss my blog last week?  Click here to read.

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.