"How come I love having an episode of deja vu? Its akin to an out-of-body experience, I would think. It sits with me, happily, begging me to delve into my memory to find its match point." - Rachel Nichols
Is it just me but it certainly appears that we have seen this before. Stocks flying higher on the back of supposedly good unemployment numbers and the expectation that the economy will rebound in the second half of the year. Stock valuations are at their second highest level in history and yet they seem to continue higher. The Federal Reserve wants us to think all is well with the economy so it continues to hint that higher interest rates are coming "soon" and that it will exit from its strategy of creating liquidity out of thin air, magically evaporating $4 trillion without any impact to the markets.
While on the surface things do appear to be headed in the right direction when compared to original expectations it is clear things are very different. Every report that comes out either beats sharply lowered expectations or is revised lower once the real data is known. Take for example first quarter GDP growth. At the beginning of the year first quarter GDP growth was forecast to come in at 1.9% but this was relatively quickly revised down to 1.4%. Subsequent to this the Bureau of Economic Analysis reduced its estimate to 0.2% but today's report on inventories showed an increase of only 0.1% instead of the estimated 0.6% so this will take the GDP data lower. I would not be surprised to see GDP contract in the first quarter but this does not seem to bother the markets.
What does matter is low interest rates and on this front there is no end in sight. Even with the newly printed unemployment numbers coming in at 5.4% the Federal Reserve will still not be required to raise rates any time soon as the anemic GDP growth shows a complete lack of economic traction which should keep inflation at bay. Furthermore while the unemployment numbers are clearly heading in the right direction it appears that businesses have little desire to add more workers as production levels were stable as was the work week and earnings. This leaves little doubt that the consumer will not be a catalyst for growth in the second half of the year, resulting in continued slow growth and no chance of an interest rate hike. Furthermore the thought of raising interest rates blowing the budget deficit into orbit is not something that anyone can stomach particularly in this run up to the presidential elections so to me these rates (outside of an unknown catastrophic event) should remain mute.
In fact with rates in Europe below zero (you pay to have them hold your money) and debt across the globe continuing to spiral higher it seems that Deja Vu is back. Therefore to me it is not whether the stock market will collapse it is just from what altitude. Looking at the S&P which sits just below its all time high at 2116, there is no reason to believe that 2500 or 3500 is out of the question. As long as interest rates stay low, which I believe that they will, the market seems content to rally higher, poor economic data or not. The issue then is that if it is overvalued at 2116 and could correct to at least 1500 on the downside then if it does get to 3500 and corrects to 1500 the pain will be far greater. This will be the same story of 2000 and 2008 repeating itself but there is a twist.
In the past the market buckled to local pressures which were normally related to higher interest rates slowing the economy too quickly. The solution was to lower interest rates and free up liquidity. This time around, with the world awash with debt and interest rates at unsustainably low levels, there is no safety valve. This is what makes this time around Deja Vu with a Twist. What concoctions can they come up with next time to "save" us from their mess? I came up with the solution a few years ago which was laughed out of the room; but I will repeat it here and - the global bond. In fact the more I see the madness the more I am sure that this will be the result. If there is a global meltdown caused by global debt the only solution would be to sweep the balance sheets clean by rolling the whole lot into one massive global bond supported by the goodwill of all the countries of the globe. Next to impossible I can hear you say, but what choice will they have and, if that ever happens, you will be able to say "Now that is Deja Vu with a Twist!"
Friday, May 8, 2015
Friday, May 1, 2015
A Bubble in China?
"Globalization has created this interlocking fragility. At no time in the history of the universe has the cancellation of a Christmas order in New York meant layoffs in China." - Nassim Taleb
Over the last few years there has been plenty of speculation that the miracle that is China's economic growth would become undone and that in the very near future China would fall into a recession dragging the rest of the world with it. The thought was that with all the over building and excess manufacturing capacity combined with rife political nepotism and its resulting inefficiencies mixed in with poor economic oversight and mismanagement, the economy would soon collapse. Even with their massive trade balance and capital surpluses China would not be able to handle a slow 6% to 7% GDP growth. So the world held its breath as China's economic growth slowed during the recession and then speculated for a number of years that the economic spending on useless projects would soon backfire; but with China entering another year of slower GDP growth (potentially sub 7% GDP growth) it is interesting to uncover reasons that reduce the fear of an imminent collapse.
The first metric is a look at some of the cities that were essentially ghost towns a few years ago. Zhengzhou as an example was desolated in 2013 and now is teaming with people, businesses, universities and schools. This is not to say that housing, which was the main economic driver, will resume its ascent. Housing prices fell 6% last year and could fall even further this year. For this reason many builders have placed their projects on hold and are waiting for a more favorable housing environment before completing them. This will take some of the pressure off prices and with sales of houses increasing more than 20% in 2014 over 2013 it will not be long before building resumes.
The second potential problem is their ever increasing public and private debt level. Looking at the debt as a number it certainly shows signs of being a massive problem but digging a little deeper reveals that a lot of the debt is concentrated in government entities, construction and property developers. While still high, owing money to yourself is a problem that can be sorted out over time (the United States is certainly betting on this theory as well) rather than being forced upon you by outside creditors. That said should a few large property developers who are currently in the throws of defaulting spook the market, a problem could ensue but for now it appears that these problems are contained.
The third metric is China's consumption-led growth. With the burgeoning middle class starting to gain traction, China's consumer led consumption is on the rise. With more and more new jobs being created in the service sector, even a slower GDP growth can be tolerated as consumer consumption can offset investment led consumption once again allowing China to handle a slower growth rate than was previously estimated.
So while it seemed like China was on the verge of collapse is appears that it may be able to dodge a bullet. That said China's weak and flawed economic foundations still require a lot of work. It is still difficult to move money around the country or invest abroad, options for savers and investors are limited largely to state controlled enterprises, municipalities have limited ability to control their finances or change tax structures essentially handcuffing them economically and, while they are trying to crack down on bureaucratic self dealing there is still a lot of work to be done. All in all though it appears that things are headed in the right direction and this is a good thing for the rest of the world particularly when the global economy has become so interwoven. So while there may still be a bubble in the Chinese stock market there is hope that the economy will be able to withstand slower growth.
Over the last few years there has been plenty of speculation that the miracle that is China's economic growth would become undone and that in the very near future China would fall into a recession dragging the rest of the world with it. The thought was that with all the over building and excess manufacturing capacity combined with rife political nepotism and its resulting inefficiencies mixed in with poor economic oversight and mismanagement, the economy would soon collapse. Even with their massive trade balance and capital surpluses China would not be able to handle a slow 6% to 7% GDP growth. So the world held its breath as China's economic growth slowed during the recession and then speculated for a number of years that the economic spending on useless projects would soon backfire; but with China entering another year of slower GDP growth (potentially sub 7% GDP growth) it is interesting to uncover reasons that reduce the fear of an imminent collapse.
The first metric is a look at some of the cities that were essentially ghost towns a few years ago. Zhengzhou as an example was desolated in 2013 and now is teaming with people, businesses, universities and schools. This is not to say that housing, which was the main economic driver, will resume its ascent. Housing prices fell 6% last year and could fall even further this year. For this reason many builders have placed their projects on hold and are waiting for a more favorable housing environment before completing them. This will take some of the pressure off prices and with sales of houses increasing more than 20% in 2014 over 2013 it will not be long before building resumes.
The second potential problem is their ever increasing public and private debt level. Looking at the debt as a number it certainly shows signs of being a massive problem but digging a little deeper reveals that a lot of the debt is concentrated in government entities, construction and property developers. While still high, owing money to yourself is a problem that can be sorted out over time (the United States is certainly betting on this theory as well) rather than being forced upon you by outside creditors. That said should a few large property developers who are currently in the throws of defaulting spook the market, a problem could ensue but for now it appears that these problems are contained.
The third metric is China's consumption-led growth. With the burgeoning middle class starting to gain traction, China's consumer led consumption is on the rise. With more and more new jobs being created in the service sector, even a slower GDP growth can be tolerated as consumer consumption can offset investment led consumption once again allowing China to handle a slower growth rate than was previously estimated.
So while it seemed like China was on the verge of collapse is appears that it may be able to dodge a bullet. That said China's weak and flawed economic foundations still require a lot of work. It is still difficult to move money around the country or invest abroad, options for savers and investors are limited largely to state controlled enterprises, municipalities have limited ability to control their finances or change tax structures essentially handcuffing them economically and, while they are trying to crack down on bureaucratic self dealing there is still a lot of work to be done. All in all though it appears that things are headed in the right direction and this is a good thing for the rest of the world particularly when the global economy has become so interwoven. So while there may still be a bubble in the Chinese stock market there is hope that the economy will be able to withstand slower growth.
Friday, April 24, 2015
CMI Flashes Red
"We now know that the readings of last month were not a fluke or some temporary aberration that could be marked off as something related to the weather. There is quite obviously some serious financial stress manifesting in the data and this does not bode well for the growth of the economy going forward." - National Association of Credit Management report for March 2015
The Credit Managers' Index (CMI) is an index put together by the people paid to spot trouble early. Credit managers are the people that approve or reject applications for credit. Furthermore they are the same group that try to collect on the debt once it is issued. So this group has a very keen understanding of the health of the economy which is why I like to follow the index closely.
To give you a better understanding of the index it is based on a scale of 50. Anything that is higher than 50 means that the indicator is showing signs of health; a reading therefore less than 50 shows signs of strain. Back in 2008 the reading plunged from roughly 55 to 50 in a couple of months before then falling to 40 in the midst of the recession. Once again this reading has fallen from 55.1 to 51.2 in two months, a sever contraction not recorded since right before the previous recession. Prior to February the index had hovered around 55 for the past 5 years with moderate fluctuations but nothing serious. So in February when the index tested its lower boundary it was a concern but now that it has bust the bubble it could mean trouble is coming at a very rapid clip.
Digging into the numbers shows that while the number of applications for credit is rising, the number being rejected is growing faster. This means that the companies requesting the credit are struggling and are not strong enough financially to handle the additional credit so they are being turned away. Companies that could be given credit lines are not taking on more debt so the number is falling. This is creating a financial squeeze similar to that which occurred right before the previous contraction. With this type of financial squeeze going on it is only a matter of time before a number of bankruptcies are announced but for now this is one number that has yet to fall into the negative category.
The ripple effect of these bankruptcies will be felt throughout industry as these debts that were previously recorded as either performing loans or accounts receivable will have to be written off creating an overall contraction of credit and a strain on company and bank cash flows. The problem this time around is that the Federal Reserve has already spent $4 trillion getting us nowhere so announcing another round of quantitative easing while more likely than not, will not help alleviate the stresses caused by a weak business environment. What it could do is once again ignite the currency warfare and drive not only Europe but the rest of the world into a recession.
Keep your eyes on this indicator as it does not normally flash red unless there is a real danger ahead.
The Credit Managers' Index (CMI) is an index put together by the people paid to spot trouble early. Credit managers are the people that approve or reject applications for credit. Furthermore they are the same group that try to collect on the debt once it is issued. So this group has a very keen understanding of the health of the economy which is why I like to follow the index closely.
To give you a better understanding of the index it is based on a scale of 50. Anything that is higher than 50 means that the indicator is showing signs of health; a reading therefore less than 50 shows signs of strain. Back in 2008 the reading plunged from roughly 55 to 50 in a couple of months before then falling to 40 in the midst of the recession. Once again this reading has fallen from 55.1 to 51.2 in two months, a sever contraction not recorded since right before the previous recession. Prior to February the index had hovered around 55 for the past 5 years with moderate fluctuations but nothing serious. So in February when the index tested its lower boundary it was a concern but now that it has bust the bubble it could mean trouble is coming at a very rapid clip.
Digging into the numbers shows that while the number of applications for credit is rising, the number being rejected is growing faster. This means that the companies requesting the credit are struggling and are not strong enough financially to handle the additional credit so they are being turned away. Companies that could be given credit lines are not taking on more debt so the number is falling. This is creating a financial squeeze similar to that which occurred right before the previous contraction. With this type of financial squeeze going on it is only a matter of time before a number of bankruptcies are announced but for now this is one number that has yet to fall into the negative category.
The ripple effect of these bankruptcies will be felt throughout industry as these debts that were previously recorded as either performing loans or accounts receivable will have to be written off creating an overall contraction of credit and a strain on company and bank cash flows. The problem this time around is that the Federal Reserve has already spent $4 trillion getting us nowhere so announcing another round of quantitative easing while more likely than not, will not help alleviate the stresses caused by a weak business environment. What it could do is once again ignite the currency warfare and drive not only Europe but the rest of the world into a recession.
Keep your eyes on this indicator as it does not normally flash red unless there is a real danger ahead.
Friday, April 17, 2015
A $2 Trillion Hand Brake
"I couldn't repair your brakes so I made your horn louder." - Unknown
In a fascinating article in the Economist Magazine entitled "The paradox of soil", the authors put forth that the cost of strict land regulation in major metropolitan areas around the world is like a hand brake on economic growth. In the United States it is estimated that the lost GDP is around 13% a year or $2 Trillion. This is a very large number and unlocking this blockage would result in significant benefits to society and economic growth.
In the past restricting land development, particularly in large metropolitan areas, was thought prudent due to the inherent slums and poor living standards that urban sprawl created. Through the years land development controls were put into place to restrict development so that these problems were eradicated. Fast forward to today and these controls have now moved far past the median and are creating enormous drags on economic growth. Removing or streamlining a significant portion of these over burdensome controls is the key to unlocking significant economic gains.
In the past it was thought that technology would make cities obsolete. Workers would be able to work anywhere so there would be a tendency to relocate out of the cities to cheaper more remote places. It turns out that the opposite is true. Major metropolitan areas create brain pools that cannot be replicated elsewhere. People living in these brain pools are stimulated by their peers in ways that cannot be replicated moving away. For this reason cities like London and San Francisco continue to attract people while the outlying areas remain a backwater.
Furthermore it is shown that due to the concentration of people in the metropolitan areas a large swath of wealth inequality occurs in these cities as landlords receive a larger proportion of income on their land holdings that those who own similar tracts of land outside of these areas. The impact is even larger when you consider that as the rent rises the poor are pushed further from the city center, away from the brain pool and this further out of the main stream. This inability to partake in the activities of the main stream expands the inequality and forges a barrier to entry.
In addition, as the cost to living in these cities increases people that are living on the margin of prosperity leave the city in search of a better quality of living elsewhere. As we have seen above, leaving the brain pools reduces their productivity thereby slowing economic growth and pulling harder on the economic hand brake.
I have to say that I am living through the nightmare that is city planning and development in that I have spent the past 4 years trying to get a 22 unit parking lot built downtown San Diego. Now I will be the first to admit that this is not the type of expansive land use that the authors of the article are promoting but when you consider that after 4 years I still do not have the necessary permits issued you can see immediately the drag on economic growth. Were it easier to obtain permitting I would have considered building an apartment complex (which is exactly what the authors think will lead to greater economic growth) but who knows how long that would have taken and how much it would have cost.
So while I believe that some land development restrictions are required to ensure green areas and healthy living standards for all, loosening the strangle hold that is strict developmental control and allowing development to occur would have an immediate and direct impact on the economic outlook to not only the city but the nation as a whole and that should be a high priority in all cities across the globe.
In a fascinating article in the Economist Magazine entitled "The paradox of soil", the authors put forth that the cost of strict land regulation in major metropolitan areas around the world is like a hand brake on economic growth. In the United States it is estimated that the lost GDP is around 13% a year or $2 Trillion. This is a very large number and unlocking this blockage would result in significant benefits to society and economic growth.
In the past restricting land development, particularly in large metropolitan areas, was thought prudent due to the inherent slums and poor living standards that urban sprawl created. Through the years land development controls were put into place to restrict development so that these problems were eradicated. Fast forward to today and these controls have now moved far past the median and are creating enormous drags on economic growth. Removing or streamlining a significant portion of these over burdensome controls is the key to unlocking significant economic gains.
In the past it was thought that technology would make cities obsolete. Workers would be able to work anywhere so there would be a tendency to relocate out of the cities to cheaper more remote places. It turns out that the opposite is true. Major metropolitan areas create brain pools that cannot be replicated elsewhere. People living in these brain pools are stimulated by their peers in ways that cannot be replicated moving away. For this reason cities like London and San Francisco continue to attract people while the outlying areas remain a backwater.
Furthermore it is shown that due to the concentration of people in the metropolitan areas a large swath of wealth inequality occurs in these cities as landlords receive a larger proportion of income on their land holdings that those who own similar tracts of land outside of these areas. The impact is even larger when you consider that as the rent rises the poor are pushed further from the city center, away from the brain pool and this further out of the main stream. This inability to partake in the activities of the main stream expands the inequality and forges a barrier to entry.
In addition, as the cost to living in these cities increases people that are living on the margin of prosperity leave the city in search of a better quality of living elsewhere. As we have seen above, leaving the brain pools reduces their productivity thereby slowing economic growth and pulling harder on the economic hand brake.
I have to say that I am living through the nightmare that is city planning and development in that I have spent the past 4 years trying to get a 22 unit parking lot built downtown San Diego. Now I will be the first to admit that this is not the type of expansive land use that the authors of the article are promoting but when you consider that after 4 years I still do not have the necessary permits issued you can see immediately the drag on economic growth. Were it easier to obtain permitting I would have considered building an apartment complex (which is exactly what the authors think will lead to greater economic growth) but who knows how long that would have taken and how much it would have cost.
So while I believe that some land development restrictions are required to ensure green areas and healthy living standards for all, loosening the strangle hold that is strict developmental control and allowing development to occur would have an immediate and direct impact on the economic outlook to not only the city but the nation as a whole and that should be a high priority in all cities across the globe.
Friday, April 10, 2015
When will the Bull market end?
"As a bull market continues, almost anything that you but goes up. It makes you feel like investing in stocks is very easy and safe and that you're a financial genius." - Ron Chernow
I am repeatedly asked when I think the Bull market will end so it was interesting when I read a blog article today written back in November 2013 by Manley Market Insight where he answered the question by pointing to three reasons for a possible decline: 1) the Federal Reserve adopts a restrictive monetary policy; 2) sales and earnings decline sharply without prompting from the Federal Reserve; and, 3) valuations become too high and collapse on their own weight.
I completely agree with him but it appears to me that we do not only have one of these problems but all three. Right now we have a Federal Reserve that has stopped printing money and is hinting at raising interest rates (restrictive monetary policy); corporate sales have been declining for a while and the US Commerce Department announced that in Q4 2014 corporate profits fell 3% and are on pace to decline again in the first quarter of 2015; and no matter what market metric you look at the market is way overvalued. In fact the market is at its second highest level in its history. With trading volumes dropping and the length of the bull market at six years already almost twice as long as the average bull market, it appears to me that we may have a triple play brewing.
A lot of the cause of this is the recent strength of the US dollar. The vast majority of the fortune 500 rely on expansion and growth in markets outside of the Untied States and with weakness in foreign currencies and countries, sales growth and profits are being hit. Even the benefit of the lower oil price is muted as consumers are not only saving the extra cash but they have not really felt the full impact as prices at the pump have risen by almost 20% during the last two months. Volatility is also picking up with the most 1% daily moves since Q4 2011 right before the last 10% correction.
With all of the poor economic news coming out of Europe, Asia and South America I cannot imagine that the Federal Reserve will be dumb enough to raise rates any time soon. In fact the one thing that no-one is talking about is the next round of quantitative easing from the Federal Reserve. Personally I expect more easing before any type of interest rate increase. In fact I expect that this year there will be a 10% plus correction in the market that will force the Federal Reserve to inject more stimulus into the economy. Unfortunately the type of stimulus that they are akin to use has never worked and hence it will be more futility and cause a larger problem later, however it will have the effect of stimulating the market to possibly new highs.
As I have mentioned above the market is on a seriously rocky road and the stimulus is not a fix but rather a larger problem. If you are looking for a place at which to sell, this might be a good time to diversify out of the market and head to distant shores.
I am repeatedly asked when I think the Bull market will end so it was interesting when I read a blog article today written back in November 2013 by Manley Market Insight where he answered the question by pointing to three reasons for a possible decline: 1) the Federal Reserve adopts a restrictive monetary policy; 2) sales and earnings decline sharply without prompting from the Federal Reserve; and, 3) valuations become too high and collapse on their own weight.
I completely agree with him but it appears to me that we do not only have one of these problems but all three. Right now we have a Federal Reserve that has stopped printing money and is hinting at raising interest rates (restrictive monetary policy); corporate sales have been declining for a while and the US Commerce Department announced that in Q4 2014 corporate profits fell 3% and are on pace to decline again in the first quarter of 2015; and no matter what market metric you look at the market is way overvalued. In fact the market is at its second highest level in its history. With trading volumes dropping and the length of the bull market at six years already almost twice as long as the average bull market, it appears to me that we may have a triple play brewing.
A lot of the cause of this is the recent strength of the US dollar. The vast majority of the fortune 500 rely on expansion and growth in markets outside of the Untied States and with weakness in foreign currencies and countries, sales growth and profits are being hit. Even the benefit of the lower oil price is muted as consumers are not only saving the extra cash but they have not really felt the full impact as prices at the pump have risen by almost 20% during the last two months. Volatility is also picking up with the most 1% daily moves since Q4 2011 right before the last 10% correction.
With all of the poor economic news coming out of Europe, Asia and South America I cannot imagine that the Federal Reserve will be dumb enough to raise rates any time soon. In fact the one thing that no-one is talking about is the next round of quantitative easing from the Federal Reserve. Personally I expect more easing before any type of interest rate increase. In fact I expect that this year there will be a 10% plus correction in the market that will force the Federal Reserve to inject more stimulus into the economy. Unfortunately the type of stimulus that they are akin to use has never worked and hence it will be more futility and cause a larger problem later, however it will have the effect of stimulating the market to possibly new highs.
As I have mentioned above the market is on a seriously rocky road and the stimulus is not a fix but rather a larger problem. If you are looking for a place at which to sell, this might be a good time to diversify out of the market and head to distant shores.
Friday, April 3, 2015
Rethinking Bonds
"He behaved like an ostrich and put his head in the sand thereby exposing his thinking parts." - George Carman
Plenty of investors have portfolios with a large allocation to bonds. It is the part of the portfolio that is considered safe and the base for creating a sustainable retirement. With rates at historic lows the main issue with a bond portfolio is reinvestment risk. This is the risk that some of your longer dated higher coupon bonds are maturing. The proceeds, if they are reinvested into similar longer term bonds, yield next to nothing. The reinvested dollars yield a very low amount creating havoc with a retiree's income.
In the modern world where financial companies are constantly trying to show the world that retirement is easy, millions of people are pouring billions of dollars into target dated funds, The idea is a nice one (and I use nice in its true sense meaning a fair idea with limited merit) but the problem is that it automatically shifts the needle on allocations more heavily into bonds as you age. This is creating a lower overall portfolio return and is not producing the desired returns impacting the ability to retire.
Rather than blindly following the herd pull your head out of the sand and survey the investment scene. First thing to do in a low interest environment is to look for places where there is yield. When you find it make sure that you are not accepting too much risk for the return. As most high yielding (and I am thinking in the neighborhood of 6% and higher here) investments are fraught with danger there are limited opportunities in this market to find the safe haven required by your retirement funds.
Assuming that you are unable to find a safe investment yielding anything of significance the next thing to do is to invest in shorter term bonds. I would not look out much further than two or three years. I know that you will be giving up some yield as short term rates are lower than long term rates but the difference is marginal. One or two percent difference will have a powerful impact on your portfolio over the long run due to the power of compounding however if rates start to rise then the drop in value of the long term bond would mean you are either stuck in that low interest investment or you have to take a far larger hit to your portfolio by selling the bond at a large loss. This to me means that you should rather earn a lower rate for the short run in order to participate in a larger rate of return later in the cycle.
The last thing you can do is reduce your allocation to bonds and focus on other parts of the market that can provide the boost your portfolio needs. One place to look is the stock market and this is touted by the "experts" as the only place to look but finding high yielding stocks is not easy and most of these stocks come with a double dose of risk; possibly cutting the dividend in poor times and/or falling precipitously from their current highs. To me this risk is the same as the higher yielding high risk bond investments. So you will have to look further afield to find returns and yields that match the requirements of your portfolio. One of these places is the property market where there are some parts of the country that can produce relatively high returns on investment with the safety of a free and clear property. Outside of this keeping this part of your portfolio secure while mitigating risk is becoming ever more difficult but one thing is for sure you will need to take some responsibility and control of your investments as we all know what happens when the blind lead the blind!
Plenty of investors have portfolios with a large allocation to bonds. It is the part of the portfolio that is considered safe and the base for creating a sustainable retirement. With rates at historic lows the main issue with a bond portfolio is reinvestment risk. This is the risk that some of your longer dated higher coupon bonds are maturing. The proceeds, if they are reinvested into similar longer term bonds, yield next to nothing. The reinvested dollars yield a very low amount creating havoc with a retiree's income.
In the modern world where financial companies are constantly trying to show the world that retirement is easy, millions of people are pouring billions of dollars into target dated funds, The idea is a nice one (and I use nice in its true sense meaning a fair idea with limited merit) but the problem is that it automatically shifts the needle on allocations more heavily into bonds as you age. This is creating a lower overall portfolio return and is not producing the desired returns impacting the ability to retire.
Rather than blindly following the herd pull your head out of the sand and survey the investment scene. First thing to do in a low interest environment is to look for places where there is yield. When you find it make sure that you are not accepting too much risk for the return. As most high yielding (and I am thinking in the neighborhood of 6% and higher here) investments are fraught with danger there are limited opportunities in this market to find the safe haven required by your retirement funds.
Assuming that you are unable to find a safe investment yielding anything of significance the next thing to do is to invest in shorter term bonds. I would not look out much further than two or three years. I know that you will be giving up some yield as short term rates are lower than long term rates but the difference is marginal. One or two percent difference will have a powerful impact on your portfolio over the long run due to the power of compounding however if rates start to rise then the drop in value of the long term bond would mean you are either stuck in that low interest investment or you have to take a far larger hit to your portfolio by selling the bond at a large loss. This to me means that you should rather earn a lower rate for the short run in order to participate in a larger rate of return later in the cycle.
The last thing you can do is reduce your allocation to bonds and focus on other parts of the market that can provide the boost your portfolio needs. One place to look is the stock market and this is touted by the "experts" as the only place to look but finding high yielding stocks is not easy and most of these stocks come with a double dose of risk; possibly cutting the dividend in poor times and/or falling precipitously from their current highs. To me this risk is the same as the higher yielding high risk bond investments. So you will have to look further afield to find returns and yields that match the requirements of your portfolio. One of these places is the property market where there are some parts of the country that can produce relatively high returns on investment with the safety of a free and clear property. Outside of this keeping this part of your portfolio secure while mitigating risk is becoming ever more difficult but one thing is for sure you will need to take some responsibility and control of your investments as we all know what happens when the blind lead the blind!
Friday, March 27, 2015
Maximizing Your Retirement Dollar
"The quality, not the longevity, of one's life is what is important." - Martin Luther King, Jr.
I don't think I have ever said that my blog is a must read but if you are approaching, planning for, or in retirement then this blog is a must read. Trying to make our retirement dollars last through our remaining life expectancy is one of the most important considerations that we have. Not running out of money before you die has to be a priority and therefore maximizing your retirement dollar is critical.
In an excellent article in the Financial Analysts Journal by Kirsten Cook, William Meyer and William Reichenstein, the authors present a methodology for extending your investment portfolio without changing your investment strategy or the amount that you have invested but by simply using the tax code to your advantage. Now some of my international readers may think this does not apply to them but I am sure that reading this article will spark some ideas that you can use at home to assist your portfolio.
The common rule of thumb is that in retirement you should first exhaust your taxable investments (TI), then your tax deferred investments (TDI) and finally your tax exempt investments (TEI). The authors of the article point out that if the tax rate is flat there is no difference between the TDI or the TEI, It is only when there is a progressive tax structure (such as the one in the United States) where a difference exists. In a flat tax environment whether you have a TDI or a TEI account will result in the same net amount. You can try it on a calculator if you like but believe me placing an amount net of tax into a TEI and growing it at a set interest rate for any amount of time will give you the same result as placing the whole amount into at TDI and withdrawing the total amount and deducting the same tax rate as before. In this environment it makes no difference which tax protected account you withdraw from first. The only way you can extend your dollars is by drawing down on your TI portfolio first.
Turning to the progressive tax environment results in a completely different equation. As before drawing down on your TI first is a must but after that things get interesting. The first thing to determine is the total amount that can be withdrawn before you trigger the next higher tax bracket. Once you have these amounts you can start to plan and it is surprising to discover that the optimal tax strategy may be to withdraw amounts from your TDI before it is required. The authors in fact discovered that the optimal strategy is one where you convert two or more blocks of your TDI portfolio into TEI investments. This is allowed as a Roth conversion in the United States. Each block needs to be placed in its own separate account. The accounts are opened and funded at the beginning of the year with investments from the TDI portfolio. Each allocation amount is the maximum allowed in the lowest (or second lowest depending on the size of the portfolio) tax bracket. So for example in the United States in 2013 an individual could have placed $47,750 and only triggered the second tax bracket of 15%. At the end of the year the converted TEI with the highest value is left as a TEI and the others are reconverted back to the TDI therefore only one conversion is taxed. Doing this throughout the portfolio extended the life of the portfolio by an average of 6.5 years!
So you may be asking why even have a TDA why not invest everything into a TEI? The answer is that there are benefits to the TDA in that you should be able to fund it with more money as you did not need to pay tax on the money before funding and this larger amount will grow tax deferred therefore growing to a larger ending balance than the TEI. The key then is trying to minimize the tax burden on the withdrawals from this investment and I have shown you one clever technique above. A second technique is to maximize the withdrawals on this account in any year where you have large expenses such as medical bills that will offset the tax paid on this withdrawal. Doing this will also extend the life of the portfolio.
So while I do not typically like to delve into taxes this is an excellent way to stretch the life of the portfolio and this could be critical to some of us. Furthermore having investments in TDI and TEI investments can be beneficial so do not steer everything away from the standard TDI investments as these can provide a higher value and if planned for correctly should not cause you too many tax nightmares. In the meantime as I have now stretched out your portfolio I think you and I better start limbering up our bodies so that we can enjoy the extra years.
I don't think I have ever said that my blog is a must read but if you are approaching, planning for, or in retirement then this blog is a must read. Trying to make our retirement dollars last through our remaining life expectancy is one of the most important considerations that we have. Not running out of money before you die has to be a priority and therefore maximizing your retirement dollar is critical.
In an excellent article in the Financial Analysts Journal by Kirsten Cook, William Meyer and William Reichenstein, the authors present a methodology for extending your investment portfolio without changing your investment strategy or the amount that you have invested but by simply using the tax code to your advantage. Now some of my international readers may think this does not apply to them but I am sure that reading this article will spark some ideas that you can use at home to assist your portfolio.
The common rule of thumb is that in retirement you should first exhaust your taxable investments (TI), then your tax deferred investments (TDI) and finally your tax exempt investments (TEI). The authors of the article point out that if the tax rate is flat there is no difference between the TDI or the TEI, It is only when there is a progressive tax structure (such as the one in the United States) where a difference exists. In a flat tax environment whether you have a TDI or a TEI account will result in the same net amount. You can try it on a calculator if you like but believe me placing an amount net of tax into a TEI and growing it at a set interest rate for any amount of time will give you the same result as placing the whole amount into at TDI and withdrawing the total amount and deducting the same tax rate as before. In this environment it makes no difference which tax protected account you withdraw from first. The only way you can extend your dollars is by drawing down on your TI portfolio first.
Turning to the progressive tax environment results in a completely different equation. As before drawing down on your TI first is a must but after that things get interesting. The first thing to determine is the total amount that can be withdrawn before you trigger the next higher tax bracket. Once you have these amounts you can start to plan and it is surprising to discover that the optimal tax strategy may be to withdraw amounts from your TDI before it is required. The authors in fact discovered that the optimal strategy is one where you convert two or more blocks of your TDI portfolio into TEI investments. This is allowed as a Roth conversion in the United States. Each block needs to be placed in its own separate account. The accounts are opened and funded at the beginning of the year with investments from the TDI portfolio. Each allocation amount is the maximum allowed in the lowest (or second lowest depending on the size of the portfolio) tax bracket. So for example in the United States in 2013 an individual could have placed $47,750 and only triggered the second tax bracket of 15%. At the end of the year the converted TEI with the highest value is left as a TEI and the others are reconverted back to the TDI therefore only one conversion is taxed. Doing this throughout the portfolio extended the life of the portfolio by an average of 6.5 years!
So you may be asking why even have a TDA why not invest everything into a TEI? The answer is that there are benefits to the TDA in that you should be able to fund it with more money as you did not need to pay tax on the money before funding and this larger amount will grow tax deferred therefore growing to a larger ending balance than the TEI. The key then is trying to minimize the tax burden on the withdrawals from this investment and I have shown you one clever technique above. A second technique is to maximize the withdrawals on this account in any year where you have large expenses such as medical bills that will offset the tax paid on this withdrawal. Doing this will also extend the life of the portfolio.
So while I do not typically like to delve into taxes this is an excellent way to stretch the life of the portfolio and this could be critical to some of us. Furthermore having investments in TDI and TEI investments can be beneficial so do not steer everything away from the standard TDI investments as these can provide a higher value and if planned for correctly should not cause you too many tax nightmares. In the meantime as I have now stretched out your portfolio I think you and I better start limbering up our bodies so that we can enjoy the extra years.
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