The yield curve is getting a lot of attention because it has flattened 65 basis points this year. Although the yield curve is a good indicator of where we are in the economic cycle, it does not indicate a recession is likely. Fundamental data are supportive of economic expansion.
(Source: Bloomberg, NBER, GSAM, as of 11/30/2107)
A 64-year-old woman asked her financial advisor, “Why is the annuity a good idea?” He replied that it gives her what she wants, a guaranteed income. That is the key. His approach solves problems by giving people what they want. Wants are emotionally based. Needs are comparatively fact-based.
Rather than pander to emotional desires, I try to convince clients to do what I would do if I were in their situation. A fiduciary does not begin with the emotional component as the objective.
As interest rates increase over the next few years, it will be easier to generate income from a diversified portfolio. While interest income will be taxed as ordinary income, capital gains and qualified dividends are currently taxed at lower rates. Lower expenses, the step-up in basis for non-qualified (not in a retirement plan) assets, and access to a much wider investment universe are benefits of regular investing versus an annuity.
She is concerned about negative media. She believes everyone is expecting a market correction. I responded that if most people are bearish, then that would be baked into prices already, reducing the risk of a correction. Negative sentiment is healthy. Exuberance is dangerous. Markets are counter-intuitive, which explains why emotional investing is a bad idea.
As reference, the above chart illustrates a popular, low-cost balanced fund (the blue, top line). The 2000 – 2002 correction barely registers as a dip with the balanced fund. The blue line shows that a 3 to 5-year reserve fund would have been sufficient to avoid selling at a loss during the 2008-2009 crisis. The fund’s performance suggests that concerns referencing the last 2 major bear markets are more about the unknown than they are grounded in fact. This is not unlike children being afraid of the monster under the bed.
The orange line below the blue line represents the S&P 500. Investing in only the S&P 500 is not a good idea, but that seems to be the straw man argument many insurance companies use to sell annuities.
Finally, consider the commission. How much is it and where does it come from? This is not alchemy.
Past performance is not a guarantee of future results. Investing involves the risk of principal. The chart illustrates the performance of a popular balanced fund from January, 1999 to April 27, 2015. The fund may hold up to a 75% equity allocation. The chart is intended to illustrate the performance of a diversified portfolio relative to the S&P 500 during the 2000 – 2002 and 2008 – 2009 bear markets. Diversification does not guarantee against loss. The balanced fund is the Dodge and Cox Balanced Fund, and the data is from Morningstar.
First let’s define “Crash”. To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover? Another consideration is stock market valuation.
By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years. The risk of a crash depends on valuation. The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield. That’s reasonable. Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal. It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.
So how do you prepare, just in case? The conventional approach to hedging the stock market is to incorporate bonds to a portfolio. You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio. Currently the ability of bonds to generate income is diminished by Fed policy. While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons. Choose your poison.
An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time. A key benefit of financial planning is that it identifies liquidity needs. During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist. This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.