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September 2011 January 2011
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The great recession is over but the slowest recovery is on-going. A recent poll of 43 corporate and academic economists put the likelihood of a recession within the next 12 months at 26 percent. The economists foresee economic growth, job creation, consumer spending and home prices all rising but at such a slight pace that few will notice. Investors who held on since the March 2009 stock market bottom have been richly rewarded. As I write this, stocks are still up over 11% on average in the last 12 months, in spite of an 18% recent decline. A new Associated Press poll found that 87 percent disapprove of their own member of Congress. The American people have spoken and there will be compromise in Washington or the voters will “throw the bums out.” Governments around the world will keep the economic expansion intact. All in all, on a global scale, we have no other alternative. Twenty-two years ago, the Berlin Wall was taken down from the East German side. Today Egypt, Libya and Syria are replacing failed systems with the rule of law as best they can. All of these events; The Great Recession, the tsunami in Japan, the debt problems in the US and Europe, and upheaval in the Middle East are happening at a faster pace than anyone could have imagined. This pace creates anxiety, and anxiety creates volatility in stock markets around the world. However, in the final analysis stocks are worth what they earn and the earnings are up sharply and the companies have huge cash reserves to invest in their own stock or pay out in the form of dividends. Insiders are buying stocks at the highest rate since the bottom in March of 2009 and the price earnings ratio is about 12, while the average for the last 60 years is around 16. All of this leads me to believe that people are so distracted by the negative media noise that they are missing the bigger picture. Gross domestic product, a measure of economic output, has topped prerecession levels. We are in a slow recovery from a huge recession but recovery it is. I can’t thank all of you enough for your patience through all of this and I feel you will be rewarded again as the ripple effect of recent, global, tumultuous events recede. Unknowable surprises will continue at a record pace but I feel history will repeat itself and the USA will continue to be the leading economy in the world for many years to come. Ralph Waldo Emerson said it best when he wrote, “The years teach much which the days never knew.” Sincerely, Seth M. Pearson, CFP SMP/km P.S. Happy New Year! I think this is a good time to give you our guess on what to expect in 2011. I’ve included more than I normally do on the bond market because the media will certainly be creating a lot of anxiety as the economy improves, interest rates inevitable rise, and bond prices fall. Last February we sent this letter to everyone who owned the Vanguard GNMA Bond Fund (symbol VFIIX). “I’m writing to you because you currently own the Vanguard GNMA bond fund and we believe that the next cycle for interest rates is up. In July of 2003, this fund lost 3.0% of its value because interest rates started to climb. However, by the end of 2003, the fund was up 2.49% for the year. This fund is about 30 years old and it has averaged a total return of 8.37% a year, since June of 1980. It would not surprise me to see this fund do the same thing in the next twelve months as it did in 2003. In other words, you could have short-term losses of 3% to 4%, offset by the coupon interest that is being paid by the GNMA bonds each month. This fund has been a great provider of long-term income and I expect that to continue, but not without short-term losses. That is the trade-off you accept by owning this fund. If you cannot tolerate even a short-term loss, then this fund may not be the best one for you.” BONDS When rates rise, bond values will fall and the income that funds pay will rise. If you don’t sell the bond fund, your income will not be effected adversely and eventually the interest rate cycle will reverse itself and bond prices will rise, increasing bond values and slowly reducing the income. On average, these cycles last about 5 years. Another alternative is to buy the US government bond itself. In this cycle we feel that rising stocks values will drive the total return of the portfolio but eventually the next recession will arrive and stock prices will fall. When that happens, historically, government bonds go up, reducing the overall volatility of the portfolio. The following information outlines a strategy that has helped many clients through the cycles of boom and bust, growth and recession, rising and falling interest rates. THE US GOVERNMENT BOND STRATEGY The face value of a bond is the amount of money the investor will get back at maturity. The price of the bond fluctuates in value until it matures. When a bond sells for more than its face value, it is at a premium and when its price is below its face value, it is selling at a discount. The coupon is the interest that will be paid monthly or semi annually and is a fixed percentage of the face value of the bond. Government bonds are the safest bonds. The U.S. Government bond is a direct obligation and since the government can literally print money to pay back investors at maturity, it is generally considered as a risk-free asset. However, as interest rates rise, the price of a bond falls, so a sale of the bond before maturity could result in a loss. To avoid any loss of principal, you simply hold it until it matures and continue to collect the fixed interest payment which is also guaranteed by the U.S. Government. When you invest in a government bond, it is very important to know what the yield to maturity is so there is no doubt about what you will receive in interest and ultimately in principal at maturity. The Government National Mortgage Association (GNMA) also known as a “Ginnie Mae” is a U.S. Government-owned corporation. They are the only mortgage-backed securities guaranteed by the United States Government. GNMA securities have the same credit rating as the Government of the United States. The interest payments and the return of principal at maturity are guaranteed by the full faith and credit of the U.S. Government. The Ginnie Mae has no relationship at all to Fannie Maes or Freddie Macs, which were stockholder corporations traded on the New York Stock exchange and had absolutely no guarantee of principal or interest from the government and were part of the 2008 government bailout. The US government created the GNMA in 1968 to promote home ownership within the Department of Housing and Urban Development. Ginnie Mae buys home mortgages originated under programs run by the Federal Housing Administration, the Veterans Administration and the Rural Housing Service. It then pools mortgages with similar characteristics and issues securities backed by the payments on the loans and guaranteed by the US Government at maturity. Since inception, the GNMA has issued more than $2.1 trillion with about $500 billion currently outstanding. BOND LADDER Successful investors have used the bond ladder strategy to reduce the interest rate risk of bonds. It is a portfolio that has different maturities. A GNMA Government bond has guaranteed principal payments every month spread out over the “average life” of the bond. If interest rates go up, you will receive principal each month to reinvest in bonds paying a higher rate, increasing the overall yield to maturity. If interest rates fall, the entire bond that doesn’t mature each month continues to earn the higher rate, which would also protect the overall yield of the bond ladder. In other words, it is a strategy that can add value no matter which way rates move. A traditional, intermediate term Treasury ladder would hold Treasuries maturing each year, for the next 12 years. Current yields start at less than .5% and end with the 12 year Treasury paying almost 3.5%. The average rate of return would be approximately 2%. Each year, as one Treasury matures, you would buy a 12 year Treasury to maintain the intermediate term ladder. As rates move up, the overall rate of return moves up as well. Each year the guaranteed principal of the maturing Treasury is realized. A GNMA Government bond acts like the traditional, intermediate term Treasury ladder. As guaranteed principal is paid at maturity, you reinvest that in a 12 year Treasury paying 4%. The overall rate of return would be about 4% instead of 2% and the short term part of the ladder would be earning 4% instead of less than .5%. LIQUIDITY The following is an example of how an investor might use a bond ladder for liquidity while protecting the principal at maturity, which is guaranteed by the U.S. Government. If for instance, an investor purchased a $100,000 GNMA U.S. Government bond with a yield to maturity of 4% and each month some of that principal was paid back over the next 12 years, they would receive about $11,000 a year for the 12 year period for a total of $132,000. If the “life” of the GNMA was the 12 years, then the investor never had to sell any of the Government bond and had the liquidity of approximately 11% a year of the original investment. Investors should plan to hold the GNMA until the principal is paid back each month rather than sell it, which could mean getting back less than the guaranteed amount at maturity. In 2004, the Fed began the last tightening cycle. It was very slow and gradual as it raised rates 17 times from 1% to 5.25% from 2004 to 2006. Ben Bernanke recently stated that the Fed will keep rates low for an extended period of time but history will repeat itself and the next cycle of rising interest rates will begin. The GNMA bond pool has a stated maturity of 30 years but because of principal payments each month, refinancing, and other factors, today the average life of the pool is 8 years, according to the Wall Street Journal on 1/4/2011. For this report, I am assuming that the average life of this 4% GNMA might extend out to 12 years as rates rise. The average life is defined as the average time that each principal dollar in the pool is expected to be outstanding. CONCLUSION RECAP:
BOND FUNDS For the majority of investors, bond funds offer a number of advantages over the individual bonds, including regular monthly income, greater diversification, greater liquidity and professional management. Regular monthly income: Bond funds typically distribute all of their interest income in the form of dividends each month. This income may either be paid in cash or reinvested to purchase additional fund shares. Individual bonds, however, generally pay interest every six months, and that interest cannot be reinvested automatically. Diversification: A bond fund may hold hundreds, or even thousands, of bonds from a few or many different issuers. This diversification means that the failure of one issuer to pay interest or to repay principal should have only a slight effect on your investments. Key characteristics of bonds Average quality: Independent bond-rating agencies, such as Standard & Poor’s and Moody’s Investors Service, evaluate the ability of taxable bond issuers to repay loans. These agencies assign credit rating ranging from Aaa or AAA (highest quality) to C or D (lowest quality). Average effective maturity: The average length of time before bonds in a fund reach maturity and are repaid is known as the fund’s average maturity. The average effective maturity affects a fund’s yield as well as the level of risk to investors’ principal. In general, the longer the average effective maturity, the more a fund’s share price will fluctuate in response to changes in interest rates. A fund with an average effective maturity of 1-5 years is considered a short-term bond fund; one with a maturity of 5-10 years, an intermediate-term bond fund; and one with a maturity of more than 10 years, long-term bond fund. Average duration: This measurement can be used to estimate how much a bond fund’s share price may rise or fall in response to a change in interest rates. Bond funds with long average durations (more than 7 years) are likely to have negative returns during years when interest rates rise significantly. Bond funds with average durations of less than 3 years have rarely had negative calendar-years returns. * Past performance, of course, is no guarantee of future returns. Municipal bond funds also rise and fall in value. State and local governments back these bonds using income taxes, sales taxes, property taxes and other revenue. During the last “Great Recession” of 2008, municipal bond funds fared quite well compared to stocks and they continued to provide predictable tax free income. However, when the Fed increases interest rates the regular cyclical factors will push values down and income up. Ultimately, taxes will have to go up to reduce the unprecedented deficit making tax free bonds and bond funds attractive for the surging demand of the 78 million baby boomers on their way to retirement. Like the private sector, local governments are drastically cutting their budgets to address the effects of the Great Recession and eventually a balance is achieved, obligations are met and stability returns to the bond markets. Compared to the Federal Government, which has debt of 62% of GDP, municipal finances have debt burdens of about 7%. Historically, municipal bonds had a default rate of just .16% from 1986 through 2008 and is an immense market of nearly $3 trillion in outstanding issues. However, investors in any bond fund should anticipate short term, sudden losses as rates rise and ultimately the reverse of that when the next inevitable recession arrives. It is interesting to note that intermediate Treasuries averaged 5.48% a year for the last 83 years. What can we expect once employment numbers improve? In 2004, the Fed last began a tightening cycle raising interest from 1% to over 5% in about 2 years. The increase was slow and gradual. On average, most bond funds lost money (2-4%) during the 2nd quarter of 2004 but these losses didn’t continue as the funds reinvested bonds maturing at higher rates. Today, it seems like a big trade off – get out of bond funds and bonds and earn very little while you wait for rates to rise or experience losses offset by interest earned over the course of a year perhaps leading to the same outcome. To develop your own customized plan to deal with rising interest rates, don’t hesitate to call us anytime at all. Recently, Vanguard suggested a buy and hold approach for bond fund investors: “For long-term investors, rising rates can boost returns”, the fund company argues. To appreciate why, consider that bond fund investors receive interest that can be reinvested to buy more shares. When rates rise, the yields on reinvestments climb. Over time, higher yields can compensate for declines in share prices that occur when rates increase. To make the point, Vanguard provides an illustration of how bond funds would perform during 7-year periods under different interest rate conditions. Say a fund yields 4 percent. Rates climb by 2 percentage points in the first two years and then stay at 6 percent for the next five years. During the first years, the fund would lose 0.8 percent. But after that the fund would stay in the black as higher reinvestments prop up returns. For the full seven-year period, the fund would return 4.2 percent. Now imagine that instead of rising, rates dropped by 2 percentage points in the first two years and then stayed at 2 percent. During the first year, the fund would return 8.8 percent, but for the full seven years the total return would only be 3.8 percent. Armed with the hypothetical data on bond fund returns, investors should be able to wait through periods of rising rates, says Stephani Smith, a Vanguard principal. “If you are mentally prepared to accept some temporary losses, you should be able to stick it out and not deviate from your long-term plan” she says. STOCKS The Great Recession is over. In March of 2009 I sent a newsletter to everyone saying that “the best time to be invested in the stock market has always been at the point of maximum fear.” Since then the market has grown by over 75%. In the past 10 years, stocks have lost ground. The last time that happened was in the 30’s during the Depression. After that, a long period of substantial gains followed (60 years in fact). In the 40’s, the market was up 9.2% a year on average, in the 50’s up 19% a year, in the 60’s up 7% a year, in the 70’s up 6% a year, in the 80’s up 17% a year and in the 90’s up 18% a year. We are still the biggest producer of goods and services in the world and as in previous recoveries, over 75% of the 500 biggest US public companies are reporting better earnings than analysts predicted. We are all shaken from this great recession. Consumers and companies continue to wisely deleverage, which puts them in a much better position going forward, but unfortunately slows the recovery, especially in the job area. So a slow recovery is to be expected with the stock market continuing the advance ahead of job creation and after improving earnings. Sir John Templeton said “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Someone else said, “the fundamental things apply as time goes by.” The historical record has never been as bleak as the media noise predicts today. The forecasts, of course, are not guarantees and are based on everything that can be known today. Unfortunately, it is the unknowable surprises to come that will buffet our path from skepticism to optimism. Since World War II, expansions have lasted, on average, nearly 5 years. Media news information is relentlessly bombarding our minds with more negativity than we can possibly interpret properly, driving many to a state of high anxiety. The media knows this doomsday information is good business for their bottom lines. Meanwhile this economy is making steady gains and better employment numbers are bound to follow. Earnings among the S&P 500 companies are projected to increase 14% this year. The same companies trade at 12.9% times their earnings, which is below the average ratio of 16.4 since 1956. In November, consumer spending increased for the 5th month in a row and that accounts for about 70% of the economy in general. Last month, fewer people filed applications for jobless benefits. On 1/5/2011, the Wall Street Journal reported, “The ADP said US employers added 297,000 private-sector jobs last month. That was much stronger than the 100,000 jobs analysts forecast private employers would add in December, hinting that the US labor market is picking up faster than previously thought.” In a year or two, unemployment will probably drop and consumer spending will accelerate – supporting economic growth. There is an old saying about the stock market when the Fed reduces interest rates, “don’t fight the Fed”. Historically, the market goes up when rates are down and today the Fed rate is just about zero and a self-sustaining recovery is underway. The panic is over and we all might be surprised by the upside in the next year. Russia recently hired US banks to help them sell $59 billion of stock in companies owned by the government. How the world has changed in the last 20 years! People in China, India and Russia have chosen our capitalistic path to improve their lives. Our proven system is their light at the end of the tunnel. There is no other daylight for them. Since 1871, research illustrates 14 ten year periods for US stocks with negative returns including this one. In the decade following every single one of the previous 13 negative episodes, real returns exceeded 10% a year. Remember what Mark Twain said “History never repeats itself, but it often rhymes.” On the other hand, averages are not always helpful in assessing risk. You can drown in a river that is, on average, 3 feet deep by walking across 2 feet of water until you fall into a 10 foot hole! NEW TAX LAW The Bush tax cuts continue for 2 years! $5 million Federal Estate tax exemption enacted! $5 million Gift tax exemption enacted! Short term I feel this will be good for the economy but inevitably we must reduce the deficit to avoid the kind of problems we see in countries like Ireland, Spain, Greece and France. Our US bond ratings will suffer driving interest rates suddenly higher, if we don’t reduce the deficit in time. To reduce the deficit we will need to reduce spending, increase taxes and as needed, allow immigration to fill the gaps in the labor force (more people to tax). By the way 40% of the total population growth in the US is from immigration, and people are literally dying in their attempts to get into this country. There is still more opportunity here for more people than any other country on earth. Luckily for us, globalization means that the rest of the world is giving us the time we need to reduce the deficit, and as Winston Churchill one said, “America, after exhausting every other alternative, will do the right thing. The biggest surprise in this new tax law is the $5 million unified gift and death tax exemption. That means each person could put up to $5 million in a Dynasty Trust without any state or federal tax and that amount will be protected in perpetuity, generation after generation, from future changes in the tax law. I wrote a short book about Dynasty Trusts that was highlighted in the New York Times. In my 40 years as a Financial Planner there has never been a law that allowed anyone to shelter as much. Many will be advised to fund these trusts now, over the next 2 years, before they reduce or eliminate this exemption. If you haven’t read my book or know someone who might benefit from reading about this strategy, call for a free copy now. This $5 million exemption will expire in 2 years. The other important implication of the tax cut extension is the ability to convert IRA money to tax free Roths, paying these taxes now at what might be the lowest rates in our lifetimes. Everyone should diversify their income tax strategy when the future is so uncertain. SUMMARY Everything that can possibly be known about the economy is reflected in the collective wisdom of the world’s investors and the stock market recovery. Global reliance on each other and the recent tax cut extension will probably give us the time we need to get our house in order. Interest rates should move up in a controlled, steady path for the next 2 or 3 years. In other words, we should be fine. However, it is what can’t be known about the future that we have to prepare for. With that in mind, don’t be afraid to keep one or two years of your cost of living in short term accounts like money markets or 6 month CD’s even though they are practically paying zero. Surprises will happen and that liquidity will not only give you peace of mind but allow you to access what you need without selling stock funds or bond funds when they are down. Since 1926, on average, an allocation to stock increases the probability of meeting your needs for lifetime income. Inflation and health care costs later in life lead prudent investors to a balanced portfolio of cash, stocks and bonds. In 2011, I expect stock returns to drive the total return of a balanced portfolio up, while bonds drop as rates rise and cash provides the liquidity for emergencies. Stock and bond market volatility creates anxiety which is the trade off you accept to improve the odds of living comfortably in retirement and perhaps leaving something meaningful to the next generation. Good or bad, we are all in this together, trying to achieve the best results we can with the least amount of volatility. I hope it helps you to know that we share your concerns and take the responsibility as your advisor very seriously. As always, feel free to call us with any questions or concerns you may have. Of course, all investments are subject to risk. The interest rates and math calculation used in this report are based on sources I respect but are not guaranteed by me. Diversification with a bond ladder can be an excellent strategy but it does not ensure a profit if the bonds are sold before maturity. This information contains guesses about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast. The opinions stated here are subject to change at any time, and past performance is, of course, no guarantee as to future results.
Sincerely, Seth M. Pearson, CFP
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