The monster under the bed

Alfred E. Neuman

One of the fun things about being a personal finance writer is the number of “Dear idiot” letters you get. Stories about the Federal Reserve Bank tend to get them. (“You idiot! Don’t you know the Federal Reserve is evil?”). So do stories about taxes. (“You idiot! Don’t you know that Girl Scout cookies are deductible?”)*

Inflation is another source of contention, particularly if you note that inflation has been moderate, which it has been, whether you’re using the Consumer Price Index, the GDP Price Deflator, or even the Billion Prices Project. But your perception of inflation depends on what you spend the most on. If you have kids in college or if you rely on prescription drugs, your personal inflation rate is pretty high.

Those who grew up in the 1970s and early 1980s recall when a 5% inflation rate was considered moderate, as opposed to the most recent 2.2% rate. And they fear a resurgence of inflation, with good reason: It erodes the value of retirement savings and pensions.

The consumer price index has averaged a 1.7% annual gain the past decade, and actually dipped into deflation — a period of falling prices — during the Great Recession. And the forces of deflation are still all around us: The favored tactic of technological disruptors such as Amazon, Uber and others, is to drive prices down and drive competitors out of business. This was a favored tactic of the Gilded Age, aided even further by the gold standard, which tends to favor deflation over inflation. I go on at some length about the subject here.

The Federal Reserve traditionally raises interest rates to slow the economy and cool inflation, and it lowers rates to stimulate the economy and encourage inflaton. The Fed has already nudged short-term interest rates higher five times since 2015, but rates are still extraordinarily low by historical standards. Most think the Fed is acting not out of fear of inflation, but out of fear of not having any ammunition to fight the next recession, whenever that may be.

Tomorrow’s Consumer Price Index report hits the headlines at 8:30: The consensus forecast is for a 2.1% year-over-year change for 2017. Anthing higher, particularly for the core CPI (less food and energy) is likely to make for an upsetting day in the bond market, where yields have been creeping higher and prices lower. The iShares Core U.S. Aggregate Bond ETF (AGG), a useful proxy for the bond market’s total return, has already fallen 0.57% this year, according to Morningstar.

Right now, there’s a balance between inflationary forces — a strong economy and fiscal stimulus — and deflationary ones. In the normal course of events, the Fed tightens too much during inflationary periods, causing the economy to slow, earnings to fall, and stocks to tumble. So there’s reason to watch inflation warily.

Is it time to panic? Well, no. It never is. If you’re particularly concerned about inflation, you might consider a fund that invests in Treasury Inflation Protected Securities, whose price is keyed to changes in the CPI. The current yield on TIPS shows that Wall Street expects inflation to remain at 2% the next 30 years. If you think they’re wrong, then one good pick would be Vanguard Inflation-Protected Securities Fund Investor Shares(VIPSX).

It may well be that technological changes have redefined the upper bound of inflation in the economy. Tomorrow’s CPI print is no reason to go running from the room in terror. But it’s worth keeping an eye on the monster under the bed this year.

* They aren’t, if you eat them.

The busy season for outlooks

Economists and money managers give forecasts because people ask them to, and this is the time of year when people like me ask people like them for their forecasts.

You have to take all forecasts with a grain, if not a block, of salt. Nevertheless, I got the chance to interview some smart people, such as Will Danoff, manager of Fidelity Contrafund, who’s bullish on the U.S. and technology. And then there’s Jerome Dodson, manager of Parnassus, who has the crazy notion that companies that treat employees well will prosper.

Anyway, here’s their outlooks for 2018, along with Mark Mobius of Franklin Templeton, Robert Doll of Nuveen and Joe Davis of Vanguard.

http://www.investmentnews.com/article/20180106/FREE/180109962/2018-outlook-in-equity-investing-is-mostly-bright?issuedate=20180108&sid=outlook20170108

Dogs and diversification

When it comes to investing, you’re better off with a pack of dogs, rather than just one pup. And the returns from Dogs of the Dow this year provesit.

The basic premise behind the Dogs of the Dow is fairly elegant. You’re supposed to buy stocks low and sell them high. But many stocks deserve to be low: They’re poorly managed, like Wells Fargo, or they’re in a dying business, like Gannett, or they’re really just walking catastrophes, like Enron.

Whatever the faults of the Dow, the 30 stocks in the Dow Jones industrial average are large-company high-quality stocks spread across a variety of industries. But each year, some of these companies lag the broad index and others lead. It’s just the nature of the market, which loves different industries at different points in the market.

Rosie, the dog of the day

The ones that are unloved — and, hence, dogs — are the ones with the highest dividend yields. Companies normally don’t have high yields because their executives are swell people who want to dole out profits to investors. Most often, it’s because the company’s stock price has been clobbered.

After all, a stock yield is a function of two factors: Its 12-month payout divided by its current price. A stock with a $1 annual dividend and a $50 price has a 2% yield. Drop the price to $40, and the yield pops up to 2.50%. So typically, a Dog of the Dow has a high yield because its stock price has been clobbered.

Last year’s dogs rose by an average 23.6%, vs. 21.83% for the Standard & Poor’s 500, proving that sometimes it does indeed pay to buy low and sell high. (The Dogs of the Dow have had a spotted record the past few years).

This year’s Dogs of the Dow prove a further point: It’s better to invest in 10 stocks than one or two. Here are how 2017’s dogs fared last year:

1/1/2017
12/31/2017
Investment Ticker Return
(Cumulative)
Boeing Co BA 94.50%
Caterpillar Inc CAT 74.75%
Chevron Corp CVX 10.59%
Cisco Systems Inc CSCO 31.19%
Coca-Cola Co KO 14.39%
Exxon Mobil Corp XOM -3.75%
International Business Machines Corp IBM -4.03%
Merck & Co Inc MRK -1.46%
Pfizer Inc PFE 15.75%
Verizon Communications Inc VZ 4.07%
Average 23.60%
Median 12.49%

Dividends, gains, reinvested. Source: Morningstar.

As you can tell, without the returns from the big dogs — Boeing, Caterpillar and Chevron — the dogs would be whining instead of barking.

The Dogs of the Dow is an interesting lesson in dividends and value investing — but its biggest lesson is that it’s better to own the entire litter than just one pup.

 

 

 

Securities cops: Be careful with crypto

The North American Securities Administrators Association (NASAA) are on the front lines fighting investment fraud. When they start sounding alarms, it’s usually best to listen. And today they’re sounding the alarm on all things crypto.

NASAA Reminds Investors to Approach Cryptocurrencies, Initial Coin Offerings and Other Cryptocurrency-Related Investment Products with Caution

Borg: “Go beyond the headlines and hype to understand cryptocurrency investment risk.”

WASHINGTON, DC (January 4, 2018) – As cryptocurrencies continue to garner national and international headlines, the North American Securities Administrators Association (NASAA) today reminded Main Street investors to be cautious about investments involving cryptocurrencies.

“Investors should go beyond the headlines and hype to understand the risks associated with investments in cryptocurrencies, as well as cryptocurrency futures contracts and other financial products where these virtual currencies are linked in some way to the underlying investment,” said Joseph P. Borg, NASAA President and Director of the Alabama Securities Commission.

Cryptocurrencies are a medium of exchange that are created and stored electronically in the blockchain, a distributed public database that keeps a permanent record of digital transactions. Current common cryptocurrencies include Bitcoin, Ethereum and Litecoin. Unlike traditional currency, these alternatives have no physical form and typically are not backed by tangible assets. They are not insured or controlled by a central bank or other governmental authority, cannot always be exchanged for other commodities, and are subject to little or no regulation.

A NASAA survey of state and provincial securities regulators shows 94 percent believe there is a “high risk of fraud” involving cryptocurrencies. Regulators also were unanimous in their view that more regulation is needed for cryptocurrency to provide greater investor protection.

“The recent wild price fluctuations and speculation in cryptocurrency-related investments can easily tempt unsuspecting investors to rush into an investment they may not fully understand,” Borg said. “Cryptocurrencies and investments tied to them are high-risk products with an unproven track record and high price volatility. Combined with a high risk of fraud, investing in cryptocurrencies is not for the faint of heart.”

Last month, NASAA identified Initial Coin Offerings (ICOs) and cryptocurrency-related investment products as emerging investor threats for 2018. Unlike an Initial Public Offering (IPO) when a company sells stocks in order to raise capital, an ICO sells “tokens” in order to fund a project, usually related to the blockchain. The token likely has no value at the time of purchase. Some tokens constitute, or may be exchangeable for a new cryptocurrency to be launched by the project, while others entitle investors to a discount, or early rights to a product or service proposed to be offered by the project.

NASAA has developed a short animated video to help investors understand the risks associated with ICOs and cryptocurrencies. NASAA first alerted investors of the risks associated with cryptocurrencies in 2014.

Common Cryptocurrency Concerns

Some common concerns investors should consider before investing in any offering containing cryptocurrency include:
  • Cryptocurrency is subject to minimal regulatory oversight, susceptible to cybersecurity breaches or hacks, and there may be no recourse should the cryptocurrency disappear.
  • Cryptocurrency accounts are not insured by the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits up to $250,000.
  • The high volatility of cryptocurrency investments makes them unsuitable for most investors, especially those investing for long-term goals or retirement.
  • Investors in cryptocurrency are highly reliant upon unregulated companies, including some that may lack appropriate internal controls and may be more susceptible to fraud and theft than regulated financial institutions.
  • Investors will have to rely upon the strength of their own computer security systems, as well as security systems provided by third parties, to protect purchased cryptocurrencies from theft.

Common Red Flags of Fraud

NASAA also reminds investors to keep watch for these common red flags of investment fraud:
  • “Guaranteed” high investment returns. There is no such thing as guaranteed investment returns, and there is no guarantee that the cryptocurrency will increase in value. Be wary of anyone who promises a high rate of return with little or no risk.
  • Unsolicited offers. An unsolicited sales pitch may be part of a fraudulent investment scheme. Cryptocurrency investment opportunities are promoted aggressively through social media. Be very wary of an unsolicited communication—meaning you didn’t ask for it and don’t know the sender—about an investment opportunity.
  • Sounds too good to be true. If the project sounds too good to be true, it probably is. Watch out for exaggerated claims about the project’s future success.
  • Pressure to buy immediately. Take time to research an investment opportunity before handing over your money. Watch out for pressure to act fast or “get in on the ground floor” of a new tech trend.
  • Unlicensed sellers. Many fraudulent investment schemes involve unlicensed individuals or unregistered firms. Check license and registration status with your state or provincial securities regulator. Contact information is available here.

 

 

A word for the naive: Well done!

One of the duties on the long list of grownup responsibilities is to figure out how much money to put into your company’s 401(k) offerings. Many people, rather than figuring out their long-term goals and tolerance for risk, simply split their money equally between all the options.

This is known as the 1/n portfolio among the nerdly, or more generally, the naive portfolio. And its results generally aren’t that bad, even when compared with high-powered optimized portfolios.

What makes the naive portfolio more interesting is that companies don’t choose their 401(k) offerings much differently than naive investors do: That is, they tend to offer very large funds with a good near-term track record. The odds are good that your fund’s 401(k) offerings are simply the largest funds available. Here are the 10 largest mutual funds, ranked by assets, and how they performed last year.

Name Ticker Morningstar Category 2017 gain
Vanguard Total Stock Mkt Idx Inv VTSMX US Fund Large Blend 21.05%
Vanguard 500 Index Investor VFINX US Fund Large Blend 21.67%
Vanguard Total Intl Stock Index Inv VGTSX US Fund Foreign Large Blend 27.40%
Vanguard Institutional Index I VINIX US Fund Large Blend 21.79%
Vanguard Total Bond Market Index Inv VBMFX US Fund Intermediate-Term Bond 3.46%
American Funds Growth Fund of Amer A AGTHX US Fund Large Growth 26.14%
American Funds Europacific Growth A AEPGX US Fund Foreign Large Growth 30.73%
Vanguard Total Bond Market II Idx Inv VTBIX US Fund Intermediate-Term Bond 3.51%
JPMorgan US Government MMkt Capital OGVXX US Fund Money Market – Taxable 0.77%
Fidelity® 500 Index Investor FUSEX US Fund Large Blend 21.72%

Dividends, gains reinvested through Dec. 29. Data via Morningstar.

The portfolio’s total return: 17.8%, which lags the Standard and Poor’s 500 stock index by a bit more than four percentage points. On the other hand, the portfolio is only 70% invested in stocks, which is what you’d want in a diversified portfolio. The 20% allocation to bonds and 10% allocation to money market securities (as well as a 10% slug of foreign stocks) are reasonable diversification for a moderate portfolio.

Of note, too: This is a dirt-cheap portfolio, with an average expense ratio of 0.25%. Low expenses are one of the single most important predictors of future returns: The less you give to your fund company, the more you get to keep for yourself.

What could go wrong? Three things, none of which seem terribly serious. The first is the preponderance of index funds, which will guarantee you nothing more (or less) than what the market does. If the S&P 500 goes down 20%, this portfolio’s two S&P 500 index funds will go down 20%, too. But it’s unlikely that actively managed funds will get out of the way in time, either: Most didn’t during the 2007-2009 bear market. And remember, the portfolio is only 70% in stocks.

The second is that, thanks to the market’s runup, you’re now about 74% in stocks. This is not particularly something to worry about at the moment. Now, if you had been in these 10 funds for the past 10 years, your portfolio would be 81% in stocks.  This is better than watching your stock allocation shrink. But you might have a greater exposure to stocks in the next bear market than you’d like. If that’s the case, you should sell enough of your winning funds and reinvest the proceeds in your laggards, bringing you back to your original 70% stock allocation.

The final problem is that the 10 funds in the chart are there because they have been wildly successful in the past decade. Money follows success.  It’s a good bet that the 10 largest funds today won’t be the 10 largest in the next decade. When you’re at the top, there’s nowhere to go but down.

Unfortunately, if you’re simply investing in what the company offers, there’s not much you can do about that. Nor, for that matter, can you predict accurately what the 10 largest funds of 2028 will be. The main thing is to keep an amount in stocks that you can live with.

 

 

 

 

 

 

A change of heart

A Christmas Carol is about a change of heart — in this case, the heart of Ebeneezer Scrooge: 

Oh!  But he was a tight-fisted hand at the grind- stone, Scrooge! a squeezing, wrenching, grasping, scraping, clutching, covetous, old sinner!  Hard and sharp as flint, from which no steel had ever struck out generous fire; secret, and self-contained, and solitary as an oyster.  

The spirit of Scrooge — pre-haunting Scrooge — has been alive and well in American business for a good many years. Just as Scrooge rolled up the profits of his lending business while his clerk froze, U.S. companies have only grudgingly doled out wages. The chart, left, shows average weekly wages, adjusted for inflation, the past decade. Annual rate of increase: 0.52%.

At the same time, profits, cash and profitability at major U.S. corporations have been hitting new highs. This isn’t terribly unusual: Companies typically don’t raise wages unless they have to, and they don’t have to until unemployment falls below 5% or so.

Nevertheless, workers’ share of corporate fortunes have been unusually small, especially in light of productivity improvements. Workers have produced more, but received far less of that improvement than in the past. (Keep scrolling past the graph, because I can’t figure out how to decrease the white space that follows).

 

 

 

 

 

 

 

 

 

 

 

The tax reform bill passed by Congress assumes that corporations will pass on their massive tax savings to workers, and also use that extra money to reinvest in other businesses. Will it work? It depends on who you ask, which means that no one really knows. A few companies have already announced bonuses and cited the tax reform measures as their reason for doing so.

Some, such as Wells Fargo, have waffled on whether the increase was because of the tax bill or not. Others, like AT&T, have also announced layoffs at the same time.

Nevertheless, it’s entirely possible that at least some of corporate tax savings will, indeed, make it to employee salaries, new hires or even new factories. Alas, there aren’t many funds that specialize in employee happiness. But here are a few suggestions on what might make a good investment in light of tax reform:

  • Parnassus (PSRNX). This fund takes the position that companies that treat employees well tend to do well in the long run. It’s not infallible — awful companies prosper sometimes, too — but the fund has gained an average of 10.5% a year the past decade, vs. 8.3% for the Standard & Poor’s 500 stock index.
  • Financial funds. Tax breaks plus looser regulation generally should benefit banks. SPDR Capital Markets ETF (KCE) is a good low-cost choice, as is iShares U.S. Financial Services ETF (IYG).
  • KKR & Co. LP. The private equity and real estate manager specializes in merge and acquisitions. Should companies use their newfound cash to buy other companies, KKR is a logical beneficiary.

A cynic would observe that companies have long had the ability to give their employees a raise, and have simply decided to keep most of that cash in the CEO suite. A big infusion of cash from the tax bill could simply increase those tendencies. On the other hand, we can all hope for a change of heart — although, as was the case with Scrooge, the proof was in actions, not theory.

 

 

The season for giving

Most people who invest are periodically troubled by the actions of the companies whose stock they buy. While you probably won’t see a headline like “Equifax Sought in Bar Stabbing,” you probably have seen headlines like “Equifax CEO Richard Smith steps down amid hacking scandal.” You may also have noted that Mr. Smith left the company with an $18 million pension. Heck, I would have run the company into the ground for half that.

It’s no wonder that funds that screen for environmental, social and governance factors are becoming increasingly popular. Of those three factors, I’d argue that governance is the most important. (In fact, I did, right here in my latest column for InvestmentNews). Funds like Parnassus (PARNX) have fared extremely well by investing in companies that treat employees well, don’t cut corners to save costs, and don’t pay CEOs gargantuan salaries.

It’s the social part of ESG investing that gets sticky. Just this morning I got a press release for the eVALUEator Biblically Responsible Index (BIBLX). According to the announcement, “The index is designed to invest solely in companies with activities and practices consistent with Christian values. These standards allow BIBLX to limit portfolio exposures to practices related to abortion, pornography, alcohol, tobacco, gambling and anti-family entertainment.”

You may not be surprised to learn that the world isn’t in agreement on all Biblical principals. Mennonites, for example, would object to defense stocks; others cite an obligation to be good stewards of the earth and would avoid polluters. And, of course, there are those who don’t use the Bible as the basis for their faith.

If you can’t find a social fund that fits your specific views, it might be more effective to invest in a broadly based index fund or other fund and simply donate the proceeds to a charity that addresses your favorite cause. If you donate appreciated shares of a stock or fund, you can also sidestep any taxes on capital gains. And there would be a certain symmetry in selling shares of a major polluter and donating the proceeds to The Nature Conservancy or cashing in shares of a tobacco company and giving the money to The American Cancer Society.