The convergence of the twain

And as the smart ship grew

In stature, grace, and hue,
In shadowy silent distance grew the Iceberg too.

Thomas Hardy, The Convergence of the Twain (Lines on the loss of the Titanic)

 

Thomas Hardy’s poem makes sardonic note that, while the Titanic was taking form in Liverpool shipyards, so, too, was the iceberg that doomed it. And, while each bull market grows, so do the forces that will eventually cause it to stop.

What will cause the death of this bull market? No one really knows, and the nature of a bear market is that few see it coming. But if I were to put money on it, the most likely assassin would be the Federal Reserve, rather than disappointing Facebook earnings.

The Fed’s job is to keep the economy on a sustainable growth rate, which means that the economy should grow fast enough to keep unemployment low without inflation. (To the cognici, this is the non-accelerating inflation rate of employment, or NAIRU, which sounds like something out of the Mork and Mindy Show.) Just what NAIRU is is a matter of debate among economists. It’s enough to know it exists.

When the economy is sluggish, the Fed lowers short-term interest rates, which makes it cheaper for companies to borrow and invest. It allows people to refinance mortgages and other debts at a lower rates – essentially, putting money into their pockets.

When the economy is growing too fast and inflation is rising, the Fed raises short-term interest rates to slow the economy. When rates rise, it’s more expensive to borrow, which slows the housing market and makes companies more wary of borrowing.

While the Fed may say that it doesn’t want to cause a recession or slow down the stock market, rising interest rates often do both. A recession wipes out wage inflation: You can’t have wage inflation if people are getting laid off, and you can’t have a wage-price spiral without rising wages. Most stock investors know that higher rates can augur recession, and they tend to sell stocks as rates creep higher. And, on a technical note, stock analysts tend to reduce price targets when interest rates rise.

The most famous example of the Fed crushing stocks and the economy was in 1981, when the Fed hiked short-term interest rates to the highest in modern history: The three-month Treasury bill yielded 16.3% in May of that year, and a sharp recession followed. Inflation, as measured by the Consumer Price Index, fell from 9.79% in May 1981 to 2.36% by July 1983.

But most other bear markets have been preceded by rising rates: The 1987 market crash, for example, as well as the 2000-2002 tech wreck and the 2007 financial meltdown all had rising rates at their backs. While none of those rate hikes were as severe as in 1981 – and you can debate whether they were the proximate cause of the bear market – few bear markets start after a prolonged period of the Fed cutting rates.

What does all this mean? If you have ten or more years to reach your savings goals, not a thing. In fact, a bear market is a good thing if you’re young and contributing regularly to a stock fund in a retirement account. You get the chance to buy stocks cheap over a long period of time.

If you’re close to your goal, however, you should at least think about how much you have in stocks. The most logical way is to rebalance: If you set a goal of 60% stocks and 40% bonds, for example, you’re probably out of balance now. It wouldn’t hurt to sell enough stocks and buy enough bonds to get back to that 60% and 40% risk.

“Not dead; just resting”

Back in the days when we communicated by graphite scrawls on dried wood pulp, I would occasionally get notes from relatives wishing me a speedy recovery from my broken arm. Subtlety was not my family’s strong point.

Communicating by pixels in phosphor, alas, hasn’t sped up my process much. To answer a few questions:

Q: Did you break your arm?

A: No.

Q: Is that any way to keep a lawn?

A: Hey, I’ve been busy.

Q: Doing what?

A: Writing. Just not here. But you can read my latest column in Morningstar right here. More to come shortly.

The convergence of the twain

And as the smart ship grew
In stature, grace, and hue,
In shadowy silent distance grew the Iceberg too.

— Thomas Hardy, The Convergence of the Twain (Lines on the loss of the Titanic)

Thomas Hardy’s poem makes sardonic note that, while the Titanic was taking form in the Bellfast shipyard, so, too, was the iceberg that doomed it. And, while each bull market grows, so do the forces that will eventually cause it to stop.

The RMS Titanic, pre-iceberg

What will cause the death of this bull market? No one really knows, and the nature of a bear market is that few see it coming. But if I were to put money on it, the most likely assassin would be the Federal Reserve, rather than disappointing Facebook earnings.

The Fed’s job is to keep the economy on a sustainable growth rate, which means that the economy should grow fast enough to keep unemployment low without inflation. (To the cognici, this is the non-accelerating inflation rate of unemployment, or NAIRU, which sounds like something out of the Mork and Mindy Show.) Just what NAIRU is is a matter of debate among economists. It’s enough to know that the Fed tries to balance inflation, interest rates and employment.

When the economy is sluggish, the Fed lowers short-term interest rates, which makes it cheaper for companies to borrow and invest. It allows people to refinance mortgages and other debts at a lower rates – essentially, putting money into their pockets.

When the economy is growing too fast and inflation is rising, the Fed raises short-term interest rates to slow the economy. When rates rise, it’s more expensive to borrow, which slows the housing market and makes companies more wary of borrowing.

While the Fed may say that it doesn’t want to cause a recession or slow down the stock market, rising interest rates often do both. A recession wipes out wage inflation: You can’t have wage inflation if people are getting laid off, and you can’t have a wage-price spiral without rising wages. Most stock investors know that higher rates can augur recession, and they tend to sell stocks as rates creep higher. And, on a technical note, stock analysts tend to reduce price targets when interest rates rise.

The most famous example of the Fed crushing stocks and the economy was in 1981, when the Fed hiked short-term interest rates to the highest in modern history: The three-month Treasury bill yielded 16.3% in May of that year, and a sharp recession followed. Inflation, as measured by the Consumer Price Index, fell from 9.79% in May 1981 to 2.36% by July 1983.

But most other bear markets have been preceded by rising rates: The 1987 market crash, for example, as well as the 2000-2002 tech wreck and the 2007 financial meltdown. While none of those rate hikes were as severe as in 1981 – and you can debate whether they were the proximate cause of the bear market – few bear markets start after a prolonged period of the Fed cutting rates.

The Fed has raised its key fed funds rate seven times since 2015, admittedly from its lowest base ever. The central bank’s target is between 1.75% to 2.0%, and most predict it will raise rates at least one more time this year, and possible several more times next year. Already, the yield on most money market funds is higher than the dividend yield on the Standard & Poor’s 500 stock index.

What does all this mean? If you have ten or more years to reach your savings goals, not a thing. In fact, a bear market is a good thing if you’re young and contributing regularly to a stock fund in a retirement account. You get the chance to buy stocks cheap over a long period of time.

If you’re close to your goal, however, you should at least think about how much you have in stocks. The most logical way is to rebalance: If you set a goal of 60% stocks and 40% bonds, for example, you’re probably out of balance now. It wouldn’t hurt to sell enough stocks and buy enough bonds to get back to that 60% and 40% risk. Somewhere out in the future, rising stock prices and rising rates will converge, and the results are rarely pretty.

The RMS Titanic, post-iceberg.

Buybacks hit new record: Should you care?

Let’s listen to the latest board meeting of Twango, the highly profitable and entirely fictitious company that makes banjos for Latin dance bands. Thanks to an inexplicable surge in banjo-fueled Tango raves – and a major tax cut – Twango is showing record profits this year.

“What are we going to do with all this money?”, asks the CEO. “Should we give the workers a raise?”

“Heck, they got 1% last year,” the treasurer says. “That’s 1% more than everyone else in the country got.” (No, really.)

“Why not raise the dividend?”

“If we do that, we’ll have to pay the increase for eternity,” the treasurer says. “Don’t know if we want to risk that.”

“How about expanding the factory? Increase advertising? Expand to Europe?”

“Whoa, whoa, whoa,” says the Treasurer. “Someone needs to switch to decaf.”

“Ok, then, let’s buy back some stock.”

“Great idea!” says the board.

While this is entirely fiction, it’s not implausible. Companies spent a record high $189.1 billion in stock buybacks in the first quarter, according to Standard & Poor’s. All other things being equal, buybacks should shrink the number of shares outstanding, thereby making remaining shares more valuable. And you can stop a buyback program with a phone call, and no one on Wall Street will say boo. Aside from showing a lack of imagination, what’s wrong with buybacks?

Ever tried to find a picture of a stock buyback? Here’s a nice giraffe photo.

For one thing, an announced buyback program doesn’t really mean anything if the company doesn’t actually buy back stock, and this is an annoyingly common practice. For another thing, many buyback programs are simply a way to pay off executive options. If our Twango CEO exercises his options for 10,000 shares, the company has to get that stock from somewhere, and it’s usually via a buyback program.

Finally, many companies, like many individuals, aren’t particularly good at buying back their own shares. In 2008 and 2009, buyback programs died like a lawn in the middle of a heat wave. Even now, the excellent insiderscore.com has a long list of companies that are buying back shares at high prices.

At least at the moment, buyback strategies haven’t been producing dividends. Invesco BuyBack Achievers ETF  (PKW), the largest and oldest buyback ETF is down 3.31% this year, while the Standard & Poor’s 500 stock index is up 2.46%. The ETF buys shares of companies that have reduced their share count by 5% or more in the past 12 months. Top three holdings: Walt Disney, American Express, and Procter & Gamble.

SPDR® S&P 500 Buyback ETF  (SPYB) is a newer, smaller entrant into the buyback field. It screens stocks based on the cash value of the actual (not announced) buyback, rather than on the reduction of shares outstanding. The ETF is up 1.58% this year – not better than the S&P 500, but better than the Invesco ETF.

Those looking for companies that seem willing to invest money in the business might check out the Nasdaq US CapEx Achievers Index (CAPEXA). The stocks in the index have increased their capital expenditures for at least three consecutive years. At the moment, there doesn’t seem to be an ETF modeled on the index. Top three holdings: Procter & Gamble, Chevron and Oracle.

Buyback strategies, like most strategies, work best when Wall Street thinks they will. And from 2009 through 2013, buyback strategies worked very well indeed. Lately? Not so much. At least at this point in the economy, it might be best to buy stocks of companies that know how to use their money to grow their business – instead of ones that can’t think of anything better to do with it.

 

 

 

Tracking the MSM

Even if you hate the mainstream media, here’s an MSM you can learn from: The Main Street Meter, via the Leuthold Group.

The MSM is the level of consumer confidence, as measured by the University of Michigan Consumer Sentiment Index, divided the unemployment rate. And right now, the MSM index is pretty high – and it has been for a while. (You can see the charts and read the article here) Good news, right?

Not exactly. Jim Paulsen, Leuthold’s chief investment strategist, notes that when the MSM index is high, investors tend to be frisky – more motivated by greed than fear. More troubling, though, is that with low unemployment, other troubles start to emerge. Typically, low unemployment is a precursor to inflation and higher interest rates.

The MSM’s highest points since 1960 have been 1968, 2000 and now. While this doesn’t mean that the stock market is going to collapse tomorrow – or even over the next few years, it does mean that the outlook for the next five years or so isn’t terribly good.

A high MSM does indicate that it might be a good time to add inflation-sensitive investments, such as real estate and commodities, to your portfolio. Typical late-cycle stock sectors, such as energy, materials and industrials, might fare well also.

Mr. Paulsen cautions that the MSM is not a good short-term market predictor, something it shares with that other MSM. But for those with the long term in mind, it’s an indicator worth following.

 

Off balance?

Three years ago on this blog, I introduced the Amish Portfolio — essentially a bare-bones, low-cost portfolio for those who get a little buggy by complex investment recommendations. If you have a wood-burning computer to track it, all the better.

The portfolio consists of three funds:

* Vanguard Total World Stock Index fund (ticker: VTWSX). The beauty of this fund is that you don’t have to fret about how much to have in international stocks and how much to keep at home. It’s all in there, according to market capitalization: 56.5% North America, 21.5% Europe, 20.8% Asia, and 8.0% emerging markets. Cost for the investor shares: 0.19% a year, or $1.90 per $1,000 invested.

* Vanguard Total Bond Index fund (VBMFX). You get broad exposure most types of U.S. bonds. Current yield: 2.54%. Cost: 0.15%, or $1.50 per $1,000.

* Vanguard Prime Money Market (VMMXX). Hey, it’s a money fund. It yields 2.03% after its 0.16% expenses.

The suggestion for conservative investors: 20% Vanguard Total Bond, 20% Vanguard Prime Money Market and 60% Vanguard Total World stock. You can add to stocks (and reduce cash or bonds) depending on your personal risk profile.

A mix of stocks, bonds and money market funds is remarkably self-balancing: Despite the stock market’s runup, the conservative blend above is at 65% stocks, 18% bonds and 18% money market funds. It probably doesn’t need to be rebalanced now.

Had this been your portfolio for the past five years, however, you’d now be 76% in stocks — far more than your initial target. In this case, you’d want to sell enough from your stock fund and add to your money fund and bond fund to get to your original 60% stocks, 20% bonds, 20% money fund allocation.

Rebalancing too frequently means that you’ll be cutting off your gains too quickly. (In a taxable account, it means you could be triggering taxes, too). Using the 10% rule typically means occasional rebalancing, and often when one market — stocks or bonds — are a bit frothy. If you’ve been in the market for a while, and you have a set allocation to stocks, now might be the time to rebalance.

 

 

Why buy bonds?

Why do economists continue to give interest-rate forecasts, despite the fact that they’re generally awful at predicting interest rates? Probably because people ask them to. But if you’re thinking of investing in a bond fund now, it would help to have a forecast in mind – if only to give you an idea of the risks you’re incurring.

People ask economists to give interest rate forecast because so many things depend upon your assumption for rates, and that’s especially true for bonds. Bond prices fall when interest rates rise and they rise when interest rates fall.

Just how vulnerable is your fund to interest-rate changes? You can get a good idea by looking at the fund’s duration, which tells you how much a bond’s price will fall, given a rise in interest rates of one percentage point. Consider the Vanguard Total Bond Market Index Fund ETF (BND), the largest bond ETF, which is also a good proxy for, well, the total U.S. bond market.

The Vanguard ETF, for example, has a duration of 6.09 years, meaning a rise in rates of one percentage point would mean a principal loss of about 6.09%. That loss would be offset, somewhat, by the interest investors receive from the bonds. The ETF has a yield of 3.13%, according to Morningstar Direct. If you were to assume that rates will rise by a percentage point, your total return – price decline plus interest – would about a 3% loss.

Interest rates have been rising since July 2016, when the bellwether 10-year Treasury note hit an all-time low of 1.38%. It’s trading at 2.85% now. Since that date, Vanguard Total Bond Market Index Fund ETF has lost 1.75%, including reinvested interest. While interest payments have certainly offset most of the fund’s losses, it hasn’t been enough to eliminate them entirely. The past 12 months, the fund has lost 0.82%.

Army ants.

Here’s where the forecast comes in. If you were to assume that interest rates will rise a percentage point in the next year, you should brace yourself for roughly a 3% loss. That’s not a catastrophic loss – bond bear markets are like getting attacked by very mean ants – but you might consider a few other options.

One is a money market fund. Just as the 10-year T-note yield has been rising, so has the yield on money market funds. Vanguard Prime Money Market Fund Investor Shares (VMMXX) has a yield of 2.02% and – assuming the fund maintains its constant price of $1 per share – it has very little potential for a principal loss.

Another is a fund with a tolerable track record of managing interest-rate risk. (Typically, these funds are also deft with credit risk – buying bonds from shaky companies that are getting better). One is Dodge & Cox Income (DODIX). It has a duration of 4.2 years, a 3.02% yield, and an expense ratio of 0.43%.  The past two years, the fund has averaged a 2.94% gain – not much, but better than the average fund.

Bear in mind if bonds are a part of a long-term plan, you shouldn’t dump your bond funds because you’ve got a feeling rates will rise.  Over the long term, bonds have a great record in dampening the effects of stock downturns. But if you’re trying to figure out where to invest money now, a money fund or Dodge & Cox Income are two good places to start.