The Three Percent Solution

When I was growing up, we had a lot of cats. I don’t mean three or four cats. We usually had upwards of ten, all descended from a single calico named Caroline. My parents underestimated both the gestation period of the common house cat, as well as the neighbors’ interest in adopting kittens, no matter how tri-colored and adorable. I thought little of it: I liked cats, and still do, and to me, having 10 or more cats in the house was perfectly normal. It wasn’t until I was older that I realized how peculiar that was.

One of the peculiarities of the past decade – and it’s been a singularly peculiar decade – has been the exceptionally low level of interest rates. The average yield on the three-month Treasury bill the past 10 years has been 0.38%, according to the Federal Reserve. And that figure is inflated somewhat by the first 12 months of the series, when three-month T-bill yields averaged a whopping 2.14%. After that, the three-month bill yielded an average 0.18%. (For purists, this is the market yield, not the discount yield).

For anyone who has been investing the past decade, 0.18% seems about normal. Money market mutual funds, whose yields track the short-term T-bill, have yielded next to nothing – and sometimes actually nothing – for much of the past decade. The same is true for bank CDs. But this is not normal. The average yield for the three-year T-bill since 1934 is 3.5%. If we want to get rid of the very highest and very lowest yields, we get a typical yield of 3.18% over that 83-year period.

Why is this important? For large swaths of the nation’s history, you could get a yield of 3% or more by taking virtually no risk. But for the past decade, that 3% yield has been entirely elusive. To get even a modest 3% yield, you had to take unprecedented risk, either by investing in dividend-producing stocks, or by investing in corporate bonds.

Barring some unforeseen disaster, the period of rock-bottom rates is over. From October 2009 through October 2015, the three-month T-note yielded an average 0.07%, as the Fed kept rates low to stimulate the moribund economy. Today it stands at 1.26% and, should the Fed raise rates as expected, will rise to about 1.5%. Analysts widely expect the Fed to raise rates another half percent or more next year, bringing T-bill rates to about 2% to 2.25%.

While this is still low by historical standards, it holds some interesting implications for long-suffering savers. First, a 2.25% riskless yield could be enough to dull investors’ interest in dividend-producing stocks. Currently, the Standard & Poor’s 500 yields 1.9%. While companies are flush with cash – and get more so should corporate tax rates fall – a 1.9% yield is not a terrific reward for stock market risk when T-bills are sitting at 2.25%.

Yields on bank CDs are already rising. The highest yielding nationally available one-year CD, offered by online bank Banesco, weighs in at 1.75% with a $1.500 minimum, according to BankRate.com. Goldman Sachs Bank USA offers a one-year CD at the same rate. A five-year CD from Capital One 360 yields 2.45%, but it makes little sense to lock in for five years when rates are rising.

Money fund rates are rising as well. Vanguard Money Market Prime (VMRXX) currently sports a 1.20% yield. And Bankrate.com lists three bank money market accounts with yields of 1.5%. (Bear in mind that bank money market account yields are set by the bank, while money market accounts are set by the market).

Investors who decided to seek a bit more yield by investing in short-term bond funds may want to rethink that strategy. Vanguard Short-Term Bond Index fund (VBISX), for example,  has gained 1.39% the past 12 months, including reinvested dividends. Its 12-month yield is 1.54%, indicating that investors have taken a modest loss on principal. If the Fed continues to raise rates, investors will get higher yields, but also increased principal losses.

If you’re a long-term investor with reasonable risk tolerance, there’s nothing wrong with investing in a stock fund that aims for high or growing dividends. Members of the Standard & Poor’s 500 stock index have record amounts of cash, the economy is growing, and they may get even more cash through proposed corporate tax cuts. And several funds offer a convenient way to buy dividend stocks. T. Rowe Price Dividend Growth (PRDGX), for example, has gained 17.35% the past 12 months and offers a 1.4% yield. Fidelity Dividend Growth (FDGFX) has gained 16.13% the past 12 months with a 1.47% yield. Vanguard Dividend Growth, alas, is closed to new investors.

If you’re simply looking for income, however, and you’re worried about the stock market, you may soon be able to put some of that worry to rest by going to cash. Any reasonable portfolio needs exposure to stocks for long-term growth, so don’t sell everything. But if you want to raise a little cash, you’ll get a bit more reward than you have for most of the past 10 years. And that’s one thing about our current investment climate that actually isn’t peculiar.

 

They don’t ring a bell

According to hoary Wall Street lore, they don’t ring a bell when a bull market ends or a bear market begins. (Those would actually be the same thing). But Federal Reserve Chair Janet Yellen did all but that today when she spoke at the Kansas City Fed’s economic conference in Jackson Hole, Wyoming.

“I believe the case for an increase in the federal funds rate has strengthened in recent months,” Yellen said, which is just about as close to skywriting “RATES ARE GOING UP!” as a Fed chair can get. Wall Street, which has anticipating higher rates since 2009, reacted predictably, selling off stocks and bonds at the same time. The Dow Jones industrial average fell 53.01 points, to 18,395.40, and the bellwether 10-year Treasury note yield rose to 1.635%. Bond prices fall when interest rates rise, and vice-versa.

Naturally, the case for raising interest rates soon is debatable. In terms of timing, the Fed is traditionally reluctant to raise rates in the months before a presidential election. If that reasoning still holds, the next opportunity to increase the key fed funds rate would be in December.

And on a relative basis, interest rates are pretty high already. The fed funds rate is 0.25% to 0.50%. The European Central Bank’s rate is zero, as is the Bank of Japan’s. The Swedish central bank’s rate is -0.25%, and the Swiss government rate is -0.75%.

The Fed doesn’t control long-term interest rates, but the picture there is just as grim. Germany’s 10-year yield is -0.07%. France’s decade note yields 0.17%, albeit with a certain je ne sais quois. Italy’s 10-year rate — Italy’s! — is 1.17%.

What is starting to make the Fed uneasy, however, is rising wages. The Fed has been able to flood the world with easy money for nearly a decade without fear of a wage-price spiral because wages have been flat for more than a decade. You just can’t have a wage-price spiral without higher wages.

Oddly — and somehow justifiably — those at the lowest end of the wage spectrum have been seeing the biggest wage increases, thanks in large part to state-mandated minimum-wage increases. But that’s not the only reason. Many companies, such as Walmart and McDonald’s, have come to the realization that they rely heavily on those who face the public. Those people are almost invariably on the lower end of the wage spectrum.

Perhaps Lily will get a raise.
Perhaps Lily will get a raise.

Service companies are also discovering, to no one’s surprise than theirs, that people who don’t make much don’t feel a lot of loyalty to their employers. Low-wage employees will often gladly jump ship to another company that pays better wages. In the recession, companies could simply say, “Be glad you have a job.” But many of the new job gains have gone to low-income employees — so much so, in fact, that there’s a relative shortage of people willing to take low-wage jobs.

“Wage acceleration has been concentrated in low-pay sectors, such as restaurants and retailing,” says Bank of America Merrill Lynch. “In our view, the increase in low-pay wages is due to state-level minimum wage increases and a shortage of younger, less-educated workers. We see sharp increases only in low wage sectors: broader wages should rise more gradually as joblessness falls.”

The Fed raises interest rates to slow the economy and reduce the threat of inflation. But bear in mind that interest-rate increases take a long time — 18 months or so — to fully take effect on the economy. Furthermore, a more or less normal fed funds rate, which is neither accommodative nor restrictive — is somewhere between 3% and 4%. It will take many more quarter-percent rate hikes to get back to normal.

The big danger is that the economy isn’t exactly boiling over. Current estimates for third-quarter gross domestic product are a 1% increase or less.

If you’re looking for a rate shock, you probably won’t see one any time soon. You may start to see better rates on bank CDs: The top ones now yield about 1%, according to Bankrate.com. But you should start to be wary of interest-rate sensitive stocks, such as utilities and preferred stocks. And if you’re thinking of loading up on bonds, you might want to wait a bit.

 

 

 

 

Greetings from Lacunaville

SDSC_0368tarting in January, I’ve been writing full-time for InvestmentNews, doing a monthly column for Money magazine, and studying for the Certified Financial Planner mark. (This, apparently, is also a test of your prowess with a hand-held calculator). And I went to Africa.

The blog, as you may have noticed, has, um, languished. I’m hoping to revive it on a somewhat irregular basis, which, come to think of it, is pretty much its usual schedule.

I’ll be updating my links pages in the next week or so. In the meantime, here are some things to watch for today, as well as some things I’ve found interesting or peculiar.

This week, all eyes are on the Bureau of Labor Statistics’ employment situation report, out at 8:30 a.m. Friday. But the stock market seems to be resigning itself to an interest rate hike, probably in June or July. (A later hike would give the impression of a political motivation, and the Fed generally doesn’t like to do that). The current consensus estimate for new nonfarm jobs is 158,000, according to Bloomberg, with the unemployment rate falling to 5%. (And, yes, the total unemployment rate is still high, but it’s the nonfarm payrolls number that Wall Street watches.)

Wages also seem to be firming up, and it should be interesting to see if traditional summer employers, such as ice cream vendors and lawn mowers, have a hard time finding help this year. All of these would seem to give the green light to the Fed to raise rates.

Of course, we’d be talking about a lordly fed funds rate of 0.5% to 0.75% after a Fed hike, an increase that will be promptly reflected in your credit card bill and eventually in your money market mutual fund account. For those who still watch their money fund account, the average money fund now yields 0.10%, nearly triple its rate at the start of the year.

DSC_0353The stock market typically dislikes interest-rate hikes. Higher rates mean bonds become more competitive with stocks, and increase short-term borrowing rates. On the other hand, higher short-term rates mean that companies will earn somewhat more on their cash, and that savers will earn slightly more on their cash.

The old adage about Fed rate hikes — three steps and a stumble — meant that the stock market takes the first two hikes as a sign that the economy is improving, and rallies. At the third hike, stock investors realize the Fed wants the economy to slow, and stocks sell off. Bear in mind that the adage originated when a normal fed funds rate was 4% to 5%. It would take a stairway, not a few steps, to get us back to the traditional stumble level, assuming the Fed raises rates at a quarter-point a pop.

I’m an optimist, and think that rising earnings are a good thing — in fact, the one thing that the economy desperately needs for sustained growth. Most companies, despite their complaining, have nice profit margins, good balance sheets, and plenty of cash. They might even be surprised to learn that when their employees get raises, they spend more — and even on the products their employers sell.

DSC_0488The one caveat: Stocks aren’t cheap, at least by the price-to-earnings ratio of the Standard and Poor’s 500 stock index. The current PE, based on forward earnings estimates, is 17 — a tad feverish, although nothing like the levels during the technology bubble. Nevertheless, at these levels, it’s a bit like driving a bit too fast on old tires. If the market takes a rate hike really badly, investors could find that both bond and stocks slide off the road. And in that case, having a bit of cash in a money fund might be a good safeguard.

 

How the naive are faring

You could line up all the advisers from here to Albuquerque, and you still wouldn’t reach a conclusion as to the best diversified portfolio for your retirement savings.

Because of that, many investors simply use the 1/n portfolio — which is to say, they divide their money equally among all the options in their 401(k) plan. Among those who study these things, this is called the Naive Portfolio.

What would a Naive Portfolio look like? Most 401(k) plans are not exactly paragons of fund-picking: They often choose the largest funds. After all, those funds typically have decent long-term records and low expense ratios, and no one is going to get sued using those criteria.

Let’s compose a naive portfolio of the 10 largest mutual funds. It would look like this, ranked by size:

Tot. ret. Tot. ret.
Fund Ticker Category 2015 5 years
Vanguard Total Stock VTSMX Large blend 2.37% 13.98%
Vanguard 500 Index VFINX Large blend 2.89% 14.23%
Vanguard Total Intl Stock Idx VGTSX For. large blend -2.35% 3.30%
Vanguard Total Bond VBMFX Interm. bond 0.68% 2.86%
Growth Fund of Amer A AGTHX Large growth 6.98% 13.78%
Europacific Growth A AEPGX For. large growth 1.57% 5.49%
Vanguard Prime MM VMMXX Money market 0.03% 0.03%
Fidelity Cash Reserves FDRXX Money market 0.01% 0.01%
JPMorgan Prime MM VPMXX Money market 0.01% 0.01%
Fidelity Contrafund FCNTX Large growth 7.93% 13.87%
Average 2.01% 6.76%

Source: Morningstar.

So how did our naive investors do? At least this year, they have done pretty darn well. The average expense ratio in this portfolio is 0.35%, which, honestly, you can’t beat with a stick.

Furthermore, a 2% return is just a shade lower than what you would have gotten with a single investment in the Vanguard Total Stock Index fund. And you would have gotten that return with far less risk than a pure stock index fund, given that 30% was in money market funds and 10% in bonds.

 

Just how successful a naive investment would be over the long term is a more difficult calculation, which I’ll tackle in future posts. But the takeaway is that naive diversification is probably better than no diversification at all.

 

 

 

A whiff of deflation

Every so often, and typically at three in the morning, you wake to hear a beeping noise. Sometimes it’s the battery in your smoke detector, calling sad attention to its demise. Sometimes it’s some other electronic warning or even, perhaps, an Eviltron, a tiny device that emits random beeps just to annoy its victims. At any rate, an indicator released today just set off one of those faint warnings.

Idavet’s the Chicago Purchasing Managers Index, produced by the Institute for Supply Management. The indicator is based on a monthly survey of — you guessed it — purchasing managers across the country. The index is a diffusion indicator: A reading above 50 means the economy is in expansion, while below 50 indicates contraction.

Unfortunately, the Chicago PMI walked off a cliff, falling 5.7 points to 48.7 in September. Just to pick a few bits from the unusually gloomy report released today:

  • Production led the decline with a sharp double-digit drop that placed it at the lowest since July 2009.
  • New Orders also fell significantly and both key activity measures are running well below their historical averages.
  • Just under 30% of the panel said China’s economic woes had a greater impact on them than the problems faced by the European Union.

The quote from Chief Economist of MNI Indicators Philip Uglow was also unsettling. “While activity between Q2 and Q3 actually picked up, the scale of the downturn in September following the recent global financial fallout is concerning. Disinflationary pressures intensified and output was down very sharply. We await the October data to better judge whether this was a knee jerk reaction and there is a bounceback, or whether it represents a more fundamental slowdown.”

The indicator is particularly worrisome for the Federal Reserve, which has been trying to combat deflation for the past decade. Mostly this has been felt in falling wages: If you were laid off during the financial crisis of 2007 to 2009, it’s likely that your new job offered worse benefits and lower pay. And the current trend of the so-called “gig economy” often has even lower pay and no benefits.

When wages fall, debt becomes more and more onerous. Your best bet, absent getting a raise, is to pay off debt and decrease spending. Unfortunately, cutting spending puts further downward pressure on prices — which, in turn, puts further downward pressure on wages. As bad as a wage-price upwards spiral is, a downwards spiral is even worse. Ask someone who has lived through the Great Depression, or re-read The Grapes of Wrath.

The most tangible display of deflation is through commodity prices — and not just oil, which is an outrageously rigged market that the Fed can’t really tamper with. But prices of other major commodities, such as copper, have been plunging as well.

 

The stock market chose to overlook the Chicago PMI today, instead focusing on the ADP employment report, which showed 200,000 new private sector jobs — which is a good number. But bond yields, which are only happy when it rains, moved lower. The September PMI may be a fluke, but somewhere in the depths of the Federal Reserve, a little alarm is going off.

Cash is never trash

For nearly a year now, pundits have been describing the U.S. stock market as “the least dirty shirt in the closet,” “the least bad-looking market,” “squeakier than a bowl of mice.” Ok, they didn’t use the last one. But the general implication is stocks may be expensive, but hey — they’re not bonds and they sure aren’t cash.

cashYou may have noticed, however, that cash looks increasingly attractive this week. While you’re earning an average 0.02% a year on your money market fund, that’s generally better than losing 1% to 2% a day on your stock fund.

Think of it this way: The average large-company blend stock fund is down 4.26% the past month. If you had 30% of your portfolio in cash, and 70% in your basic large-company stock fund, you’d be down 2.98%. While no loss is good, smaller losses are always better than larger ones.

More importantly, you would have an easily accessible buying reserve for stocks that seem ridiculously cheap. Finding values is more than buying whatever’s on the new low list. But if you can find a good stock that’s selling at a 20% discount or more, then this is a good time to think about buying.

Just recently I posted a list of companies in the Standard & Poor’s 500 stock index that are selling for 20% or more below their 52-week highs. That list has only grown since then. As of yesterday, 141 stocks, or 28% of the S&P 500, were below their 52-week highs. Among the more interesting entries to the 20% discount club:

  • Asset managers. Franklin Resources is down nearly 30% from its 52-week high, and it has now been joined by Legg Mason and Genworth.
  • Luxury goods. Coach is now nearly 60% below its all-time high, and Fossil is 56.5% below its all-time high. Michael Kors is nearly half its 52-week high.
  • Railroads. Union Pacific, CSX, and Kansas City Southern are all at least 20% below their 52-week highs.

The two biggest areas that are getting clobbered are energy and technology stocks. The problems in energy are obvious: Oil is down more than 50% from its recent highs.

The problems in tech are not quite as clear, although the weakness in the Chinese market seems to be the easiest answer. But some tech stocks seem tempting at these levels: Intel sells for just 11.3 times expected earnings, and pays a 3.4% dividend, to boot. Applied Materials sells for 12.3 times expected earnings and yields 2.5%. And Sandisk sells for 12 times forward earnings and yields 2.3%. If you have the cash — and the tolerance for tech stocks — these might good places to nibble.