In which matters become more serious

Because I was born during the Taft administration, I remember that 1987 was a very, very good year in the market, at least at first. And I remember an editor, who shall remain nameless, saying, excitedly, “Isn’t it amazing how well this market is doing in the face of rising interest rates?”

The Dow Jones industrial average had climbed 27.6% in the first six months of the year, and tacked on another 7% in July 1987. And, in fact, the yield on the 10-year Treasury note had risen from 7.08% to 8.62% from the first of the year to the end of July.

From there on out, however, interest rates rose steadily, topping 10% on October 16, 1987. And the stock market, like Wile E. Coyote walking off a cliff, suddenly noticed that interest rates were rising. From its peak of 2,722 on August 25, the Dow began to stumble — first slowly, and then more rapidly. On October 15, the Dow fell 2.4%. The next day, it fell 4.6%. The next trading day, it plunged 508 points, or 22.6%, a record one-day drop.

For the past 12 months, the yield on the 10-year T-note has been creeping higher, albeit at far lower levels than 1987. (It’s still hard for me to get too worked up over a 2.84% T-note yield.) And the stock market has been soaring higher. Last year was, in fact, a very good year, with the S&P rising 22%. Even after today’s 666-point carnage (a 2.54% drop) the Dow is still up 3.3% for the year.

It’s entirely likely that interest rates will continue to rise. To quote myself: “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.” We’re closer to the average 10-year yield than we were, but we’re still a ways off. And being at the average rate of interest isn’t usually a problem for the stock market.

What is a problem is that stocks are generally overvalued. Rising rates only make that worse: Bonds and bank CDs suddenly become more attractive than they were previously. Corporate borrowng becomes more expensive. And, if rates are indeed rising because of a strong economy, higher wages will weigh on future earnings. Events must unfold to perfection at this level of stock prices, relative to earnings. And, as Wile E. Coyote could tell you, things rarely unfold to perfection.

If you’re a long-term investor, you’ll probably do better than 2.84% a year the next decade if you’re in stocks. What you probably won’t get is high returns with low volatility. If the bull market has pushed your stock allocation significantly above your target, it’s time to rebalance your portfolio back to your target. Otherwise, hang on and hope for the best, and keep saving — which is, after all, the single most imporant determinant of how much money you have when you reach your goal.

 

 

 

 

Taking the stock market’s temperature

It’s a balmy 53 degrees here, which isn’t bad for January, but the Standard & Poor’s 500 is hotter than a fire ant’s furnace. As of Jan. 25, the blue-chip index has gained 6.16%, including dividends. How do you know when hot is too hot? You can get one hint from the aptly named Thermostat fund.

A rising stock market, in and of itself, is no reason to panic. Typically, a really good year is followed by at least an OK year. When the S&P 500 gained 26% in 2009, it followed up with a 15% gain in 2010. Similarly, the index gained 13.46% in 2014 after a 32.31% advance in 2013.

What matters is how stock prices measure up against corporate earnings. The basic measure is the price-to-earnings ratio, which simply divides a stock’s price by its previous 12 months’ earnings.

The lower the PE, the cheaper the stock is, relative to earnings. A $50 stock that earned $3 last year has a PE of 16.7. Changes in either price or earnings affects the PE ratio. If the stock’s price drops to $35, its PE is 11.7. If its earnings fall to $2 a share, its PE rises to 25.

It’s not infallible. PEs were high in early 2009 because earnings were so low. Some argue that it’s best to use earnings estimates, rather than past 12 months’ earnings, to measure PE. There’s some wisdom to this: The stock market looks forward, not back. On the other hand, earnings estimates are fiction, and historical PEs are a tad more fact-based. You can get both on Morningstar’s site.

All of which brings us to the Columbia Thermostat Fund (CTFAX), created by storied value investor Ralph Wanger. The Thermostat fund adds bonds to the portfolio as the market heats up, based on the market’s price vs. long-term earnings. When stocks become cheaper, it adds more to stocks and reduces its bond holdings. The fund also has rules to prevent big swings in its holdings.

What’s the fund’s current reading? It’s got just 7.31% of its portfolio in U.S. stocks, and 2.43% in international stocks. Even by the fund’s cautious nature, that’s pretty low. Here’s how the fund’s stock allocation has varied over the years:

Source: Columbia Threadneedle Investments

The fund’s return the past 10 years has been above its category —  conservative allocation, by Morningstar’s reckoning. Nevertheless, its absolute return hasn’t been particularly spectacular. The fund has gained an average 5.35% a year the past decade, in part because it has been so conservative during bull market years.

Nevertheless, the fund serves as a useful market barometer: It’s hard to argue that most stocks are cheap now. If you’re thinking of turning up the temperature in your portfolio, you might want to take another look at the thermometer.

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

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.

 

 

 

 

 

 

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.