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.





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.

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 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 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.


Lots of cash and animal spirits: What could possibly go wrong?

If you’ve ever been to a particularly raucous New Year’s party, you know that there’s a logical progression from the first awkward arrivals and introductions until you’re sleeping in a car full of raccoons and empty Cheetos bags.  And, at the time, each step makes wonderful sense.

Right now, the markets are at a spot where spirits are high and cash is flowing like liquor at your broker’s annual Christmas party. Let’s take a look at the animal spirits first.

University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis;, January 1, 2017.

 University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis;, January 1, 2017.

As you can see, consumer sentiment has been rising since the dark days of 2009; it now stands at 98.2 — the chart is lagged by a month. Sentiment is now higher than it was in January 2015 (98.1), and the highest since February 2004.

Soptimism-graphmall business confidence is also up post-recession, but it jumped markedly after the election, presumably on the hopes of lower taxes and regulation by the new administration.

And that confidence — plus the 12% gain by the Standard & Poor’s 500 stock index this year — has sparked optimism among investors. The American Association of Individual Investors sentiment survey now stands at 45.6% bullish, vs. its 38.5% historical average. Similarly, just 25.7%  of those surveyed said they were bearish, vs. a historical average of 30.5%. Bullish sentiment is at a five-week high, and its third-highest level of 2016.

At the same time, there’s plenty of money on the sidelines, and some of it appears to be returning to stock funds. In the last week of 2016, investors poured an estimated $118 million into U.S. stock funds. But that’s a piker compared to the previous week, when an estimated $18.6 billion flooded — more than the previous 24 months combined, according to the Investment Company Institute, the funds’ trade group.

As of the end of November, there was $2.7 trillion in money market mutual funds, earning approximately zilch. A roaring stock market provides a great deal of temptation for at least some of that money.  Stock funds had about 3.2% of their assets in cash, which is not particularly high, and that figure’s usefulness has been eclipsed somewhat recently.

Another potential source of cash: Companies in the S&P 500 have a record $1.5 trillion in cash cooling its heels on their balance sheets. They can use this for buying back stocks, paying dividends, or — and this is crazy talk — reinvesting in plants, equipment and their own employees.

The bad news is that the stock market is already expensive. The S&P 500 sells at about 24 times earnings, as opposed to a historical norm of about 17 times earnings. S&P predicts that earnings will rise through 2017, bringing down the PE ratio to about 18. Bear in mind that forecasts are notoriously unreliable, particularly when they’re about the future.

Bear in mind, too, that the Federal Reserve is likely to continue to raise interest rates, and at a faster pace if the economy grows faster than expected.

Right now, it looks like animal spirits and plenty of cash will keep the market party going, and that can be good, clean fun. Enjoy the ride. Just remember that market rallies always last longer than a sober person would think. But remember that many things must go right for the rally to continue. It’s probably a good time to readjust your portfolio back to your original goals. No one ever went broke taking a bit of profits.





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 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.