Reasons to be cheerful

If you’ve accumulated any significant amount in your retirement savings, the worst thing you can do is think about how much fun you could have had with the money you’ve lost in the stock market recently.

For example, let’s say you had $50,000 in your 401(k). We’ll use as our example fund the Vanguard 500 Stock Index fund, which, as of Tuesday, had shed 9.54% since the Standard and Poor’s 500 stock index peaked on May 20, 2015. As of yesterday, $50,000 in that fund has become $45,230, a loss of $4,770.

laborThis is not an insignificant amount of money. You could put together a fun vacation for $4,770. You could have a huge Labor Day cookout and invite half the town. You could buy about a half-ton of fireworks and set them off. Heck, if your money is going to go up in smoke, you may as well get to watch it go up in smoke.

Which brings us to our first reason to be cheerful: You probably didn’t have all your money in the stock market. According to the Investment Company Institute, the funds’ trade group, investors have $16.3 trillion in mutual funds. Of that, $8.7 trillion, or 53%, is in stock funds of all sorts. Had you used the same formula as the average fund investor, you’d be down $2,538 rather than $4,770. You could still have fun with that amount of money — let’s say a big day at the Apple store — but not as much.

Both bonds and cash have made negligible gains. But teeny-tiny gains are always better than honking big losses.

Another reason to be cheerful: If you’re a reasonably sober investor, you probably didn’t have a big chunk of money riding on China A shares, or Brazilian stocks, or emerging markets debt funds, all of which have been clobbered during the recent downturn.

If you do the bulk of your investing in corporate 401(k) savings plans, you’re probably — probably — investing in relatively low-cost institutional funds. Costs always count against you, but they inflict particular pain in a downturn. If the S&P 500 is down 10% and you’re paying 1.25% for fund management, you’ve lost 11.25%. On a $50,000 stock portfolio, that’s $625 a year, which could buy you a movie ticket a week all year.

Finally, if you do have money in cash or bonds, you have some dry powder for when the market does indeed recover. Bear in mind that you’re probably not going to nail the exact bottom of the market, except by accident. If you buy before the correction is over, you’ll probably feel dumb for a few months. Don’t. If you’re a long-term investor, buying high-quality stocks when they’re down is another reason to be cheerful.

Talking trash

Junk-bond funds have many charms, chief of which is their high yields. And lately, those yields have been getting higher, at least compared to ultrasafe Treasury bonds. But this might not be the best time to buy them.

junkyardYou get high yields from junk bonds because the issuers are mini-Argentinas. You’re never quite sure if the next payment is really coming. The extra yield is your compensation for that risk.

And by and large, junk bond funds have held up reasonably well over time. The average junk fund has gained an average 7.3% a year the past five years, vs. 3.8% for the average intermediate-term bond fund, according to Morningstar.

And recently, the spread between junk bonds and Treasuries has been widening, says John Lonski, team managing director of the economics group at Moody’s Analytics. Currently, junk yields an average 4.90 percentage points more than Treasuries, Lonski says, up from a low of 3.22 percentage points last year. “That’s quite a jump,” he says.

A big reason for the gains in junk funds — which Wall Street genteelly calls “high-yield bond funds” — has been because the default rate has slowed dramatically since the 2008 financial crisis. In November 2009, the high-yield default rate was 14.6%, the worst since the Great Depression. It’s 2.01% now.

Unfortunately, the default rate could be headed in the other direction. Moody’s expected default rate for the next 12 months is 3.45%. Should interest rates rise in the next 12 months, it could be a one-two punch for junk bonds. Rising rates makes the bonds less attractive to investors, and rising default rates could push prices down further. “If you’re buying high yield bonds in the context of a worsening default outlook, you’re likely to get badly burned,” Lonski says.

So far, the expected default rate hasn’t risen above 4.5% — which would be a bad thing. “When the expected default rate rises in the face of a mature recovery, it’s not only adverse for high-yield bonds, but stocks as well,” Lonski says. “I begin to smell the end of the recovery.”

The other big default

As you read this, the U.S. stock market is selling off because Greece is teetering closer to default. But life is not good in the municipal bond market today, either. The reason: The governor of Puerto Rico has announced that the U.S. commonwealth cannot pay its debts.

How bad could that be? Pretty bad, actually. The island has about eight times as much municipal debt as Detroit does. Puerto Rico’s muni bonds were wildly popular with investors because their income was free from state and local taxes for residents of every state in the Union. And, because states and commonwealths can’t go bankrupt, investors figured they were safe.

Whoops. “The debt is not payable,” Mr. García Padilla, the island’s governor, told The New York Times. “There is no other option. I would love to have an easier option. This is not politics, this is math.”

puerto ricoYou might be thinking, “But I don’t own any Puerto Rico muni bonds!” But if you own a muni bond fund, it’s fairly likely you do. One of the largest muni bond funds is Oppenheimer Rochester Fund Municipals, a $6 billion fund. It has 27% of its portfolio in Puerto Rico bonds. Franklin Templeton Double Tax-Free fund, a $223 million fund, has 49% of its portfolio in Puerto Rico bonds.

But the biggest shock might come to holders of Oppenheimer Rochester Maryland Municipal fund, which is aimed at Maryland residents. The $60 million fund has Puerto Rico bonds stuffed into it like crabmeat in the Saturday night special on the Eastern shore. To be exact: The fund has 48% of its portfolio in Puerto Rico bonds, according to Morningstar.

The state-specific Oppenheimer Rochester funds seem to have a fondness for Puerto Rico. The Virginia muni fund has 39% of its portfolio in Puerto Rico; the Pennsylvania fund has 35%.

As of Friday, most of the Oppenheimer muni funds were showing modest positive total returns. Because Puerto Rico can’t go bankrupt, it’s likely it will try to negotiate longer payout periods or even partial debt forgiveness from its bondholders. And that, in turn, will push keep its bond prices down for some time to come.

The sky’s the limit in Europe.

The Financial Times’ blog, FTAlphaville, has a recurring feature titled “This is nuts. When’s the crash?” The feature has often focused on Chinese stock valuations, but another favorite subject is European bond yields.

mr-peanut-plantersSeriously, they’re nuts. And that should raise flags for anyone considering a world bond fund.

Bonds are IOUs that make regular interest payments. If you’re an investor, your main interest is getting paid interest when you’re supposed to, and getting your principal back. If you’re very confident about your borrower, you charge them a low interest rate. If you’re worried about getting paid back, you charge a high interest rate.

So it makes some sense that Greek 10-year bonds pay 12.6% annual interest. There may be people who believe that Greece won’t default, but they probably get that information from the radio signals in their teeth.

And it also makes some sense that Germany’s 10-year bond yield is 0.79%. The country has a solid AAA credit rating, and German inflation is lower than the Mariana Trench.

Once we get beyond Greece and Germany, things get odder. Take Italy, for example, which has the world’s third-largest bond market, behind the U.S. and Japan. Italy has a BBB-, which is considered “lower medium grade,” about ten notches below Germany. Italy’s bond yields 2.32%, or 0.03 percentage points lower than the U.S. 10-year Treasury note, which is also a AAA credit.*

Then there’s Spain, which, until recently, was also teetering on the brink of default. It’s 10-year yield is 2.34%, one-one hundredth of a percentage point lower than the U.S. Ireland’s 10-year note. Its credit rating: BBB, one notch above Italy’s, and nine below the U.S.

Bond yields take into account more than credit ratings, such as the outlook for inflation and the country’s national debt. And Spain and Italy have shored up their finances, to some extent. But bear in mind that Spain’s 10-year note touched 8% when the Greek crisis first began, and that Italy’s crested just shy of 8%. While there’s plenty of upside to yields worldwide, the sky’s the limit in Europe.

And that’s a problem if you own international bonds, because bond prices fall when interest rates rise. If your fund owns German bonds, a 0.79% yield isn’t going to cushion you from much pain. Making matters worse: If the dollar rises in value, you’ll lose on the currency translation, too. Currently, world bond funds are down an average 2.11% this year, according to Morningstar. Things are likely to get worse before they get much better.

* Ok, S&P gives us an AA+ rating. But Fitch and Moody’s go with AAA.

Bond funds of doom

chihuaThe Treasury bond market has sold off sharply in recent weeks,  which means that bond investors must be huddled under bridges, trying to piece together the shattered pieces of their lives.

No?

The average intermediate-term government bond fund has fallen 0.18% this year, and 1.02% this past month, including reinvested interest. Most bond investors are probably not waking up and shouting “I’m ruined!”

Nevertheless, it’s alarming for investors, who have plunked down nearly $57 billion into bond funds this year, according to the Investment Company Institute, the funds’ trade group. Anyone who owned bonds during the financial meltdown — government bonds, that is — was glad to have them.

But the 10-year T-note yield has fallen from 15.84% in September 1981, making it one of the longest bull markets in history. Bond bear markets, unlike those in stocks, tend to be incremental, slow-motion disasters — a bit like being mauled by old, fat chihuahuas.

The bellwether 10-year Treasury note now yields 2.49%, up from 1.67% in February. The average 10-year T-note yield since 1962 — which is far as the data on Yahoo Finance goes — has been 6.43%. The median — half higher, half lower — is 6.11%. Either way, yields have a long way to go before they reach a relatively normal yield. And if history is any guide, markets typically overshoot on the way up and the way down.

A while ago, I suggested a no-bond portfolio for those worried about rising interest rates. Basically, you’d substitute money funds for bond funds in your portfolio. After all, the Fed is likely to raise short-term interest rates, which, in turn, could push bond yields higher as well. While the bond market could certainly settle down, it’s hard to argue that yields will stay this low for a long period of time.

Image courtesy of Angry Chihuahua meme generator. Somehow, I don’t think this one will go viral. 

Death to U.S. stock funds!

A billion here, a billion there, pretty soon you’re talking real money. — Misattributed to Senator Everett Dirksen

“Oh, I never said that. A newspaper fella misquoted me once, and I thought it sounded so good that I never bothered to deny it.”Senator Everett Dirksen.

The Investment Company Institute is the trade group for the $16.8 trillion mutual fund industry. Each week, it puts out an estimate of how much money has flowed into (or out of) mutual funds. If you’re looking for evidence of a stock mania, you won’t find it here.

Angry villagers with pitchforks.
Angry villagers with pitchforks.

Last week, for example, investors withdrew $223 million more from stock funds than they put in. The past 12 months, they have withdrawn a net $12.2 billion, according to ICI estimates.

The figures are even more stark if you look at the flows for U.S. stock funds. Investors have yanked $113.2 billion from U.S. stock funds since May 31, 2013. During the same period, they have put $21 billion into hybrid funds, which invest in a mix of stocks and bonds, as well as $57.4 billion into bond funds.

These are outflows from traditional, garden-variety stock funds. Some of that money has flowed to exchange-traded funds, although it’s difficult to tease out the exact amount from ICI stats. Nevertheless, it’s safe to say that flows are nowhere near the pace set in 2000, when investors poured more than $26 billion a month into stock funds.

What’s most surprising, however, is U.S. investors’ appetite for foreign stocks. While they have been yanking money out of domestic stock funds, international funds have been the happy recipients of nearly $101 billion of fresh new cash. Part of this may be because most investors use financial advisers, who typically recommend a 20% stake in foreign stocks. U.S. investors have about 25% of their assets in international stocks now, up from 8% in 2000.

How has that all worked out. Sadly and predictably, not too well. The average large-company blend fund has gained about 8.2% the past 12 months, says Morningstar. The average large-company blend foreign fund? It’s lost about 1.4%.

And it’s not because foreign stocks have fared so poorly, although they have been unusually volatile. (We’re looking at you, Greece.) German’s stock market is up 10.4% the past 12 months, and Japan’s market has soared 35%, according to MSCI, which tracks world markets. But that’s in local currency. Translated into U.S. dollars, that’s a 9.9% loss for Germany, and a 13.4% gain for Japan. Unfortunately, many U.S. international funds are underweight Japan, because that’s been a safe bet for nearly a quarter of a century.

Despite how stretched valuations are in the U.S. stock market — and they are stretched — it’s hard to argue that individual investors are getting caught up in stock mania, at least from flows to U.S. stock funds. In fact, it’s easier to argue that investors are still exceptionally wary of U.S. stocks, and that the scars from the last two bear markets are taking a very long time to heal.

The Amish portfolio

One of the biggest arguments I hear for having a professionally managed account runs like this:

“Hey, it’s a big, complex world. You have so many investment choices: Emerging markets bond funds! Long/short funds! Bank loan funds!You need me to tell you what to invest in, because only I can figure out the right proportion of all these funds for you.”

What’s not usually mentioned, of course, is that much of this complexity is an invention of the financial services industry. No one ever went broke because they didn’t have 2.3% of their portfolio in a long/short fund. Did you miss the runup in REITs last year? Most managers did, too.

An Amish buggy in Lancaster, Pa.
An Amish buggy in Lancaster, Pa.

There are plenty of good reasons to hire professional financial help, but this big old complex world really isn’t one of them. In fact, there’s virtue in Amish-like simplicity. You can construct a low-cost, extremely diversified portfolio with three funds.

We’ll use Vanguard funds because they’re cheap. You could probably construct a similar portfolio with offerings from other companies, although you might not be able to match on cost. The portfolio:

* 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: 54.1% North America, 22.1% Europe, 14.2% Pacific, and 9.4% emerging markets. Cost for the investor shares: 0.27% a year, or $2.70 per $1,000 invested.

* Vanguard Total Bond Index fund (VBMFX). You get broad exposure most types of U.S. bonds. Current yield: 1.9%. Cost: 0.20%, or $2.00 per $1,000.

* Vanguard Prime Money Market. Hey, it’s a money fund. It yields 0.02% after its 0.2% expenses.

That’s it. A conservative mix would be 60% Total World Stock, 20% Prime Money Market and 20% Total Bond Index. You can adjust your stock portion up or down, depending on your risk tolerance. Rebalance whenever the stock portion is 10 percentage points higher or lower than your target.

If you want to add other funds to this basic portfolio, go right ahead. But as any Amish person would tell you, the more you tinker with it, more likely it is to be a little buggy.