Late Innings

TV commentators have been buzzing recently about what possible “inning” of the economic cycle the US is in.  The baseball analogy is an understandable way to frame the discussion and slightly more tangible than the question, “how long until things are bad again?”  The economy and the stock market go through cycles.  Good times don’t last forever, nor do bad times.

An important distinction needs to be made right up front.  The economy and the stock market are not the same thing.  Economic headlines remain encouraging: low unemployment, strong economic activity, and relatively strong consumer spending.  However, those numbers each measure the past.  Investors are forward-looking.  What are next year’s earnings projected to be?  How much more will the Fed raise interest rates?  What will consumer spending be next year?  Will housing starts slow more than expected?

For this reason, stock markets tend to go south much earlier than the actual economic data would suggest, and likewise, tend to go up well before the economy when coming out of a recession.  While I continue to believe that the next recession is 12-18 months away, the next bear market may be much closer.  Rather than lay out the litany of reasons why we feel that we are in the late innings (which I’ll be glad to address individually), I’d like to highlight some steps to take in case I’m correct in my hypothesis.

October’s performance offered a concerning reminder of how quickly markets can change.  After ending September with a nice gain, the S&P500 fell 6.84% in October, essentially giving back nearly all its gains on the year.  But let’s keep things in perspective.  Since 2009, the S&P 500 has rallied from 666 in March of 2009 to 2940 in September of 2018.  A rise of more than 340%.  A pullback of nearly 7% is hardly much to be concerned with, yet. 

In hindsight, the most beneficial asset allocation over the last decade was pretty straightforward: 100% US stocks.  Diversification into international stocks, bonds, precious metals, and other commodities offered no tangible improvement in total performance, and in most cases offered a substantial drag.  It’s easy to abandon the idea of diversification when one asset class has done so much better than the others, but I suspect the next decade will look considerably different than the last.  Keep in mind, from March 1999 to March 2009, an asset allocation of 100% S&P500 would have produced a total return of a whopping -26%.  (Source: Thomson One) 

Even this year, it’s hard to get excited about other asset classes.  In fact, this year may be the first since 1971 (when gold prices floated freely) that stocks, bonds, and gold have all fallen in value in a calendar year.  While many issues abound for international stocks, and interest rate hikes temper our excitement over bonds and gold, we maintain that the best investment strategy over the coming years will be an allocation that encompasses each.  Despite the unique circumstances this year, bonds and gold still offer uncorrelated returns.  One of the key ingredients to managing risk is uncorrelated assets that provide diversification in bad times. 

Health and Wealth

This month’s blog was written by our Director of Strategic Growth, Kent Oliver.  A Mississippi native, Kent graduated from the University of Georgia with a Bachelor of Business Administration in Marketing. He joined the Raanes team in February of 2018 after nearly 15 years of sales and marketing experience within two large corporations.

Recently one of my daughters was going through rhyming words in her Kindergarten class and she mentioned to me that health and wealth are nearly the same.  While she wasn’t aware in saying it, these two concepts share far more similarities than a few letters and sounds.  According to a June study from the Nationwide Retirement Institute, approximately 73% of older adults mention out-of-control healthcare costs as a top fear in retirement.  That same study indicates 64% are “terrified” of the impact health costs may have on retirement.  Yet only 48% of older adults with financial advisors have discussed health care costs as part of their plan. 

 Healthview Services’ 2017 report on healthcare costs projects healthcare spending for retirees is expected to increase an average of 5.47% for the foreseeable future, far outpacing the expected rate of inflation.  What does this mean for you as you contemplate retirement?  That same report indicates that a healthy couple retiring now at age 65 can expect to pay as much as $400,000 in healthcare expenses in retirement, taking into account premiums, deductibles, co-pays, vision, hearing, and dental costs. 

We all know that staying healthy is important, but often times it’s an overlooked aspect of our financial plan.  For the past several years a joint venture known as HealthyCapital has been incorporating statistics from Mercy Health System to produce a variety of studies aimed at exposing the impact health-related behaviors can have on retirement.  They call it the “Health Management Retirement Funding Index.”  Specifically, it looks at chronic conditions that are modifiable… conditions such as high blood pressure, high cholesterol, type 2 diabetes, obesity and smoking. 

Using an abundance of data their calculations show us what can be saved by following a physician’s orders.  For example, they note that a 45-year-old woman with type 2 diabetes could save an average of over $3300 per year in pre-retirement out-of-pocket healthcare costs just by following even basic recommendations from her physician, including things such as taking prescribed medications or limiting salt intake.  Reinvested in a 401(k) plan with modest growth rates of 6% she could increase her retirement savings by more than $100,000 and increase life expectancy by as many as 8 years!*

In addition, ample resources are available through financial advisors to limit risks associated with healthcare costs both prior to and in retirement.  From long-term care considerations to consultative solutions around Medicare planning, these resources can go a long way to preparing you for your healthcare needs in the future.

Needless to say, health and wealth have more in common than you may initially think.  Consider making health part of your next financial planning discussion.  Doctor’s orders. 

*This is a hypothetical illustration and is not intended to reflect the actual performance of any particular security.Future performance cannot be guaranteed and investment yields will fluctuate with market conditions.

Pension Problems

Nearly 28,000 employees currently work for the state of Mississippi.  For each employee hired, the state makes a promise to pay that employee a pension at retirement as long as the terms of employment are met.  The program is known as the Public Employee Retirement System, or PERS for short.  Mississippi isn’t unique; other states and corporations make similar promises.  

What is the cost of that liability to the employer? 

Jeremy Gold, an economist and one of the first actuaries on Wall Street, spent most of his life trying to answer that question.  He joined Morgan Stanley in the 1980s and became obsessed with the questionable math being used to value pension promises. Gold felt that modern pension accounting was miscalculating the true cost of pension liabilities, so he returned to school to learn more.  Gold enrolled at Wharton School of Business, obtained a PhD in 2000, and became an outspoken critic of pension liability accounting.

Eventually Gold’s crusade gained traction and found support from Moody’s Investors Services, a well-known Wall Street rating agency.  Moody's altered their own method of pension calculation in 2013 in light of Gold's findings, giving us a better picture of the situation today.

So, why does any of this matter? 

It appears that Gold may have been correct in sounding the alarm.  The gap between ‘money needed’ and ‘money in the bank’ has grown considerably in recent years for many states and municipalities.  CNN Money and Pew Research reported that the overall shortfall in state budgets is currently $1.4 trillion. 

Let’s use Mississippi as an example.  To be 100% funded, the state of Mississippi would reportedly need current assets of $42.5 billion growing at 7.8% annually to meet its pension liabilities.  However, the state’s pension fund has only $24.5 billion, a short fall of roughly $18 billion.  In other words, Mississippi only has 58% of the money it actually needs to meet the state’s pension promises.  By the way, they rank 38th compared to other states according to Pew Research.  The national average is 66%.

A more alarming consideration:  the gap between what pensions need and what they actually have has widened in recent years DESPITE the great stock market performance over the past 10 years.  In 2015-2016 (the most recent data) the funding shortfall reportedly increased by nearly $300 billion.  To be fair, low interest are the main culprit for the widening gap as they factor mightily into the calculation of ‘money needed’. 

Current employees nearing retirement likely need not be concerned with the short fall.  The situation is concerning, but it is, in essence, a math problem.  Still, a solution will need to be reached sooner rather than later for new hires to enjoy the full promise of a pension.  Taxes will likely need to increase and/or future promises may be muted. 

Jeremy Gold passed away last month from leukemia at age 75.  Forbes and the Wall Street Journal were among the many publications that ran a story about his life.   Gold’s lasting impact is two-fold, he raised awareness that: (1) changes need to be made to pension funds, and (2)  retirees need to have a backup plan beyond the promise of a pension.  Investors can still create a “pension” like income stream with other investment vehicles, but formal pensions are slowly become a smaller element in retirement planning. 

The most important takeaway from this information should be the increased importance of external savings.  For our younger clients, don’t dismiss the importance of IRA contributions rather than relying on the promise of a pension.  

Summer Reading

This month’s blog was written by our Director of Client Relations, Jim Grenn.  Jim is a Hattiesburg native, Golden Eagle, and your point of reference for any question you may have about Raanes Capital Advisors or your portfolio with us.

            At 15 years old, I was told I needed my entire large intestine removed to help alleviate complications from an autoimmune disorder with which I was diagnosed at age 12 as well as to avoid it turning into cancer at a young age.  Now in my mid-twenties, I’m thankful for having made that choice to go ahead with the surgery because first and foremost, it taught me this life we live is indescribably beautiful, and that the joy we find often results from a trial through which we’ve been.  But also during my time of recovery from several surgeries, I was given the opportunity to fine tune an area of my life that most 15 year-olds simply were not doing or even thinking of doing – becoming financially literate.

            I spent weeks on end resting at my home following surgeries.  My life beforehand had been mostly filled with track meets, football games, and basketball tournaments.  With that being stripped away from me for nearly the rest of my high school days, to be honest, I got pretty down and depressed.  My father could see that in me too.  Being a successful businessman in real estate and an overall knowledgeable individual, he decided to share some books with me on personal finance as well as investing, and how to live your life well by stewarding your finances well.  As I began to recover and get out more, my dad and I would practice ideas and concepts I learned from reading.

            On Saturday mornings, we would get up and go to estate sales.  We were never the first to show up trying to get the chest-of-drawers at a bargain, but rather to find something of unique value to different individuals.  It gave me the opportunity to learn how to negotiate deals.  One morning in particular, I found a red, diecast Volkswagen Bug - about the size of a good slingshot rock.  I negotiated the owner from a dollar down to a quarter, put it on craigslist and within a couple of days had a buyer.  We met in the Stein Mart parking lot, and he traded me 20 quarters for my little toy – my first arbitrage.  I traded 1 quarter for 20.  I thought I was brilliant. 

As I continued to practice these concepts as well as getting into more sophisticated investing, I found that my 20:1 profit may never happen again – especially not in two days.  More importantly since then, I’ve learned that the bad deals I’ve made have been the most rewarding in terms of my financial intelligence – an idea that seems so opposite to how to become successful.  In his book Rich Dad Poor Dad, Robert Kiyosaki explains this well.  “In school we learn that mistakes are bad, and we are punished for making them.  Yet, if you look at the way humans are designed to learn, we learn by making mistakes.”  In our society and school systems, financial literacy is not held as high as it probably should be, and I am concerned about our future generations’ outlook on finances as a whole.

With the summer coming to an end and schools getting back into the swing of things, I encourage you to reach out to a young individual in your life, maybe your own child or grandchild.  A financial education in addition to the education they’re receiving now will pay dividends for years to come. Encourage them to learn from the mistakes they make and to appreciate their successes.  It may even impact the direction of their career choices just as my own father’s teaching did for me. 

Email jgrenn@rjrca.com for any financial book recommendations for you or for our next generation, or drop by the office any time!

Halftime 2018

As the first half of 2018 comes to a close I’d like to recap performance (or lack thereof) and give a few thoughts for the second half.

Markets has been interesting thus far.  The S&P500 began the year by rallying 7% to start the year then promptly falling 11% over the next 2 weeks.  Since then it’s been a maddening back and forth with 5% rallies and 5% drops.  At the moment, The S&P500 is up on the year, but only slightly (+1.7% as of 6/28). 

Bond prices have struggled with interest rate hikes.  The average bond holder is down slightly on the year (-1.5%)*, as are international stocks (-4.5%)**, Emerging Market Stocks (-8.5%)***, and gold (-3.4%)****.

What does the second half of the year hold for investors?  I’m afraid it looks like more of the same maddening swings.  We maintain the belief that we are in the late innings of the bull market which may continue longer than it logically should.  In full disclosure, I felt like we were in the late innings in 2016 as well, but tax reform provided a nice lift that we didn’t expect.  Nevertheless, we are likely much closer to the end of the bull market than the beginning.  

The case for the bull market (gains) to continue:

Earnings must continue to surprise on the up-side and investors have to maintain confidence that a recession is years in the future.  2016 and 2017 saw investors bid prices higher in hopes of increased earnings from the tax-reform.  We are now starting to see the earnings come through – and thus far they haven’t disappointed, but investors are now in search of the next catalyst.

Case for a bear market (losses) to takeover:

Trade war concerns still loom large and could escalate.  Increased tariffs are likely to weigh on stocks.  Futhermore, interest-rate hikes are increasing yields on ‘safe money’ investments like CDs and saving accounts, which is likely to remove some incentive for investors to chase returns in the stock market.  In the end, higher rates will likely remove some of the desire for investors to continue to pay premium prices on stocks.

On a different note, most of the performance in the overall market over the last 2 years has been driven by the technology sector.  Valuations look very rich for many names and should come back to earth at some point which could drive markets lower.

Of course, the wild card risks such as terrorism, political upheaval, and Twitter rants remain, but generally don’t cause long-term disruption to markets.  From a technical standpoint it’s concerning that the market bounces lower each time it gets back near the January highpoint, which leads us to believe that the January high may stick as the high point for the year.  Time will tell.  At any rate, we continue to scale back on risk and exercise caution.

*Bloomberg Barclays US Aggregate Bond TR USD

** MSCI ACWI Ex USA

***MSCI Emerging Markets

****SPDR® Gold Shares

 

Student Loan Concerns

As a kid, the last day of school was always exciting!  It meant the beginning of summer, which afforded the ability to swim, sleep late, and stay up even later.  My friends and I would rotate spending the night at each other’s house.  Video game tournaments would last until the wee hours of the mornings before someone would eventually get mad and throw the controller.

As an adult, the end of the school year brings slightly different feelings.  On the surface, it means having to find activities to entertain kids for 8 weeks.  More importantly, it means being one year closer to car purchases and college expenses!

The sobering truth is that college costs have risen three times faster than inflation over the last twenty years.  Unfortunately, the use of student loans is now the most common way to pay for college.  Last year, seventy percent of college grads carried a student loan balance at graduation.  The average was $37,000.  About 6% of college grads owed more than $100,000.  That’s a difficult starting point on your first day in the working world. 

On the economic front, student loans have risen at such a dramatic pace that many economists are concerned about the long-term impact on the economy.  Student loan debt totals more than $1.4 trillion, the second highest category of debt in the country behind home loans. 

Who owns all those loans?  The largest loan holder is the federal government.  Federally-owned student loan debt totals nearly 6% of the total economy, up from 0.8% a decade earlier.  The 90-day delinquency rate on those loans is over 11% according to the New York Fed.

For comparison, the delinquency rate on mortgage loans at the peak of the 2008/2009 financial crisis was 11.5% according to the Federal Reserve.   Currently, the mortgage delinquency rate is about 3.5%.

With that said, the student loan issue is relatively unlikely to lead to a crisis like we saw in the mortgage market a decade ago.  The most likely outcome is that high student loan debt becomes a drag on spending and hampers economic growth as interest rates move higher. 

More importantly, as parents or grandparents or other family members, we can begin planning now for the future education of our loved ones.  There are various tools available to plan and save for future college costs and other expenses, such as cars.  Pre-paid college tuition plans are available in most states, as well as 529 College Savings Plans.  Even Roth IRAs offer educational flexibility.  Custodial accounts (UTMA / UGMA) also provide an avenue for family members to save money for more flexible expenditures that aren’t necessarily college related.

If you are interested in learning more about strategies to save money for the next generation please contact us to discuss your specific concerns. 

 

Source: CNBC, Wall Street Journal

Can Interest Rates Predict Stock Market Performance?

Much talk has been made recently about rising interest rates.  One of the most followed gauges of interest rates is the rate paid when the US government borrows money.  This information is regularly available and acts as a proxy for interest rates in the economy.  The government routinely borrows money at differing time intervals, e.g., 2 years, 5 years, 10 years, 30 years, etc.

Depending on the marketplace, each time interval likely has a different interest rate.  Interesting, these interest rates have historically been a signal to stock investors as well as bond investors.  Allow me to clarify:

As of 4/26/18, the 2-year Treasury Bond interest rate was 2.48%

As of 4/26/18, the 10-year Treasury Bond interest rate was 2.95%.

Therefore, the government is paying an extra 0.47% to borrow money for 10 years rather than for 2 years.

Three years ago, the difference between those two yields was 1.50%.

So what?

Well… the difference in bond yields may act as a pretty solid indicator of future returns in the stock market.  If there is only a small difference between the two (less than 1%) it generally implies we are in the later stage of the economic cycle, and future stock market returns may be muted.  Take a look at the following numbers for the S&P 500 since June, 1976, (the earliest data set I could readily find). 

 
yield spread analysis.png.jpg
 

Ideally, investors like to see steeply sloping yield curves with a big difference between short term and longer term rates.  The implications of interest rates today suggest once again that the upward trend in the stock market over the last 10 years may be running out of steam.  Returns may be muted over the coming year, and the odds of a negative outcome may increase.  Investors may be wise to look for returns in more defensive areas of the investment world and scale back on their stock exposure.

Tariffs

The last month has been filled with headlines of new tariffs being imposed from one country to another.  It began with the US imposing a new tariff to protect the American steel industry and soon shifted to tariffs on China.  Threats of retaliation came quickly from other countries, the consequences of which are unknowable, but the end result is extremely likely: inefficiencies will arise and consumers around the world will pay a higher price for a variety of products.  We’ve seen this before.  Let’s examine.

Smoot - Hawley Tariffs

US farmers were struggling to make money in the late 1920s.  Rather than focusing on oversupply, imports were blamed for the falling prices.  Senator Reed Smoot and Representative Willis Hawley had a plan to help.  They proposed an additional tax on imported crops and produce from overseas to help protect the US farming industry, known as the Smoot-Hawley Act.  This tariff would push prices higher and protect the American farming industry.

In order to win support for the bill, Smoot and Hawley compromised with the requests of more and more congressmen as each lobbied to protect industries in their hometowns. 

“Why just protect farmers, when we can protect other industries?” the congressmen argued.  By the time the bill made its way through Congress, the total number of proposed tariffs had grown to 890, impacting more than 20,000 imported goods.     

Canada responded to the new tariffs by imposing a collection of harsh tariffs on American imports.  Europe followed suit as well, and soon the Smooth Hawley tariffs escalated into a full-blown trade war.  Global trade of goods and services fell nearly 66% in the five years following the enactment of the tariff in late 1929, coinciding with the depths of the Great Depression.

Tariffs didn’t disappear completely after the failure of the Smoot-Hawley, but the push for protectionism slowed tremendously as tariffs decreased around the world following the passage of the Reciprocal Trade Agreement in 1934 by President Roosevelt, which was aimed at reducing tariffs and barriers to trade.

Playing Chicken

One of the more fascinating tariffs that remained was the tax imposed by European countries on imported chicken from the United States.   Shortly after World War II, advancements in the chicken farming industry in the US increased supply tremendously, transforming the food from a delicacy to a low-cost dining option.  European chicken farmers had a hard time competing at the lower prices as the cost of poultry plummeted. 

France was the first European country to impose a tariff on imported chicken in 1961, but other European countries soon followed suit to protect their own chicken producers.  The US responded with tariffs on imported European goods like brandy, and ‘light’ trucks. The brandy tax was a direct shot at France, while the ‘light’ truck tax was aimed directly at Germany.  Volkswagen’s truck sales plummeted in the United States, and the additional hike in prices for French brandy caused Americans to look elsewhere for their nightly toddy.

To this day, the chicken tax on American imported chicken remains in effect.  While most of the tariffs imposed in response to the chicken tax have disappeared, the tariff on ‘light’ trucks and delivery vans also remains.  Ironically, this has also created complicated production issues for many of the US automakers. 

As globalization took hold in the 1990s, it became advantageous for US automobile companies to take advantage of cheap labor abroad.  Ford, for example, found a booming business for pickup trucks in Thailand, where they opened a factory in the mid-1990s.  The factory in Thailand specializes in smaller vehicles, such as lightweight pickup trucks and delivery vans.  Ford, however, can’t import delivery vans into the US from their Thai factory without incurring the 25% tariff still in effect from the 1960s.  In order to circumvent it, Ford reportedly imports passenger vans equipped with seats and seatbelts, then converts them into delivery vans by removing the seats and seatbelts and opening up the cargo hull. 

The end result is that American consumers still pay a premium for delivery vans because of a tariff on chicken imports to Europe imposed in the 1960s. 

Needless to say, tariffs have historically created inefficiencies that distort free markets and raise prices for consumers.  Unfortunately, these tariffs will likely do the same.

 

Sources:

Fred McMahon.  History is clear—high tariffs and trade wars devastate countries.  October 3, 2016. Fraser Forum Fraser Institute.

If You Aren't Worried About A Trade War, You Don't Know About The Chicken Tax.  Mar 3, 2018.  Bryce Hoffman. Forbes Magazine.

To Outfox the Chicken Tax, Ford Strips Its Own Vans. By Matthew Dolan. Updated Sept. 23, 2009 12:01 a.m. ET