The Sidewinder

The Sidewinder

What a confusing time. Thousands of headlines over six, yes SIX years. From Bernie Madoff to a 2013 blockbuster stock year we have had most if not all we could ask for. Throw in a war or two, some pension disasters, a few tax increases, and a government that has indicated by its financial behavior that it is fairly confused and you get, well, us. Whew! I need a breather, but not now. Let’s bring some CLARITY to the picture.

If you have been invested since year end 2007, and you measure the stock market by the Dow Jones Industrial Average (Dow), you are barely above zero after inflation. The Dow has been roughly trading sideways with a huge helping of volatility. This is calculated using the Bureau of Labor Statistics (BLS) own Consumer Price Index (CPI) calculator. It shows a TOTAL gain of 1¾% over the entire period, or 0.232% annualized and compounded.

Volatility has been beyond high. Measuring the intra year high to low is a “peak to trough range”.  Here, I use the S&P 500 for some comparison. The yearly ranges are:

2008: 49%,  2009: 51%,  2010: 29%,  2011: 19%,  2012: 23%,  2013: 36%

Average: 35%

Is it any wonder investors were a bit on edge? The volatility hit and just kept coming. Hence the inflows into bonds to offset the volatility increased dramatically. Bonds have price movement, too, to be fair. Volatility is typically much lower, and they pay interest along the way. They have been a nice diversifier in a very uncertain world.

Let’s review some numbers using the Dow Jones 30 Industrials including dividends as our stock measurement, and the bond index proxy of the Barclays US Aggregate bond index. You already know that the value of a dollar is fleeting. Inflation reduces it. So, I will also factor this in.

This graph shows the S&P Composite from the Schiller Fact Set. It has been a long, hard grind for stock investors, the WOW factor of last year notwithstanding.

      

                          Source: Schiller Fact Set

Taking away 2013 returns actually puts stock investors slightly behind 2007 after adjusting for inflation five years later! Even with this, my opinion is that going forward the positive outweighs the negative.

 

My Opinion on the Future

In my opinion, the investment markets generally rest on these legs:

Inflation: Fed would like to see some inflation. This would help it believe we have less chance of deflation, a worse plight. Their forward guidance suggests slightly rising interest rates in 2015. Labor earnings have started to increase. Average hourly earnings growth is up 2.5% over 2013 (Bureau of Labor Statistics). Fed likes this. It generally portends inflation and some inflation shows an improving economy.  I rate this positive.

Jobs: Joblessness reports are better…kind of. Neither I nor Fed is convinced. Looking harder at the numbers suggests that unemployment (U3) is down, but there are actually fewer hours worked per employee. One estimate from Edward Lazear, (Chairman of the President’s council of Economic Advisors 2006-9) suggests that we are the equivalent of down about 100,000 jobs from last September. U3 will never capture this statistic. I rate this negative.

Earnings: Record US earnings have been had for several quarters (S&P). Compared to 2007 earnings are slightly ahead after inflation. This is good news, especially their consistency.  Profit margin is great. Average S&P 500 margin is 21.5% (S&P). Corporate cash remains about 30% of current assets (S&P). This cash should eventually be better used in productive endeavors as management gains more confidence. I rate this positive.

Overseas earnings are more volatile and less predictable than those in the US. Parts of the world, including Europe are emerging from their financial depths. This leads to opportunities. I rate this positive.

Growth: US GDP growth is about 2.6% year over year. This is significantly below typical recovery growth. Its composition shows lower than average consumer spending and business investment. It is, however, positive. That’s a start. 2014 should have less drag. Consumption is increasing. Corporate capacity utilization is up very slightly from last year to 79.2% (Fed). We actually have a budget for the remainder of the year. Congress is overspending its pocketbook, but at least we now know by how much. Household net worth has actually peaked over that of 2007 even after inflation is factored in (BEA, Fed). Debt service as a percent of after tax income has fallen from 13.5% to 10% (BEA, Fed). I rate this positive.

I think slow growth while climbing the wall of worry is the order of the day. There is no question that there are several parts of our economy remaining hobbled. Regulation is stifling growth and rightfully causing management caution in business investing. Our medical delivery system has been largely changed via federal government authority.  Overall federal taxes have increased and we expect state taxes will, too. Public pensions have been grossly mismanaged and are a formidable expense. We are definitely not operating on all 8 cylinders. But, we are operating better than much of the remainder of the world. My experience tells me that value is relative, and we are relatively more valuable than our competition around the world, but there is value elsewhere, too.

It is time to talk. It is time to act.

Chris

Securities offered through LPL Financial, member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The opinions expressed in this material do not necessarily reflect the views of LPL Financial

“When You Come to the Fork in the Road, Take It!” Yogi Berra

                                                  The Scrambler at the MN State Fair

Trying Times, If You Like to Take Risks

I am told there are times that try men’s souls. I think they’re right. I also think that Ben Bernanke and Janet Yellen would heartily agree. I did a manual review of the volatility they and we have endured over the last couple of years. Through simple observation we have had these ten S&P 500 roller coaster rides in 2012-2013 and the average number of days it took them to happen:

The long, hard grinds up and the shorter, abrupt bungee jumps off the cliff make for enough volatility for a lifetime when we add the 2008-2010 circus. Can you imagine being on the Federal Reserve Board during this debacle?

Punching Bag

Fed likely has the finest information flow on the planet about most everything economic. It has scores of brilliant people to sift through all of it. Even with this advantage, its forward guidance has lacked accuracy. I won’t quite say Fed has been bewildered, but you get the idea. It truly has not been easy. We add the extra volatility knowing approximately 75% of all trades on the major market US Markets are by computer algorithms receiving information and making millions of trades in an instant, you have the ingredients for a short term nightmare. The short term, and I mean really short, dominates daily market activity while most individuals are investing for the long term. In the meantime, Fed continually takes the brunt of thousands of second guessers. Tough position. It continues its course, I think, because it knows its role is crucial to US economic survival in the same way we as investors know our roles are crucial to our financial survivals.

Understanding of the investor’s role in the market can be appreciated reading people like John Templeton, Ben Graham, Warren Buffet, and Bill Gross; all of whom have taken their share of punches, but did exceedingly well. They spent their lives trying to make sense of the markets. They each mention a large amount of luck, good or bad that influences everyone’s short term. Last year it was good. This year could be good or bad. Over the long term, however, logic is more likely to be in your favor. They may be able to determine what a stock should be worth, but they cannot tell you when it will be worth it. Future retirees are in the same boat in that they know they want to Be Done, but there is no longer a company run pension to take them there. I think this is especially appropriate to discuss now. We have had some relief from the debacle that essentially derailed finances in this country for the last six years. There may be a price to pay for the way we did it or it may turn out to be a stroke of genius. No one knows. What we know is that the country must review its current circumstances, make decisions, and move forward.

A Design for the Future

I have never heard of anyone willing to base his retirement on someone else’s whim. “If I win the lottery, if I get that inheritance, if I win Dancing with the Stars I will retire.”  Leaving it to chance just does not make sense. Instead, you purpose to make thoughtful estimates of what it will take to achieve your goal no matter what the Fed, politicians, or anyone else says or does along the way. This is called design. In the nowadays world of personal pensions, this is really, really important to focus on. It is also important to understand that unlike the pensions of the olden days, if you make a big mistake, no one will be there to write a check to shore it up.  A flaw in the design means it just does not work. We do not want that.

The Drill

Over the last thirty plus years of doing this and successfully retiring many, many people I have discovered several truths about successfully Being Done. Over the next few posts, we are going to drill down into what it takes to design and carry out your own pension successfully.

In the meantime, please feel free to contact us at (952)230-1340 to chat about this or any other thoughts or concerns.

Warm Regards,

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this commentary may not develop as predicted. Stock investing involves risk including loss of principal. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. The S&P 500 is an unmanaged index which cannot be invested into directly.  Unmanaged index returns do not reflect fees, expenses, or sales charges.  Index performance is not indicative of the performance of any investment.  Past performance is no guarantee of future results.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The LPL Financial registered representatives associated with
this page may only discuss and/or transact business with residents of the following states:  MN, TX, IA, WI, VA, NM, CO, AZ.

Let's Get Real!

In what does America have confidence right now? The stock market? Congress? The Judicial branch? The Executive branch? Corporate profits? The Federal Reserve System ?

Everyone of these has a massive impact on our economic system. For example, recall the stock market sell off in May. Our market was down just under 6% within 48 hours when Chairman Bernanke announced that things were looking up and they provided guidance on when they would begin to close down their asset purchase programs and let interest rates rise. He essentially undid his guidance. Never mind. 

Instead, they are more cautious. Their NEW guidance arrived last week indicating they have lowered their growth forecast by about 12% for 2013 and anywhere in a range of 3%-11% in 2014. Providing guidance has consequences. The more important lesson of this is that while there is little question we are in an economic recovery is not without larger than average bumps in the road. All recoveries are characterized as “climbing a wall of worry”. This one, however, is exceptional.

The Fed has helped MAKE the present economy what it is by artificially lowering interest rates. This has helped us ease through our current credit depression. The Fed is feeling its way through it. There are varying opinions among Fed governors on how to proceed. What once seemed to be a collective , unified body now openly discusses future uncertainty.  Our country has only been through a couple of these in its history, and they did not turn out well. The Fed really wants this to turn out well. It is using all of the tools at its disposal. They have had success. This one has been far easier, but at a price. The price has been credit uncertainty for our overall system. The Fed offered up its good name in exchange for money it didn't have to purchase government bonds. It likely paid prices higher than would have been paid in the open market. As a result, its balance sheet has now expanded by about $3.5 trillion. This is not a small sum for the Fed. Eventually, they will need to begin selling these assets to recoup their money and pay down their very real debt. Rational market players are apprehensive about to whom these will be sold and at what price. When prices decline, yields go up. Hence, interest rates rise. This can be counterproductive to a recovery. It can impact lives. There is much at stake here. 

As a society, we need to act as if we understand this. I fear much of the country does not.  Part of the population wants to spend and run up debt like it always has.  Part of the country wants to live within a budget that will cause hardship.  All of the country wants the problem to go away so it can get on with life.

You and I must make smart choices.  We have four primary choices when we invest: stocks, bonds, cash, alternative investments.  Next week will go through what makes sense for now and why.

Please feel free to contact us at 952-230-1340.

Chris

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bonds and bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

Stock investing involves risk including loss of principal.

Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.


Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.


The LPL Financial registered representatives associated with
this page may only discuss and/or transact business with residents of the following states:  MN, TX, IA, WI, VA, NM, CO, AZ.

Wristwatches and Hurricanes

Against the overall backdrop of an economic recovery, along with a series of unusual conditions

that I described in our last issue of FinancialMuscle.com, I believe these are on the short list of

issues of which to remain aware when building a sound financial strategy. Each has a large

component of government intervention and each is very large. The goal here is not

recommending a strategy. Instead, it is educating on issues that are real and should have weight

in any personal financial strategy.

Japan: Japan has suffered since the 1990s what we are suffering now. They haven’t been able to

cease propping up banks and real estate developers, even now over 20 years later. According to

the International Monetary Fund, from a 2010 estimate for 2012, Japan’s gross government debt

as a percentage of its GDP was 236%. The United States number was 107%. According to one

researcher Japan has been able to keep their economy from tragic contraction because private

citizens funded government debt at low interest rates. This is changing because Japan’s

population is aging. The quote I recall is “last year, they sold more adult than baby diapers.” The

aging population is cashing in bonds for retirement, rather than remaining a net buyer because so

many are in retirement. Now Japan has to go out to the international marketplace to issue new

debt at higher costs. Interest expense will rise. Average government bond yields of 2% or higher

means their interest expense is not covered by tax revenue. They would be forced to respond by

printing even more money while going further into debt.

US Entitlements, and Pensions: Entitlements are obviously out of control and un-affordable.

The only way to come up with the money is to raise tax at the risk of lowering private sector

growth even more. This is not a good option, but it is happening.

US Housing and Commercial Real Estate Markets: It is very obvious that these marketplaces

are being propped up by artificially low interest rates. Our risk is that interest rates increase

making housing and commercial real estate, far less affordable. A hypothetical 3 ½% 30 year

mortgage for $200,000 generates about a $900 monthly payment. Raise the rate to closer to a

long-term average of about 6% and that payment jumps to about $1,200. That’s a 33% increase.

Raising interest rates can have a bad effect on the stock and bond markets also. We saw this in

May of this year when Fed Chairman Bernanke indicated that his organization was on course to

allow interest rates to move up about a year and a half from then. Within a couple of days the

stock market was down by almost 6% (S&P 500 high on June 19, 2013: 1652.45 and low of 1560.33 on June 24, 2013).

Complex systems: What I am going to write here is a bit complex. If your eyes glaze over a bit,

just skip to the emboldened sentence below. Recent research writings by Rubino [2013]

explained that there are complicated mechanisms in finance as well as complex systems. A

complicated mechanism is like a car engine or a wristwatch. It has many moving parts that don’t

talk to each other. They simply move around doing what they’re supposed to do. A complex

system is more like a weather front. It has parts too, but they communicate with each other and

can respond by growing and shrinking. He refers to an “epic feedback loop” that turns a tropical

depression into a category five hurricane. As one component speaks to another within the system

exponential growth can occur. Double the size of one component and perhaps the entire system

grows 50 fold. The component here that can increase leverage many fold is bank balance sheets.

Long and short leveraged asset positions result in what appear to be moderate risk positions.

They actually represent far more risk than appears for a key reason. Consider that in year 2000,

volatile leverage positions approximated $30 trillion. Today they are about $596 trillion.

The way they are structured indicates the system is growing in a nonlinear fashion while the net

risk position appears to be moderate. This is exacerbated by the fact that everyone is everyone

else’s counter-party. Essentially, systematic risk is not priced into the value of these volatile

leverage positions. An International Monetary Fund working paper from 2012 essentially says it

like this: “The network topology where the very high percentage of exposures is concentrated

among a few highly interconnected banks implies that they will stand and fall together.” They go

on to further explain that one of the benefits of such a small, clustered group of banks

maintaining the lion share of [leverage] makes regulation far easier than it was in 2008”.

As always, please feel free to contact me at 952-230-1340. If you have any questions or would

like to discuss what is written here.

Warm regards,

Christopher Gerber, CFA




Stock investing involves risk including loss of principal. 

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The LPL Financial registered representatives associated with this page may only discuss and/or transact business with residents of the following states: Minnesota, Wisconsin, Texas, Florida, Arizona, New Mexico and Virginia.

Current Portfolio Key Issues

Your Financial Muscle

I read recently an old fighter saying that says, “The punch you don’t see is the one that gets you.”

This FinancialMuscle edition is meant to discuss some key issues that I feel should affect our judgment. It is not meant to give advice. It is only meant to inform and educate.
Over the last year it’s easy to assume that if we put everything in the stock market, we could have made great returns. That, however, is not what investors do. They look forward. They have to make smart choices about their money based on the data that they have at the time. I call this “being in it”. You make your best decisions based on the information you have. Recently, I was able to go to the 150^th anniversary of the Battle of Gettysburg and its reenactment. I remember thinking at the time that the generals running the battle were really “in it”. Soldiers had to eat and sleep, not everyone was compliant, no one knew when the next battle was or what the outcome would be, and sometimes bullets and cannonball were flying everywhere, while men were screaming and horses were wailing. Add to that the fact that you could barely see because the fog created by the gunpowder clouded the skies. It was all out of their control. In 1863, when all they had were messengers on horseback to let them know what was happening miles away, generals still had to make decisions. There were no iPhones or sophisticated communications like we have grown used to. There were no satellite pictures showing troop movements. They made their best efforts appraisal given the information at hand. It’s noteworthy how that hasn’t changed. With sophisticated communications and mountains of historical data, you still can’t predict the future. We are still in the business of making decisions with much at stake when it comes to your money.

What We Know

So, what information do we have at hand? The numbers indicate that we are in a recovery. The recovery is barely. Here’s how we know this:

·         Gross domestic product is inching up net of inflation (the little under 2% annual rate),

·         Light vehicle sales have been inching up, albeit in fits and starts for several months,

·         Housing starts have broadly inched up, although they are nowhere near the long-term average,

·         Inventories have been inching up and are roughly equivalent to their long-term average,

·         Capital goods orders have been broadly inching up since 2012 and are above their long-term average,

·         Household debt as a percentage of disposable income has dropped pretty consistently since 2007 while household net worth has been inching up through the second quarter of 2013.

All of these indicate that things are generally on the mend, albeit at a very, very slow rate. These are generally indicators of the business cycle, but the credit cycle is a different story.

Yes, we have a credit cycle, too. Interest rates go up and credit becomes more expensive, interest rates go down and borrowing becomes cheaper. That’s a credit cycle. Credit has been easy for several years and pretty much all of the bullets have been shot from the Federal Reserve gun. Yet, the economy can barely get off the runway. We have a mismatch between the normal credit cycle and the normal business cycle. Usually they move in unison. As business heats up interest rates go up to slow business down, and as business decreases interest rates go down to speed it up. That is not exactly what’s happening now and that creates uncertainty.

More of What We Know

Asset Prices: Having important issues is nothing new. These are different, though. They are big:

1) Increasing government regulation over private industry which has in some cases come close to paralyzing free market business operations.
2) Moving private debt to the public balance sheet through treasury, fed, and fiscal operations.

The casualty of these behaviors is lowered asset prices. Starting in 2008 prices of assets corrected. They had been propped up by government and private easy money programs. Think: low-doc and no-doc mortgages at low interest rates. We found out the hard way that cash flow does not lie. When people could no longer pay their mortgages on time investors dumped the underlying securities and lowered asset values…as they should have…to be in line with the real abilities of debtors to pay back. Housing prices, business prices, most asset valuations in society crashed. The recovery has gone slowly since.

Since 2008 free and easy cash from the Fed has eased the pain. Unfortunately, easing the pain is essentially a valuation lie. The full measure of pain eventually happens no matter what. Investors ultimately vote based on real value as opposed to fictitious value. All easing does is prolong pain while increasing debt, hence making more pain along the way. Since government creates little value, the money it uses to ease pain is of lesser and lesser value because it is backed up by decreasing ability to pay. The hope from the Fed is while easing the pain the economy can gain momentum and pick up where the Fed leaves off. It could work. It has worked in the past, but not on this scale. This is new scale. The jury is out.

Looking Forward

Operating intelligently means evaluating where our system is against where each of us are personally. For those who have plenty of financial cushion in their lives taking large scale stock market risk could pay off. For those for whom a mistake is more meaningful, remaining conservative can be a very smart option. Even if the market goes up another 20% or even 30%, the risk of loss - which is just as large - can be devastating. This plays out in a retiree’s life in a way that is generally undesirable. Perhaps he has to lower his lifestyle or go back to work. Most people do not like being forced to be in this position. This is where having a realistic, workable strategy pays off. Living well can result from designing a strategy that realistically considers goals, resources, and risk.

Please feel free to contact me if you have any questions or would like to talk at 952-230-1340.

Warm Regards,

Christopher Gerber, CFA

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The LPL Financial registered representatives associated with this page may only discuss and/or transact business with residents of the following states: Minnesota, Wisconsin, Texas, Florida, Arizona, New Mexico and Virginia.

The Clearing Point

  

Being in the business of helping people make smart choices about their money is very serious business. The decisions we make now can have long-lasting effects on how we live our lives. Therefore, in the process of taking this very, very seriously occasionally I will change directions on an as needed basis as our environment changes directions. It's all part of the normal process.

Last week I mentioned on my Facebook page that I am somewhat more optimistic than I was six months ago. This is true. But, it is with qualifications.

Surprisingly, it is not because I think the unemployment declines or the increased consumer spending numbers, or any government programs coming out are anything to write home about. They're not. What I am more optimistic about is that the news has been pretty bad for quite a while. What this means is that the ever present, world renowned pricing mechanism has been allowed to do its job for quite a long time. Since it is always truthful… eventually …we now have information to write home about.

Specifically, I am referring to the price of housing. We may begin to see a glimmer of light in our housing spelunking adventure.

According to several sources including the National Association of Realtors, FactSet, and the US Census Bureau; several important things of occurred over the last few years.

• The median price of existing home sales has dropped from a peak in November, 2005 from $227,000 to $165,000 as of November, 2011.  That’s a drop of over 27%.
• Mortgage payments, on average, for new homes as a percentage of average household personal income is down to 10.3% as of November of 2011. To give you some perspective, back in 2006 it was approximately 20%. Back in 1982 it was 37%.
• Household debt as a percentage of disposable income is down to 11%. This is about average historically. At its worst it was up around 14% back in the third quarter 2007.
• We are at the point where the national average mortgage payment for a home of $521 per month is below the national average rent of $708 per month according to JP Morgan.

Tipping Point, Perhaps

Because we have reached a point where key statistics are similar to some key long-term averages, we have to question whether this downturn can go further or not. It is possible that a lot more could go wrong. Or, with housing prices off 27% and the average homeowner paying roughly 10% of their average household income on house payments, we could be close to a price clearing point. That's the point where supply intersects demand and pricing pressure one way or the other is not abnormal.

Healthy Dose of Reality 

• Job growth is still very, very slow. In fact, it may in truth, still be negative. The official number has improved over the last quarter, but there is legitimate concern over how unemployment is calculated. It is important to note that the labor participation rate is a factor in the calculation that has legitimately made the news. This number appears to be uncharacteristically gyrating based on some suspect assumptions. I think this should be the focus of another blog discussion. Suffice it to say unemployment improvement is by no means a slam-dunk.
• Government debt continues to rise. February of 2012 marks one of the highest ever debt months for our treasury. It took on approximately $154.8 billion that month alone. Federal government spending now accounts for approximately 20% of overall spending in our economy (Survey of Current Business). This does not account for state, municipal, and county government spending. It is too high for a flourishing economy. I will refer to a quote from Sir John Templeton when he said "When the government gets in we get out. When the government gets out we get in". Historically, our economy has been far healthier when the government accounted for a smaller part of total spending. What I am watching now is how willing government is to step aside to let the private sector assume more of the spending pie. . No matter who runs the government, this has to happen to spur long-term, high-quality economic growth.
• The federal debt as a percentage of GDP as of 2011 is about 67%. This is historically high, but not the highest ever.

Let's Digress

How much debt is too much debt?  Let's look inward. How much debt is too much debt in our own lives? It is not uncommon for the average American homeowner to earn $75,000 and borrow $200,000 for a home. This is a personal debt to GDP ratio of 260%. It's done daily. If we extrapolate that to our federal deficit, were looking pretty good. But.......More often than not the government backs mortgage loans thereby taking away lender risk. Individuals do not have S&P ratings, but our government does and it matters. So by government fiat our loan becomes AA rated.  It used to be AAA.  Ultimately, the S&P rating of government debt matters and ours has decreased a notch in 2011. So, the comparison to personal debt is not really that valid because the government has tentacles just about everywhere in our system and its perceived ability to pay on time can have marvelous or catastrophic effects depending on how its credit quality is managed. Conversely, if I default on my one mortgage, the only person it affects is me.

Why Are they Still Lending Us Money?

We don't know exactly how much debt is too much debt. BUT, we have a measurement for it. Interest rates reflect the willingness or reticence of investors to trust our safety. Currently, international investors are readily lending to our Treasury even though interest rates are at or near zero in many cases. They are lending their money to us for a song. We must conclude that the U.S. Treasury is still considered the safe haven in the world compared to the rest of the world. This is a very important point.

The treasury is banking on its having plenty of room to continue borrowing. They probably do, based on current interest rates. However, make no mistake about it: interest rates will eventually be increased. When interest rates increase the first time, it will probably be teensy. The press will jump all over it 24/7, the markets will gyrate, they will settle down, and life will go on. Surprisingly, we aren't there yet.

Conclusions 

Overall, I recommend the following: 

• Keeping our eyes on our actual goal.
• Building our portfolios based on our actual goal.
• Not being distracted by the stock market and its wild returns and gyrations. 
• Keeping in step with your investment policy statement unless we see a really good reason to veer from it.
• Maintaining optimism with a healthy dose of realism.

As always, please feel free to call me at 952-230-1340 if you would like to talk.

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

 

Securities offered through LPL Financial. Member FINRA/SIPC.

So, You Want the Money...

In January, I asked what would happen if you had a 30 year US government Treasury bond and you wanted your money before 30 years is up. Here is the answer...

Most things in the world are for sale, and bonds are no different. The wild card is the price. Perhaps surprisingly, the bond market is set up to be pretty orderly when determining price. It is not like selling a home, mostly, but just partly. When you sell a home the first thing a real estate agent does is check the prices of homes sold (if ANY right now) in your neighborhood. He figures that most homes in the 'hood are roughly the same. Then he adjusts for amenities. In the end, he does not move the price too much from the 'hood's average price. It is fairly but not totally subjective. We always think our home is worth more because of some special things we have done to it. It is only human to think so. The bond market is not so subjective.

The value of a bond is based on these items:

1. Cash flow it makes you
2. How long the cash flow lasts
3. How safe the cash flow is
4. What other similar bonds are paying
5. Government regulation
6. Will any of the above change

The Math Thing

The real estate agent can guess. The bond buyer has no such luxury. Your bond is a cash flow maker. That's it. How it is priced is an amalgamation of the points above in as mathematical of a fashion as possible. Before your eyes glaze over, let me explain…
Let’s cover 1 through 4 all in one swoop.

Assume you have a government bond that pays interest for 30 years at 4%. To buy it, you give the dealer $100,000. You begin receiving your $4,000 annual interest (it actually pays $2,000 every 6 months) for the next 30 years. Let's say that in 2 years you want your money out.

In 2 years you have a 28 year bond. The dealer compares your bond to other 28 year bonds for sale and finds that they are paying only about 3%. Since yours pays 4%, it is worth more than the competition.  He will pay you a PREMIUM for your bond since IT pays a premium interest rate. He will pay you enough that when he resells it (net of his service fee for providing a liquid market for your bond) the new buyer will receive net 3% interest based on the price he pays and the annual cash it pays.

He will value it as he should value any cash flow producing mechanism, whether a bond, a rental home, a commercial building, an oil well…whatever. It is worth the value of all the future expected cash flows DISCOUNTED back to today based on how long you have to wait for them and how reliable they are. The longer you have to wait, the bigger the chance of something going wrong. SO, the discount rate reflects this.

Think of the discount rate like this: It is the rate of interest you must earn to compensate you for the use of your money over some time, and also for the chances of something going wrong.

Now, add in 5 and 6 Above…

So, General Motors bondholders, who were essentially thrown under the bus by the federal government in the bailout, in hindsight should have required an enormous discount rate to buy those bonds. If they knew in advance what might happen, they would not have bought them. We don’t know in advance, though, which is why what we do is called “investing”. We can only estimate our chances.

In the Real World

In the real world, cash flow management is not as simple as the example. This is why I generally use professional management. They have the staff and facilities to continually reevaluate the credit quality and relative benefits of our choices. Additionally, in the world, there are many instruments that are associated with bonds, but do not act exactly like I exemplified. They are used when conditions like changing interest rates, credit qualities, currency values, or government regulation change the playing field. Often these instruments are used to help lower risk.

The Take Away

Bond portfolios have values that change daily based on many, many factors. They often contain other instruments that can be highly beneficial in limiting our risk and potentially enhancing our return. Professional management provides a double check on our money that an individual investor could not likely do effectively by himself. Reviewing credit quality and other issues that affect bond prices requires a highly trained, professional staff.

Another very important take away is that bonds have values that very according to many triggers in addition to interest rates. Interest rates play a part, but it is wrong to assume they are the only moving part.

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Securities offered through LPL Financial. Member FINRA/SIPC.