The Federal Reserve Taper Begin

The Federal Reserve Board has made its long-awaited announcement that it will begin to scale back ("taper," in Wall Street language) its QE3 stimulus program.  The last time the Fed even mentioned starting to taper back, last fall, global stock markets and bond investors panicked and sent the markets reeling.  Now, the Fed says that instead of buying $85 billion in Treasuries and mortgage bonds per month, it will only buy $75 billion, and more cuts will come as the economy continues its recovery and the jobless rate continues to fall. 

With this announcement, markets went up and investors cheered.  Japan's Nikkei index reached a six-year high, European markets soared and U.S. stocks finished the day at new record prices.

Does any of this make sense to you?

The so-called "taper," and the QE3 stimulus program itself, are somewhat unique in the history of investment markets.  To understand QE3, imagine that at the auctions where investors buy government bonds and packages of home loans, a bidder nine times the size of Gargantua shoulders everybody else aside and insists on paying higher prices (and, therefore, receiving lower interest) than any of the other bidders.  The Fed's stated goal was to stimulate the economy by driving interest rates lower, making it less expensive for large and small businesses to borrow money, so they can build factories, expand their capacity and hire more people.

The problem with this stimulus effort was two fold:

1. Many American corporations were already sitting on tons of cash, and have little need to borrow if they really wanted to go on a building and hiring spree.  The companies in the S&P 500 index reportedly have a record $1.5 trillion in their coffers, up 14% this year alone.  Add in the money stuffed under the mattresses of some smaller companies, and the total may exceed $5 trillion. 

2. The Fed kept interest rates so low that banks did not want to loan money to small businesses and/or people who did want loans.

The Fed's mortgage purchases probably did make mortgage rates a bit cheaper for home buyers, but it's hard to tell how much.  The day after the announcement, 30-year Fannie Mae mortgage rates were up 0.01 percentage point, at 4.42%.  That's higher than the low of 3.31% in November of 2012, but still very low by historical standards.

Savers and long-term investors should breathe a sigh of relief that the Fed is finally easing out of the investment business.  Why?  For one thing, it means that economists at the Federal Reserve Board believe the economy is finally in a self-sustaining recovery mode. 

For another, it means the end of uncertainty.  When investors are unsure what to expect, they tend to expect the worst. Which is why you will read articles saying that the taper could cause interest rates to skyrocket leading to some problems with the value of ETF & mutual fund bond investments currently owned by investors. But admittedly by early indications, no such thing is happening right now, and you can bet that Fed economists are monitoring the situation and will try to nip any such problems in the bud.

At the same time, we can expect interest rates to go up over the next few years. This could be a problem for some bond ETF or mutual fund holders, but it is great news for older Americans who have been living on CD interest rates that are barely higher than what they would get if they stashed their retirement money in a cookie jar. 

For the economy as a whole, there is still plenty of cash to lend to any company that wants it if it becomes profitable to do so, housing is still more affordable than it was before the 2008 meltdown, and inflation is still currently stubbornly lower than the government's preferred target rate. All in all we are ending 2013 on a great note. However, I will personally be moving into 2014 with a little caution.

Behavioral Finance

One of the most interesting areas of financial research these past ten years has come, oddly, not from economists or investment researchers, but psychologists, who are pioneering a branch of study known as "behavioral finance."  This has led to one of the strangest sights in the history of Nobel prizes: the 2002 prize in economics handed out to psychologist Daniel Kahneman for (according to the Nobelprize.org website) "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."

The behavioral finance research tells us that most people take mental shortcuts to arrive at decisions, and some of them lead to odd conclusions.  Around the time you make your New Year's resolution to lose weight, do you buy a $500 annual membership to a gym or opt for a $10 per visit pay-as-you-go fee?  Most people who choose the former end up actually going to the gym less than once a month; the flat fee is only a bargain when you assume that the bold post-resolution intention will actually happen, but it's often a terrible deal when a person's actual behavior is taken into account. 

How do you decide whether to be an organ donor when you face the option on your driver's license application?  In countries where the default option is yes (you consent to be an organ donor), 90% of individuals happen to be registered organ donors.  In countries where the default option is no, the percentage ranges from 10% to 30%.

This research is now finding its way into the hands of policy makers, who are pioneering a new governmental role of protecting you against the dangers of your own mental shortcuts.  One recent example is automatic enrollment in a company retirement plan.  Research shows that if people are required to affirmatively opt-into having a portion of their paycheck sent to their 401(k) retirement plan, they will do so at a lower rate (67%) than if they are enrolled by default and have to affirmatively opt-out (77%).  The U.S. government has been encouraging auto-enrollment policies at American corporations, on the theory that workers will be better off if more of them are making regular 401(k) plan contributions.

Another example in Britain came when the government offered tax incentives for people to insulate their attics, reducing energy consumption and the associated pollution from energy production.  But so few people showed an interest in the incentives that the UK government finally had to switch tactics.  It offered the same tax break, but added a loft clearance service that would help people clean out their attic and give them assistance in disposing of (sell or throw away) unwanted items.  The new service tripled insulation participation rates. 

When the city of Copenhagen painted green footprints on the sidewalks leading to  litter bins, littering decreased by 46%.

The idea of applying behavioral economics to political and social initiatives sounds a lot like manipulation to its critics, who worry that we are moving toward a "nanny state" where the government feels compelled to protect us from our own behavioral biases.  Reducing litter on the streets of Copenhagen is relatively noncontroversial, but what about initiatives that try to influence buyers to select more energy-efficient cars?  Or government policies that discourage the consumption of certain foods or beverages?  The New York City ordinance against large soda containers was based on the assumption that people were unable to recognize, on their own, the health risks of soda consumption.

Interestingly, at least one of these behavioral initiatives is now showing evidence of backfiring.  The Center for Retirement Research at Boston College found that companies that have switched to automatic enrollment in their 401(k) plans have been paying for the additional cost by giving their employees smaller employer matches--3.2%, compared with an average 3.5% for plans without automatic enrollment.  At the same time, the Boston College researchers and the Vanguard organization have found that for some workers, the automatic savings rate offered in the default is lower than what many workers would have chosen if they had made an affirmative decision to participate.  Worse, the automated mix of investments (typically target date funds) that is the default option has underperformed the investment mixes that workers have tended to select on their own.  For some workers, at least, the government's behavioral finance nudge will cost them real money.

One Big Collective Yawn

The stock market reaction to the 16-day government shutdown and threat of a default on all U.S. government budget obligations (Social Security checks, interest payments on government bonds, payments under contract to suppliers and contractors, etc. etc.) was stunningly mild.  In fact, despite all the dire warnings and hints from the Democratic side of the aisle that the markets should send a loud message to the Republican party, they never did.  Investors, for the most part, saw the whole shutdown/default charade for what it was: something that a majority of our elected representatives would eventually have to decide to work out. 

Indeed, over the 16 day shutdown, the markets actually went up.  Compared with the naked fear that the Fed would stop intervening in the bond markets, the response to closing down the largest payroll on the planet and threatening to send the global economy into a tailspin registered not even a yawn.

Nevertheless, there were costs involved.  The Standard & Poors organization recently calculated that the shutdown cost the U.S. economy $24 billion--or about $1.5 billion a day.  An estimate from Moody's Analytics similarly put the figure at $23 billion--and this doesn't count lost productivity.  Hundreds of thousands of furloughed government workers are going to paid for their two-week-and-two-day vacation even though they did nothing productive.  All those tourists who would have visited national parks and purchased hotel rooms and restaurant meals didn't.  The ripple effect of thousands of government contractors twiddling their thumbs hopefully is hard to calculate. 

Perhaps the biggest cost, if we ever get a final tally, will be the interest the U.S. government has to pay on its debt.  Bond dealers were reporting weak demand for Treasury bonds at auction across the full spectrum of maturities in October, as investors demanded higher yields to cover the threat of default.  Since the recent budget deal only lasts until January 15, and the debt ceiling will be again breached on February 7, 10-year government bond holders could conceivably be looking at ten more opportunities for default before they get their money back.

The U.S. and world markets rose on the news that the government standoff had ended, but that doesn't rule out a pullback at some point in the near future.  Eventually, investors are going to realize that shutdown and default debates could become an annual event.  This is ironic, because, absent the squabbling in Washington, the U.S. economy seems to be healing nicely--if not quickly.  Just before its staff was sent home for the shutdown holidays, the Federal Reserve Bank of Chicago released its latest report on the state of the economy, saying that consumer spending continues to increase, business spending is up and manufacturing activity has expanded.  Most economists on the talking circuit these days seem to expect that the U.S. economy will show 2% growth for the year, down from closer to 3% estimates before the shutdown.

                                   40 Years As A Personal Financial Planner

This Monday, July 15, 2013, marked my 40^th year as a Personal Financial Planner.  It has been a great 40 years! I thank the College of Financial Planning, the Institute of Financial Planning (ICFP), the Financial Planning Association (FPA) and the National Association of Personal Financial Advisors (NAPFA) for continuously helping me to grow within the profession.

Many people have asked why I don’t retire.  I feel my clients need me as much or more today as they did in 1973.  You see today investment markets are faced with some of the same problems that they did in 1973.

1.   

•           In 1972 interest rates began to rise. On January 3, 1972 3 month bonds were paying 3.69% and 10 year bonds were paying 5.94%.  By January 4, 1982 3 month bonds were paying 11.87% and 10 year bonds were paying 14.19%. That was an increase of 321% and 239%.

•       I do not believe interest rates will go this high over the next 10 years, but I do believe interest rates are about to make substantial increases, that can have the same type of an effect on a client’s investments as they did in 1973.  

• In 1973 crude oil prices had risen from $2.97 a barrel on July 1, 1963 to $4.31 on July 1, 1973.  That was an increase of 45.1%.  Crude oil the continued to increase to $31.66 over the next 10 years, an increase of 734%. 

• Today oil prices have risen from $30.76 on July 1, 2003 to $96.56 on July 1, 2013.  That was an increase of 314%.  It is anyone’s guess what oil prices will do over the next 10 years, but I doubt that anyone thinks they will go down in value?  

Interest rates and oil prices are important because they affect the amount of discretionary income we have to spend and in turn how our economy grows.

No, I don’t think I will retire just yet; over the next few years my clients may need some historical prospective to protect their investments.

God bless!

Doomsday Prophecy or Just Looking For Press

Doomsday Prophecy

When a former White House Budget director who famously never balanced the federal budget suddenly claims to have special powers to forecast a major economic crisis, it's hard to understand why anybody pays attention.  But recently David Stockman, who served as Ronald Reagan's budget chief back in the 1980s, has gotten a lot of publicity for his fiery Easter Sunday article in the New York Times, telling us that America's future is bleak and everybody should get out of the investment markets as quickly as possible.  His advice (the first paragraph contains the words "we should be very afraid") is getting a lot of attention among triumphant doomsayers who have been predicting America's downfall for decades, and from economists, who wonder where Mr. Stockman learned how to add and subtract.

The article was written to support Stockman's newly-released book, called The Great Deformation, and it shows that the author knows how to generate a lot of attention.  It calls the Federal Reserve Board "a rogue central bank," and declares that the U.S. is fiscally, morally and intellectually broke.  It predicts a global currency war that America is destined to lose.  Stockton's advice: "hide out in cash."

Is this good advice?  Interestingly, the article says that the problems began in 1933, when the American dollar went off the gold standard, and have simply accelerated ever since.  But anybody who avoided the U.S. stock market since 1933, and hid out in cash, would have missed the greatest period of stock market returns in world history--not to mention the enormous strides in standards of living and, most notably, no more economic catastrophes like the Great Depression.  Even the Great Recession meltdown in 2008 has been followed by a long, steady recovery that has produced new market highs.  And despite 80 years of disconnect from the gold standard, the dollar remains the strongest currency in the world, the reserve currency against which all others are measured.

Predicting doom is a great business to be in, because our minds are wired to spook at the first sign of danger, and our eyes are instantly attracted to warning signs.  People buy because they're afraid not to.  The only problem with the doomsayers who have made these predictions is that they have never actually been right.  Betting on the end of the world, or the end of the U.S. economy, or the death of the stock market, has never been a winning choice.

In addition, you have to wonder how credible Stockman is to be telling us our economic future.  Never balancing the federal budget puts him in pretty good company, but Stockman also had an undistinguished Wall Street career at Salomon Brothers and the Blackstone Group, and his job as CEO of auto supplies manufacturer Collins & Aikman Corp. led, less than two years after he took the helm, to the company filing for Chapter 11 bankruptcy protection.

If Warren Buffett tells us to get out of stocks, we're going to listen carefully to his arguments.  When David Stockman peddles gloom to an ever-ready market, because he seems to be the only Wall Street executive who has to supplement his income with book revenues, we simply put our hands over our ears and continue with our time-tested investment policies.  If his fiery case for gloom and doom make you nervous, our best advice is to consider what would have happened if you had retreated to cash in 1933 when the S&P 500 was trading at 6.25 and stayed out while it rose to (recently) over 1,550.  Missing out on 24,700% overall growth (and all the associated dividends) might be too scary even for David Stockman to contemplate.   

The Fiscal Cliff Act

Unless you were living on the moon this past week, you know that Washington policymakers finally reached a so-called "fiscal cliff" deal that avoids a sudden return to tax rates that are now more than a decade old.  But for some reason, news outlets have been a bit stingy about telling us exactly what's in the American Taxpayer Relief Act of 2012.

The good news is that our lawmakers are creeping closer to reality about how to define "the rich;" rather than $200,000 (single taxpayers) or $250,000 in adjusted gross income (joint returns), as specified in many prior proposals, "the rich" are now defined as making more than $400,000 (single) or $450,000 (joint).  For taxpayers whose income falls below those thresholds, the temporary Bush-era tax cuts have (for the first time) been made permanent, which means that for most taxpayers, the marginal tax rates will remain the same this year as they have been for the past two.   However, taxpayers who fit this new definition of "the rich" will experience a new 39.6% upper tax bracket.  They will also be required to pay taxes on capital gains and dividends at a 20% tax rate.  (The 15% rate still applies to taxpayers below the thresholds.) 

In addition, the Taxpayer Relief Act borrows something from the Clinton era tax code: itemized deductions and the personal exemption will once again begin phasing out for individuals with more than $250,000 in adjusted gross income, or couples with more than $300,000 AGI.  At $372,501 (single) or $422,501 (joint) of adjusted gross income, personal exemptions are phased out in their entirety.

The tax bill also makes permanent the current $5 million estate and gift tax exemptions ($10 million for couples), but raises the tax rate for money transferred to heirs above that amount from 35% to 40%.  And it offers a permanent fix to the perennial alternative minimum tax problem by inflation-indexing the threshold (currently $78,750 for joint filers; $50,600 for individuals) at which people have to calculate their AMT, exempting all but about 5 million taxpayers from this chore now and in the future.

Also eliminated: the two percentage point reduction in the Social Security payroll tax--a stimulus measure enacted in 2010, which is likely to be the biggest impact of the legislation on most taxpayers.  The payroll tax rises from 4.2% last year to 6.2% this year.

Finally, the new tax law makes $24 billion in federal spending cuts, while giving Congress two additional months to decide what to do about $109 billion of automatic spending cuts that were scheduled to begin taking effect at the start of this year.

You can expect those two additional months to be spent in partisan wrangling over where, exactly, federal expenses should be cut, and news outlets have been repeating over and over the fact that March 1 also happens to be the next time that Congress has to vote to raise the debt ceiling.  We don't know whether that next debate will spill over into tax rates once again, but we will be paying attention and will keep you posted.