When you hear sirens and see an emergency vehicle speed past, it’s likely on its way to respond to an accident. These heroes head to the fire or the car wreck to help people. First responders deserve our thanks for their bravery and unwavering duty to help those in need. Yet when not fighting fires or saving lives, these same men and women spend countless hours educating us on how to prevent these accidents. They teach our children how to”stop, drop and roll”, remind us to change the batteries in our smoke detectors, and gently remind us to obey traffic laws by writing tickets if we run red lights. They are dedicated to preventing disaster to reduce damage and save lives.
You may wear your seat belt and look both ways before you cross the street, but do you exercise the same behavior when it comes to your finances?
Here are some questions to ponder as you reflect on your financial situation:
If you had a financial emergency, who would you call?
Do you have an advisor that you could call to help you if you had an unforeseen event, such as a job loss, or significant loss to your portfolio?
Do you focus on preventing financial risk?
Do you have someone who proactively counsels you on how to prevent devastating financial problems?
Has that someone called you (not taken your call) in the past year to address what would happen if things went haywire in the markets?
If you are contemplating retirement in the next five years, do you have a plan to help you get there?
Financial markets move in cycles. Investors have consistently shown their inability to make the right investment decisions when things get messy in the financial markets. They want to buy stocks when they are at their highest and sell them when they are at their lowest.
Our family has a plan to get out of our house if the smoke detectors go off. Do you have the same plan in effect for your portfolio?
Earlier this month, the government announced that there would be no Cost-of-Living Adjustment (COLA) increase for Social Security in 2016. Should retirees be concerned about not getting more money next year? This was the topic of discussion in a recent USA Today article.
I hope news like this is not startling to you or your lifestyle in retirement. Unfortunately, in this economy, these low COLA adjustments are becoming the norm for retirees. This is the 3rd time in the last 7 years that the COLA will be 0% and the average over that period is just 1.21%. This can definitely be a strain on the budget over time. While the Consumer Price Index used to calculate the COLA is at 0%, things like food, shelter and medical care are continuing to increase.
So what are you to do? Most people don’t envision their retirement being a constant worry about expenses and reduction in lifestyle. They hope that they’ve planned and saved enough to endure these sluggish economic times. The average older American gets 34% of their income from Social Security, which means 66% comes from other sources. How are your other sources of retirement income going to react and assist in maintaining your lifestyle?
Have you created a financial plan that is able to withstand 0% growth? If you don’t know, it’s time figure it out.
Stock Valuations Near the End of the Economic Cycle
How do we know when the market is expensive?
We compare a company’s stock price to the profits (EPS – earnings per share) and assets of the company that create value for shareholders. Using these fundamental comparisons - Price to sales, price to book value, price to earnings and debt to sales, we can compare the current valuation of a company to previous points in history.
How expensive are stocks right now?
Based on the current S&P 500 estimates for 2015 of $110.60 the S%P 500 index is valued at 18 times current earnings. This valuations contains an estimate for the last three months of 2015 of $30.21 in earnings per share. If this prove sot be optimistic, then the Index is trading at greater than 18 times earnings.
How did the market get expensive?
When stock prices rise in expectation that earnings will rise, but they don’t…
“For Q3 2015, the blended earnings decline is -5.5%. If the index reports a decline in earnings for Q3, it will mark the first back-to-back quarters of earnings declines since 2009.”
Earnings are declining and it has become a trend not a bearish forecast. They will continue to decline until demand materializes from somewhere. If earnings decline and demand doesn’t arrive, stock prices will fall under intense scrutiny.
Will earnings get better?
To answer this question, let’s look at what corporate accountants do to increase earnings per share.
Work to increase the company’s revenue and sales which should help EPS.
Bring new products to market that are in demand
Raise prices that customers pay
Make an acquisition to increase sales, revenue and profits
Reducing production costs by modernizing equipment or building more efficient production facilities
Reduce employee headcount (layoffs), wages, and benefits
Refinance company debt to lower borrowing costs.
Cut dividend payments to shareholders
Reduce the number of shares outstanding so that earnings are calculated over a smaller share count.
Revenue growth is stalling out so profit margins are coming into focus.
"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. - Warren Buffet
S&P 500 Profit Margins are nearing 10% (Silverblatt)
It is likely that profit margins will revert back to historical levels. This will reduce earnings and put more pressure on the cost side of business. As a result, companies are reducing wages and benefits.
Once accountants exhaust the profit nudge from reducing employee wages and benefits, they reduce hiring to essential personnel only:
"The U.S. economy created 142,000 jobs in September, a number that missed expectations and could cool expectations that the Federal Reserve will start raising interest rates soon. Unemployment held at 5.1 percent, according to the Labor Department. A separate member that includes those who are working part-time for economic reasons or have not looked for employment fell to 10.0 percent. Economists had been expecting the report to show 203,000 new jobs, from the downwardly revised 136,000 in August (from the originally reported 173,000)."
If a slower rate of hiring doesn’t help increase profitability, the accountants issue lay-offs to existing workers.
Companies have exhausted their ability to artificially manufacture EPS gains. They are now left with the reality that they are reliant on consumer spending to grow. Increasing revenue requires that a company can create demand for their products and services. Demand requires 4 conditions to materialize before a sale happens:
Products that are needed by customers
Discretionary income available to purchase
Access to credit to finance purchases that exceed income
The willingness to part with income or to take on debt to fund a purchase
Lately, even high wage earners have seen their incomes stagnate:
Stagnating wages inevitably lead to reduced spending. The feedback cycle kicks in:
Source: Survey of Consumer Expectations, 2013-15 Federal Reserve Bank of New York (FRBNY).
What happens when investors realize that the market is expensive and want to get out?
Overbought conditions that change quickly create a lopsided effect as investors head to the exits in unison. The exit can get very crowded in a hurry. This massive Chinese traffic jam is a visual example:
Here is a description of the physics behind these situations:
When this happens — when all the cars are traveling at close to the same average speed because of the vehicle density on the roadway — they become highly dependent on one another. A physicist might compare the relationship to the correlated motion of electrons in metals, which gives rise to weird phenomena like superconductivity.
Highly correlated traffic means that a tiny perturbation — a butterfly flapping its wings, or a single driver braking unexpectedly — will send little ripples of corresponding slowdowns through the entire chain of cars behind him/her. That’s one reason why slowdowns and traffic jams occur most commonly at merge points, especially exit and entrance ramps, or when lanes are closed due to road construction.
Sound familiar? The exit can get crowded with investors selling to cash but also speculators who used borrowed money to leverage their gains as the market increased. These margin investors have increasingly added to the borrowing balances since 2009:
While the total amount of margin borrowing is eye-catching, sudden reversals of margin usage are more important. These reversals signal a shift in momentum that can lead to the crowded-exit phenomenon that leads to panic selling and excessive price declines.
None of the circumstances we described here are new or secret. In fact we have been warning clients about these conditions for more than a year. Why should investors take heed now? With the summer decline in foreign stock and bond markets, investors have other options to consider besides selling domestic stocks and sitting in cash. Chris Brightman (aptly named, by the way) published an excellent article that outlines the valuation discrepancies between emerging markets and domestic markets.
You should read it and digest his analysis.
Investors have no excuse to ignore domestic economic weakness and domestic stock valuations. They have cheaper investment options to rotate into and reduce risk.
For wonky asset managers (yours truly) the first Friday of the month is "Jobs Friday". The anticipation for this morning’s report was huge since this is the most meaningful statistic (after Personal Consumption Expenditures - PCE) that Janet Yellen and the Fed will get before they reconsider their interest rate stance. If Yellen follows the bond markets lead, she stay on hold for the foreseeable future.
No need to meet this month Janet. Instead of 200,000 jobs the report came in at 142,000 new jobs. Worker participation declined to match the 1977 low. The work week shrank and wages were flat. We are tempted to cheer that part-time positions jumped 53,000. This gain unfortunately came at the expense of full-time positions which declined 185,000 in the month.
The household version of the survey which includes self-employed workers and business owner actually showed a 236,000 job DECLINE in September. Harvard economics professor Greg Mankiw has an excellent description of the survey differences here.
The pundits who called for further positive revisions to previous reports are having humble pie for breakfast too. Last months jobs stinker was met by a chorus of cheerleaders who promised that, “August is usually revised higher!” Instead of an upward revision, August job gains were indeed revised-lower. The BLS cut 37,000 more jobs from the initial report of 173,000.
We expect the jobs report in November to get worse after the long list of announced layoffs are fully reflected. Stock futures are responding with red arrows in equities and green arrows on bonds. Please revisit your stock allocation in your 401K accounts. Stay tuned.
We are at an interesting point in our political history. “Change” seems to be the buzz word that all political candidates are embracing in many aspects of their campaign. The current tax system is not immune to this change. If one of these major tax system proposals became law, it would be the first major overhaul of the tax system since the 1980’s under Ronald Reagan.
Donald Trump released his proposed tax plan on Monday. According to his release, the plan is designed to achieve 4 simple goals:
Tax Relief for middle class
Simplified tax code
Grow the economy
Don’t add to debt or deficit
What does it mean for you?
This is all just a big proposal that’s a long way from reality, but how would it impact an average client of mine. Let’s say this client is married and has $100,000 of taxable ordinary income. Under the existing tax system, this taxpayer would have a tax liability of $16,588. The Trump plan would have a 0% rate for the first $50,000 and a 10% rate for the second $50,000, so the tax liability under this proposal would only be $5,000. That’s less than a third of the current tax burden!
We have a long and winding road between now and the elections next year. Along this journey, we are going to hear many things about our country and especially taxes. I’d love to be your guide as we all try to process what this “change” means to you.
Isn’t It foretelling when Collector Car “pawn services” ramp up their marketing? Have to meet a fat margin call in your brokerage account? No worries, just pawn your vintage Ferrari or that case of Jefferson’s 1787 Château Lafite Bordeaux! (Just make sure there is no traces of Cesium-137 in it.) to Borro.com "the luxury asset lender":
They have to be the only lender on the planet that hopes their clients default so they can keep the collateral! It would be fun to shop in their retail location.