February 14, 2012
Safe From What?
The Investment View from Prescott, Arizona
By Will Hepburn
The stock market has been remarkably stable since the beginning of the year – especially for something known for its instability.
Two of stock’s cheer leaders are legendary Warren Buffett and Larry Fink, Chairman of Blackrock, one of the largest money management firms in the world. Buffet has called bonds “the most dangerous of assets”, and said that bonds “should come with a warning label.” Strong words regarding what the textbooks say are among the safest of investments.
And Fink shocked the investment world recently when he advised that investors “should allocate 100% of their assets to equities.” That is a very bold statement in an industry with herd instincts – where the big players generally all do the same things.
These two men are obviously not crackpots, so what is going on?
Bonds are priced way-high, making stocks, despite their risks, look like better investments – that’s what.
In my 20 years of teaching at Yavapai College, I drilled into my students that when someone says to you, “Its safe”, your first thought should be “Safe from what?” because there are many kinds of risk and nothing is safe from all of them.
In the textbook sense, government bonds are safer from default than stocks, real estate, or other types of bonds. As long as the government has ink for the printing presses, their bonds should always get paid off. They are still pretty safe in that regard.
But bonds have other risks and this is what Buffett and Fink allude to.
Lately, the 10-year Treasury bond, one of the most popular bond investments, has been yielding below 2% interest. It is reasonable to assume that rates will go up at some point since the historic average is around 6%.
When interest rates rise, the resale value of today’s 2% bond will dive because no one will buy it if they can get more interest from new bonds. This is “market risk” and since 85% of bonds are not held to maturity, but are sold at some point, market risk is very real for bond investors.
If rates spike back to the 6% level, a bond paying 2% could lose 30% of its market value. If rates went way up to double-digit levels, as we saw in the early 1980’s, a bond paying only 2% could lose more than half of its market value.
This is what Buffet and Fink are talking about. At today’s prices (low rates mean prices are high) bonds really have nowhere to go but down if interest rates rise. It might be a while before this happens, but someday it will.
This is one reason we also use currencies, precious metals, plus corporate and foreign bonds in our Flexible Income model* – to protect bondholders from this kind of risk.
And although I often disagree with advice from big institutions, for the first time in many years I, too, have been encouraging clients to increase allocations to growth and reduce allocations to bonds. With our Shock Absorber Growth* strategy functioning so well with such a low risk level, it makes this an easy decision, and one you should consider. If we have not discussed Shock Absorber Growth*, give me a call so we can go over it.
A Slice of Life
Happy Valentine’s Day to all my clients and friends – well, all the ladies, anyway. Your gift is at the office.
And since we have very little will power when it comes to chocolate, you had better stop in quickly before it’s gone.
Tip O’ The Day
Hull strawberries easily by using a straw.
How About That Real Estate Market?
Occasionally I am asked about the real estate market, and frankly I never expected it to get this bad, so I’m not sure how qualified I am to comment on what to expect from it now.
The statistics I hear in the news say the market is still declining, but it no longer feels like it. It seems like we are bumping along the bottom instead of dropping like a rock as we did a few years back. I suppose that is good. Well better, at least.
I am concerned that there is a large amount of “shadow inventory” yet to come on the market; homes that folks would like to sell but have never put on the market since it was so depressed.
If it proves to be true, this extra inventory could keep prices from rising significantly for many years. So anyone buying now needs to buy real estate for its cash flows and not expect a general market appreciation because that may prove to be elusive.
Occasionally someone asks me about putting real estate into an IRA, and most are not aware of the pitfalls of doing so. Here are a few things you might want to take a hard look at before plunging in:
1. First, you will need a specialized custodian that can hold and account for hard-to-value assets (IRAs need to be valued every December 31st to keep the IRS happy). That extra effort means custodians who will hold real estate for your IRA will charge a lot more than banks and brokerage account custodians that hold most IRAs now. I’m sure you can find some of these specialty firms listed on the Internet if you want to pursue this idea.
2. Real estate is normally taxed at “capital gains rates”, the most favorable of tax rates. By putting it in an IRA you are changing it to be taxed as ordinary income, the worst of tax rates. This can cut your profit in half. No depreciation deductions are allowed within an IRA, either.
3. You can’t borrow money within an IRA. No mortgages allowed, cash only, which means no leverage, which is what makes using real estate so attractive to create growth of capital. And you can’t use the IRA itself as collateral for a non-IRA loan. The penalty for mixing loans and IRAs is making the IRA taxable – all at once.
4. Self-dealing is prohibited within an IRA, meaning you can’t live in, or on, the property you buy – or the IRA becomes taxable.
5. And consider the fate of the investor who buys real estate and after a few years of paying taxes and upkeep runs out of cash in the IRA, but needs more money to pay continuing expenses. If you are no longer working, you may not be able to add to the IRA to cover these expenses, can’t borrow to pay them and can’t pay them with non-IRA money which is the same thing. You can lose property that was free and clear in the IRA because you can’t pay these expenses. And you can’t deduct the loss, either.
Alligators – investments than can eat you may be bad, but can be doubly bad in IRAs.
Buying real estate within an IRA makes dodging bullets in the stock market seem simple by comparison. I like simple.
From Service Economy to Served Economy
By Bryan Jarman, CFA
The front pages of many newspapers have recently been filled with the disturbing news of how the number of individuals and households receiving government support in some manner has exploded over the past three years.
According to a Heritage Foundation report, 67 million Americans are receiving government assistance for housing, food, health care, education or a combination of them. The average American relying on federal government assistance receives $300 more in benefits ($32,748) annually than the average American’s disposable personal income ($32,446). Even more disturbing is that 49.5% of Americans don’t pay federal income taxes.
We risk entering a dangerous downward spiral once a majority of Americans are not paying federal taxes. How can social policies be changed to reduce entitlement spending if the majority is “on the take”?
Our economy has undergone a transformation over two centuries from an agrarian-farming economy to an industrialized-manufacturing economy and is now becoming a highly developed service economy. Because the spirit of the American citizenry drives us to serve as opposed to being served, what we really want and need are jobs and not handouts.
Need a Speaker For Your Group?
Having taught at the college level and being a contributor to numerous national media, I have experience discussing many topics including how markets work, current events in the economy and how to avoid investment scams.
If your community group or investment club would like to have a speaker for a meeting, just let me know. Often I can present on short notice if your group finds itself in a bind.
Just call the office at 778-4000. Any of my staff can schedule me. Or just forward this email along to your group’s program chairperson by using the “Email This Page” link located at the top-left corner of this page.
A Handy Tip for Power Outages
Here is a great tip for if you ever have a power outage.
Get yourself a few solar yard lights and bring them inside at night if the current is off. You can hold them up by putting them in a jar or bottle and they will give off plenty of light. Place them in each room you want to use and put them back outside in the daytime for as long as the power outage lasts.
They are safe to use and cheaper than batteries. Bring in a solar light one night and test it.
What’s Going On In Your Portfolio?
All of the strategies we are using in your accounts are working well as of this writing on February 12, 2012.
Our Flexible Income strategy* is loaded with high yield, municipal and floating rate bond funds that are all performing nicely. We have a small position in gold that we purchased recently, and hold just a small amount of cash. I’m pleased to say that Flexible Income* is just perking along, making money slowly just as we like it to.
Our Shock Absorber Growth Strategy* holds pharmaceutical, retail, real estate and homebuilder stocks and stock funds. The risk of holding these investments is cushioned by pairing them with an inverse Euro fund, a “short” fund – one that goes up as the Euro goes down. This strategy continues to grow the accounts nicely with much less volatility than the market as a whole, which is exactly what we want.
Our Adaptive Balance* and Careful Growth* strategies are different blends of the Flexible Income* and Shock Absorber Growth* so they have a little of everything mentioned.
The changes we made last fall are working well, and we are on the way to having a good year in 2012.
Our Spotlight Strategy
In our Shock Absorber Equity we strive to provide growth in all markets from a blend of both long and short equity investments.
We first select the strongest of about 40 different stock market segments, sectors and regions, and then select the most complimentary inverse funds to use as a Shock Absorbing hedge for those investments. The HCM Safety Net indicator is designed to warn of sudden potential declines, in which case, stock market exposure is quickly reduced.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.