2011 Winners & Losers

As a volatile financial year comes to a close, I thought it best to reflect on the large impacts to the financial landscape for 2011.  So I will give you my list of winners and losers for the year.  However, I want to take a different spin on this type of commentary by focusing on winners & losers within 4 major topics affecting the financial universe this year. 

News Networks – Those that read my blog, or work with me on their financial planning have more than likely heard me reference the “creation of crisis” that is created by the 24-hour news networks.  Well, 2011 provided no shortage of crisis.  Financial markets down one week had them proclaiming the return of financial armageddon (a la 2008); with a subsequent rebound rally 2 weeks later.  I often urge people to take headline news with a grain of salt when it comes to personal finance.  Financial reporters are unregulated financial pundits—meaning they can say whatever they want and they are not held to any standard.  This is not the case with those folks who hold any investment license, but reporters fall into an exempt category.  No wonder every week is a new crisis.  Compound that with every other commercial on these networks focused on selling gold to the viewer, and you have networks getting rich on selling fear.

Winners: Network Corporations   Losers: Nervous viewers cashing in their IRAs to buy gold 

Europe – When continental Europe entered into the single currency in 1999, it seemed like a fantastic idea. The prolonged issues in Europe over the last two years continue to revolve around no central decision making body to set fiscal policy for the Union, while the European Central Banks sets monetary policy. The debt crisis in Greece was like a virus that infected the world including Italy, Spain and France, scaring the global economy. On Dec. 5, French President Nicolas Sarkozy and German Chancellor Angela Merkel called for a new European Union treaty to help curb spending in an effort to end Europe's debt crisis and save the continent's euro currency.  As Europe turns (pretty much every week), US financial markets react with polarity.

Winners: Europe (if they can come up with a central policy/treaty)    Losers: US Banks 

Occupiers – Life isn’t fair…let’s put that out there straight away.  But when someone comes through a college graduation to spend the next few years of their life unemployed, it starts to take a toll.  Protracted unemployment has sapped the morale of the working American—and I believe that is what we are seeing in the Occupy protests.  Meanwhile corporate profits have continued to rise. One thing is for sure, companies will not invest in hiring until they have a clearer picture of their expenses to hire for the foreseeable future—and that remains difficult with health care legislation still in question and no long-term agenda for taxes. 

Winners: Are there any?                                  Losers: Everyone (Closing of West Coast ports as the ultimate example)

Polarized Washington – The failure of Congress to come to any swift conclusion on raising the debt ceiling resulted in S&P cutting the US credit rating from AAA.  But with the refusal of policy makers to address a number of issues, it was only a matter of time.  Entitlement reform, out of control deficits, tax reform—“compromise” is not in the vocabulary of any of these politicians.  The recent failure of the “Super-Committee” is just one more example of a year of political brinksmanship.  The leadership vacuum in Washington is quickly becoming a black hole.

Winners: Career politicians                            Losers: The next generation of Americans

It is difficult to isolate the “most important issues” of the year when you write one of these kinds of pieces, but I believe these will have the most lasting effects on us all.  The bright news for the start of 2012 is that the underpinnings of the US economy continue to foreshadow strength.  Cheers to a happy and healthy new year to all.

Asset Location is As Important as Asset Allocation

After a year in which the Euro vacillated between survival & collapse, democracy reached the shores of North Africa, and Wall Street got “occupied”, one thing remained sure & true: VOLATILITY.  As I meet with people every day, it is the ubiquitous item that is keeping people up at night as they prepare to transition to & through retirement.  

A 1991 study conducted by Brinson, Singer & Beebower showed that 91% of an investment portfolio's performance is determined by the allocation of its assets—meaning diversifying (& re-diversifying) your investments between different types of companies is the best way to assure long term performance gains & reduce risk.  More recently though, the increasing complexity of economic forces and the interdependence of global markets have contributed to significantly alter the investment landscape. The current market environment poses new hurdles: unprecedented volatility, economic forces putting pressure on equity markets, the prospect of a resurgence in inflation, & rising interest rates, all compounded by unfavorable demographic trends for most of the developed world. In short, to paraphrase an old saying, in today’s investment landscape, the only certainty is that nothing is certain.

Investors can no longer necessarily rely on traditional strategies to reach their financial goals. As a result, traditional diversification (or Asset Allocation, as it is called) may not be as effective as it once was in serving investors’ needs.  However, the concept of choosing investments based on how they correlate with one another—how their prices change in relation to each other—is still an integral part of investment planning. But asset class diversification alone may not get the job done.

What I call “Asset Location” has become just as (if not more) important as asset allocation.  Asset location is about diversifying across different investment vehicles to take advantage of possible tax advantages, income focus, or non-traditional investment classes.  While traditional asset allocation remains important for a significant portion of your portfolio, asset location can help you to build an infrastructure around your investment plan to help weather times of protracted volatility.

This is how financial planning benefits the investor—more specifically, it structures portfolios by combining different asset classes and investment vehicles in an attempt to provide more effective diversification in order to combat volatility, mitigate risk, overcome inflation and provide income in your retirement years.

Please remember that diversification, asset location and asset allocation do not guarantee profit nor protect against loss in a declining market.  They are methods used to help manage risk.

Super-Failure…

The result of the U.S. debt ceiling’s dysfunctional debate this summer was Congress’s passing of the Budget Control Act of 2011, which created the Joint Committee on Deficit Reduction, more commonly known as the Super Committee. The committee was made up of 12 members of Congress, evenly divided between the House and Senate and both political parties. Their objective by November 23 was to find ways to reduce the deficit by at least $1.2 trillion (to be spread out over 10 years). Unfortunately, they failed to do so.

Failure of the congressional joint committee on deficit reduction likely means little chance to make progress on comprehensive tax or entitlement reform before the November 2012 election.

Now that the economic anchor has dropped, Washington still has to make difficult choices that will likely be a drag on already slow – but recently improving – economic growth. However, given the resiliency in Washington and Congress’s constant focus on electability over sustainability, it would not be surprising if they found a way around the mandatory cuts. After all, the ratings agencies have said that a debt downgrade is not imminent, which could have the political effect of inspiring further inaction.

Failure of the committee may present some economic hurdles, as it reduces the chances of extending recent tax breaks like the payroll tax cuts that are set to expire at the end of this year. Further, we will see mandatory cuts in entitlements and defense to the tune of around $600 billion each. These enforcement mechanisms do not take effect for 14 months, and how those cuts will be enacted is currently a bit unclear. Some members of Congress are already talking about reconfiguring the cuts.  We should have more clarity on where the cuts come from as we move closer to the time they are enacted in 2013. These automatic cuts were supposed to be painful enough that they could force agreement in Washington, but it now appears that our representatives in Congress would prefer to throw out an anchor on economic growth rather than tackle spending. Failure to reach a deal has the potential to decrease GDP growth next year by nearly 1 percent, attributed primarily to the ending of some tax breaks and not extending unemployment benefits.  Failure also kindled fears about Washington’s willingness to overcome political gridlock and take the necessary steps to improve the nation’s fiscal health.

Despite the failure, Standard & Poor’s reaffirmed that it would keep the U.S. credit rating at AA+ after removing its top AAA grade on August 5. Moody’s Investors Service reaffirmed its AAA rating with a negative outlook. In a statement following the super committee’s announcement that it was unable to reach a compromise, Fitch Ratings noted that it said in August that a super committee failure would probably result in a “negative rating action,” (likely a revision of its outlook to negative), and that a review would be concluded by the end of this month. It is worth noting that bond investors have shrugged off the August downgrade, as yields on 10-year U.S. treasuries stood at 2.56 percent on August 5th, the time of the S&P downgrade of U.S. debt, and are now around 2 percent.

With an economy still trying to climb out of one of the worst financial crises in history, I believe more political leadership will be needed to right the economic ship.

How Should We Measure Inflation?

Those readers who have heard me speak at various engagements will note that I devote a significant amount of time focusing on inflation.  My argument is always in finding the correct measure.  While the Bureau of Labor Statistics publishes their monthly change to Consumer Price Index, it remains to be seen how much “trust” should be put into these numbers.

Earlier in the year, the Wall Street Journal Online published a great piece on why the “official” inflation numbers are probably skewed.  All of the adjustments to the calculation of CPI over the last 30 years have made CPI seem “more bearable”.

Two areas that I think are of major concern in the calculation are the principles of substitution and hedonics.  Substitution simply states that when the cost of fresh vegetables creeps to high, the government calculation assumes you buy canned veggies—and thus any additional inflation on vegetables is avoided.  Hedonics attempts to value a product based on the values of its underlying constituent parts—the best example is a piece of technology.  CPI takes into account that if the same technology is the same today as it was three years ago, that the product has experienced negative inflation (deflation) due to the fact that the parts used in today’s model are better or more efficient.  I will let you judge whether that argument has merit or not.

The bottom line is that the calculation of CPI is constantly changing, and at the suggestion of one “rogue” economist John Williams, if we still calculated inflation the way we did when Jimmy Carter was president, the official rate wouldn't be current CPI of 3.7%--it would be closer to 10%.  These factors tell you how central a concern that inflation should be in the financial planning discussion.

The Impact of the “Boomer-ang” Phenomenon

As I write about often in my posts, the Baby-boom Generation are right in the midst of making the transition toward retirement.  As they do so, they must come to grips with the unique risks associated with this transition.  But a recent phenomenon is adding a new complexity to the boomers ability to plan for the retirement financial goal.  One of the realities in the era Post-Great Recession is that more adult children are expecting financial help from their parents.—in the form of a down-payment for a home, tuition payments, or in many cases a roof over their head.

There were some interesting statistics in a recent Harper's magazine article.  85% of this year's college graduates were planning to head back to live with parents for at least some time. Columbia University conducted a study in 2010 that showed 52.8% of 18- to 24-year-olds were living at home, up from 47.3% in 1970.  That means that it is now more common for this age group to be living with their parents.  Some of this can be attributed to the protracted unemployment we are facing on a national level.  Others are trying to super-charge their savings to attempt to get ahead in saving for a home.  Still others help parents in meeting monthly expenses.

The challenge (and danger) to the Boomers, is in the cases where a child living with them (or using funds ) is a significant drain on funds that were earmarked for use in retirement.  While some folks may have a goal to leave a financial legacy, this is not to be focused on at the expense of running out of money in retirement.  This creates a difficult psychological position for parents and is another side-effect of stutter-step recovery to the global financial crisis of 2008.

Be Prepared: Getting Ready to Get Ready for Retirement

If you think about it, you went to school for probably nearly a quarter of your life to prepare you for your career--a big investment of time and money.  But beyond just making sure we do not run out of money, it does not seem that we spend the same proportionate amount of time getting ready for the retirement phase of life.  With that in mind, I thought I would dedicate this week’s blog entry toward creating a checklist of items to prepare for transitioning to retirement.  Here are a few thoughts on getting ready to enter pre-retirement transition years: 

Debt: The 3 “No’s” of Preparing

•  Borrowing from Retirement Accounts—Accessing funds in an IRA comes with the sting of a 10% excise penalty tax, but many company plans allow you to borrow from them and “pay yourself back” over a specified time period.  Sometimes these loans come with record-keeping fees, and you could be missing out on potential appreciation on investment markets.

• Racking up Credit Card Debt—The interest paid to credit card companies is lost leverage in critical pre-retirement years.  Savings rate is quite important as you near pre-retirement years, and carrying balances on credit cards not only serves as impediment to saving, but also drains more money through interest costs.

• Accessing Equity in your Home—Home ownership is a critical key issue for the pre-retiree because your home will either serve as your retirement residence, or as a large piece of re-investable savings if you choose to sell and access built-in equity.  For those people carrying large loans into pre-retirement & early retirement, this key cash-flow item could force the need for more income sooner, or the need to downsize earlier.

Health:

• Not only is it no fun being in poor health in retirement, but it can also be costly.  While much of this may be out of our control due to genetics, having a healthy diet and engaging in reasonable exercise can boost general health. 

 Saving (Tax-Advantaged):

• Pre-Tax Savings Plans—For most of us, the pre-tax retirement savings plan(401k, IRA, etc.) will provide the best tax advantage; reducing taxable income now.  This is the primary place to engage in savings until you hit your limit.  Pre-retirees should aim to put as much in this bucket as their budget can bear because once earned income stops, so does their ability to use these plans.
• Roth IRA Saving—After you have max-funded your pre-tax savings and funded an emergency fund, funding a Roth IRA would allow those assets to compound tax free.  Some people may not be able to save in a Roth due to their income tax situation.
• Tax-Sensitive Savings—Saving in taxable accounts can be different to tax-deferred funds because of the requirement to pay capital gains and income tax “as you go”.  Being tax-sensitive with individual securities sometimes makes sense, as does funding cash value life insurance or annuities.  These choices are highly dependent on the goals set forth for these savings account

 Planning (not just financially):

• Just as having a vague idea about “what you wanted to do with your life” was a decent idea as you entered the working world, having some thoughts on what you want your retirement years to look like is also a good idea.  Whether it’s travel, taking up golf, or volunteering, this will give you some idea of lifestyle, which in turn gives you some idea of income needs.  Also, giving this some serious planning will help you to time your exit from the everyday workforce with what is right for you.

As I have written before, I believe that the retirement transition years are the most important in setting yourself up for the rest of your life.  It is important to be ready to start getting ready to transition.

Within the Volatility: Viewing the Positives?

Sometimes it’s hard to stay positive about the economy as you watch investment markets jerk downwards, upwards, and generally dance with volatility over a protracted period of time.  When almost every headline & television news show tells us that we are headed to recession (based largely on a leadership vacuum in world politics), I think it is important to also look at the economic underpinnings beneath the noise as well. 

A recent research report from Bank Credit Analyst Research – one of the world’s leading providers of global investment research since 1949 – listed a number of positive economic points that are worth noting when trying to determine the direction of the economy:

Oil prices have fallen sharply over the past four months. Oil is down nearly 25% from its high in late April of $113.93. This will provide relief to consumers and, combined with a bottoming in the market when we get there, will be a nice boost to potential economic growth. 

Real bond yields have fallen to extraordinari­ly low levels. Since many home­owners can therefore refinance to take advantage of better interest rates, consum­ers may begin to cash-flow relief.  

The Chinese economy continues to grow, and policymakers there have a lot of ammunition to deal with any slowing that may appear. Ear­lier this year, the fear was that the Chinese economy was trending dangerously, as policymakers at­tempted to give the people what they want in terms of economic growth to support China’s grow­ing middle class. Recent policy action in China suggests that policymakers there are moving away from a “growth at all cost” mentality to a more sustainable growth mentality. 

Treasury yields are low, indicating global confidence in the U.S. as a safe haven, despite the recent S&P “downgrade”. Now is a perfect time to have the political debate on spending and taxes. The difficulty is that, with the 2012 election cycle upon us, answers will probably not be coming forward from our lead­ers in Washington. We are on a low budget in the U.S., but that doesn’t mean that fiscal reform has to be a destroyer of our economy. Sensible spending restraint and some tax adjust­ments can allow the U.S. econo­my to expand at a healthy pace going forward.

Stock prices and interest rates are currently so low that we do not need economic growth to justify the purchase of equities. I do not think that the stellar prof­its many companies reported for the second quarter is a surprise to anyone by now. It is also en­couraging to note that earnings per share can still grow in a low economic growth environment. Firms will likely use the earnings that they do not pay out as divi­dends to repurchase shares since it is not likely that companies will continue to sit on ever-growing cash balances if they are not in­vesting for growth. It is likely this type of earnings growth will add support to the mar­kets. 

The index of leading economic indicators (LEI) rose for a third consecutive month in July. Admittedly, an advance in Au­gust will be a bit more difficult to achieve given the recent market volatility and negative sentiment. However, Fed accommodation still allows for a steep yield curve despite some recent flattening, which should provide some lift to August LEI. Unemployment claims holding in around the 400,000 mark may support LEI, and that level is not indicative of a reces­sion.

·        On Wednesday, August 24, dura­ble goods orders blew away ex­pectations.

o       A monthly surge in new orders for motor vehicles and parts – the best in eight years – headlined a strong durable goods report for July. Another economic measure that implies that the economy may not be what it appears--or at least may not be as bad as re­ported by the talking heads.

·        The Baltic Dry Index – the index measures the price of transport­ing raw materials by sea and is often cited by economists as a bellwether of global economic activity – most recent release revealed that it is now up 21 per­cent from its recent lows. Maybe those of us who think the global economy, while slowing, has not fundamentally changed are not misfits after all. While the index certainly has its critics, in an envi­ronment where investors are be­ginning to price in a global reces­sion, the increase in the Baltic Dry Index is one piece that calls that view into question.

      ·       Unemployment claims holding in around the 400,000 mark may support LEI, and that  

           level  is not indicative of a reces­sion. 

While there are certainly some fundamental issues that need to be addressed in the economy (particularly the level of government debt in Developed countries), not all news is bad news either.