Time to stand back and reassess

With the market falling off five percent after a thirty-seven percent surge, we ought to be wondering:  “What’s going on?”  For the optimists, this is basically a bull market taking a breather.  For pessimists, the rise of the last eight weeks was just another “dead cat bounce” of a market doomed to reflect lower corporate profits — sooner or later.

The “Me Generation” should be asking what either of the above answers means from an individual strategy standpoint.  To the well-balanced investor, the answer to the question should be “both of the above. “  It shouldn’t matter.   If you aren’t well-balanced, at least from a financial standpoint, today’s market level might be offering a window of opportunity to do some course correcting.

What we have just experienced is the strongest market rise since the 41 percent rise during a similar time period back in 1933.  Anyone who has stayed the course and ridden the market down to its March 9th bottom has now recovered at least some of what has been lost over the past few years.  It would have been foolish to sell at the bottom, and you didn’t, but now you find yourself thinking that it’s nice to be back — at least part way.  However, you’re also probably thinking, “I’m too old for this.”

A market recovery sets the stage for some investment course-correcting.  The past eight weeks have lifted us out of the catatonic state brought on by the stock market’s perilous journey.  We can think a little more clearly now that we have seen history repeat itself.  We know intellectually, that a plunging market will be followed by an equivalent upward snap, but there is always that nagging suspicion that maybe “this time, it’s different.”

Because this past downdraft was precipitated by a deleveraging of the financial markets, all stock of virtually all types of companies was affected.  True, some industries like automobiles were hit harder than others, but this was not a typical market decline with more pronounced losses in just one or two major sectors.  For a more common version of a crash, the dot-com boom comes to mind, and before that was the plunge in the ‘70’s of the “nifty fifty” (Xerox, IBM, Litton, etc.)  This time out, it was a deleveraging of the financial sector that brought everyone down with it.  It wasn’t funny at the time, but it amuses me now to watch an industry that limits its customers to borrowing only 50 percent of what they invest in stocks.  Anything more would be too risky.  Meanwhile, in 2004, the same industry  succeeded with the deregulation that allowed it to borrow 97 percent of what they invested, and that ridiculous thirty-to-one leverage did them in. 

Going forward, it could make sense to rearrange the deckchairs in the stock portion of a portfolio so we could relax a little more if those nattering nabobs of negatism turn out to be right.  A higher proportion of money in bonds could help protect against a further downdraft, but the question becomes, “What kind of bonds and how much?”

While it may sound blasphemous, I like the possibilities presented by high-yield corporate bonds which have lost about twenty percent of their value based on current high-yield mutual fund price performance, but they still own the underlying bonds that they can hold to maturity, and the yield at the moment is about 8-13 percent depending upon the fund.  Most of the more conservative of these funds, like Vanguard’s for example, have low fees and very few actual defaults.  The current reduced share price means that steady interest payments amount to a relatively high annual percentage return which is referred to as the yield.  Bill Gross, the bond guru running PIMCO, recommends high quality (as opposed to high yield) corporate bonds, but we would expect him to say that.  The important consideration is that these high yield corporate funds involve some short-term (as in seven -year) capital risk but they deliver immediate gratification in the form of reinvested dividends at a rate that is not that far below Bernie Madoff’s one percent per month.      

The sweet spot for bonds is to occupy one-third of a portfolio.  This is the point at which they reduce the downside of a stock market crash by about one-third while only penalizing the potential upside by one percent.  In other words, if an all-stock portfolio is expected to gain at a rate of 10 percent per year, having one-third in bonds will reduce that expectation to an annual 9 percent.  However, if the market drops by 17 percent, that bond component will reduce the overall loss to just 12 percent.  A higher percentage of bonds offers more protection, but at a much higher earnings penalty.

So, here we are with an opportunity to take breather and think rationally for a moment.  Even if we decide to do nothing, that should be the consequence of an informed decision.  The biggest obstacle is what behavioral economists have termed, “the status quo bias” — otherwise known as “shoulda, coulda, woulda.”

Dividends, buy-backs key elements

Some readers tell me they sleep at the end of their driveways on Sunday nights so they don’t waste a minute getting to my column early Monday morning. My friend, Mike Doyle, says that if he ever detects a hint of pessimism on my part, he wants to know as soon as possible so he can bail out of the markets and sell short to beat the crowd.

Shouldering this level of responsibility, I spent four hours last week listening to economist Alan Beaulieu who, based on his past track record, is remarkably prescient when it comes to offering a glimpse into our economic futures. He points out the fallacy of consumer sentiment, for example, by pointing out that when people are at their gloomiest, almost all other economic indicators rise. The stock market’s last eight weeks offer a good example of that counterintuitive disconnect. The only economic statistic that tracks consumer sentiment is the sale of used boats.

Beaulieu had some depressing news for us as he said that we are heading for a long grinding road to economic recovery and that the stock market would not rise to its September 2007 high water mark until the year 2020. Now then, on the surface that would strike some people as being really depressing news. Not me. I actually just bought a used 1967 boat. Moreover, simple analysis indicates that a long, dry period could be terrific for long-term buy and hold investors who are dollar-cost-averaging with steady contributions into retirement plans. The best thing that could happen to us over the next 10 years would be to contribute with despair into mutual funds that go nowhere quarter after quarter and that then finally double in value starting in about 2018 — exactly what happened at the end of the 1990s.

Peering under the hood of a market that goes nowhere, we can see a far more promising story if we consider the dividends and stock buybacks that are sure to be reinvested during that 10-year period.

Those quarterly statements reflecting reinvested earnings will tell an entirely different story than persistent headlines that keep comparing an in-the-tank Dow Jones average with that fondly-remembered 14,600 Dow of Sept. 31st 2007 — that quarterly statement we wish we’d framed.

This month’s AAII Journal (American Association of Individual Investors) points out the extent to which dividend-paying companies actually grow faster than the so-called growth companies that reinvest all profits. Enough convincing research now makes the case that the companies with strong dividend payout rates are actually the ones whose stock appreciates the most over the years. Setting aside the early wonders like Microsoft and Oracle, most mature companies struggling to maintain growth by avoiding dividends just don’t rise as much as value stocks over time.

Dividend payout rates for the S&P 500 were averaging about 3.7% a few months ago when share prices were at rock bottom. With a 37% rise in share values, those payout rates will have been reduced to just under 3%, assuming the dividends per share remain the same — which most do.

Besides dividends, however, are stock buybacks. In the years from 2005 through 2007, the largest 500 companies bought $2 worth of their own stock for every dividend dollar they paid out. When a company buys back its stock from the public and retires that stock, all of the remaining stockholders just received an increase in the value of the stock that remains. Why? Because the entire company and its profits are now split between fewer shares of stock. In a simple example, if five partners in a business use company profits to buy out one of the partners, the remaining four owners go from owning a 20 percent share to owning a 25 percent share — a 25 percent increase in their ownership — otherwise known as “profit.” This is how many public companies have elected to spend their profits rather than paying the money out in dividends.

Going forward, if the total earnings between dividends and buybacks adds up to 6 percent total per year — as was the case from 2005 through 2007, then $1,000 invested today will compound to $2,000 by around 2020 even if the market itself remains flat. If our current, depressed stock market actually returns to 2007 values because of a healthier economy and higher price earnings ratios, what will then be $2,000 will double to $4,000.

The lesson is to remember that companies still make money regardless of their stock prices. Staying invested and capitalizing on reinvested earnings — both dividends and stock buybacks — will always be rewarding. For entertainment, we can just sit back and watch the market do its thing.

True family wealth can’t be counted

It was a busy week in Florida. I attended my son’s graduation from veterinary school, met my engaged daughter’s future in-laws for the first time and celebrated my dad’s 93rd birthday with a family dinner that included our three generations. Along the way, I managed to plow through the book “Wealth in Families” by Charles W. Collier.

The purpose of the book is to offer advice on how to handle money and estate planning issues when families have sizable estates to pass on to future generations. Fortunately, that’s one problem I don’t have. My interest in the book was purely academic. However, there were some kernels of wisdom that would apply to any family and to an estate of any size, however modest.

Real family wealth, we should be pleased to hear, has little to do with money. The true assets of a family consist of the values and the shared dream of what they want to accomplish over the years. As a really wealthy friend of mine once put it, “the only real security anyone can enjoy in life comes from the ability to do something and do it really well.”

Most parents want their children “to be happy.” But what does this mean? In fact, the book points out that in the end what we all care most about is much deeper than financial wealth. “To be really rich is to be rich in achievement, rich in experience, and rich in friendship.”

This book is full of ideas about how to handle the issue of money within a family, but a few of the basics are as follows: 1.) focus on the human, intellectual and social capital of family members. I take that to mean reading to your kids and making sure they do their homework and have extra-curricular activities no matter how much money you have. 2.) Work on improving intra-family communication, 3.) Tell and retell the family’s important stories, 4.) Give younger family members as much responsibility as they can mange as soon as possible.

When it comes to actually distributing money, a general rule of thumb is to not do too much gifting until children or grandchildren are in their late thirties — established in life as a result of their own accomplishments. Paying for education would be an exception to the rule.

The key question is how to train children to handle money beginning at early ages. High-achieving parents can find that the skills they use in business, such as insistence on perfection and maintaining a sense of control, don’t translate into useful lessons for children when it comes to teaching responsibility around money.

“No Corvette unless you have at least a B plus in Chemistry” is hardly instructional. Children from 13 to 18 should have summer jobs, a budget, a tax return, a lesson in consumerism and credit cards, a few investments and some giving to charity. For college students, insist on summer employment, living on a budget and getting some advisor-facilitated learning about investments.

Estate taxes are largely voluntary. While they have temporarily disappeared anyway in a misguided attempt to do away with them completely, they will now return in 2011 in what is termed the “Throw-Mama-from-the-train” act. They will be returning only for larger estates, but many Americans who own houses free and clear as well as retirement accounts and other assets will be wrestling with estate tax concerns that have not been a factor for the last several years.

Gifting programs dramatically reduce what you might someday owe the government, and giving assets to charities while retaining an income interest for life can actually increase retirement income. Family foundations, thought to be only in the province of the super rich, may become far more prevalent for what would be considered as relatively small estates.

It’s reassuring to know that when it comes to handling money in a family, there is no shortage of good information available. Thanks to many books on the subject, there is no need to reinvent the wheel. Fortune magazine once speculated that the transfer of wealth accumulated by the “Great Generation” was in the trillions, but our new president is floating the idea that the first $3 million for any family will be estate-tax free. Whew. This means that most of us will dodge that estate tax bullet, leaving us with more planning time to focus on the non-financial expressions of true family wealth.

We’ve been through this before

What a great time to be old.  My father just celebrated his 93rd birthday and passed his driver’s license test that was required this year.  At Florida’s senior-friendly DMV, they checked his eyesight, took a fresh picture, and told him not to come back until age 99.  Of today’s 75,000 Americans who are over age 100, one-third of them are still driving.

Most of this same generation grew up during the depression, so the shock of today’s economic crisis probably strikes a responsive chord and brings back memories of childhood hardships.   The financial press keeps playing on these fears by pointing out that this recession has surpassed that of the Reagan era recession and is closing in on the 1930’s record.  Well, our octogenarians lived through it before, and they can teach us how to do it again.  We can all learn a lot from a generation that learned early on how to be “tight with the nickel. “

“This time it’s different,” of course, because we have a social safety net that never existed in the thirties, but what people also experienced back then was not as bad as some of the statistics indicate.  Mark Hulbert, in the New York Times, points out that while the stock market took twenty-five years, technically speaking, to return to its high of 1929, the actual market investor was whole again in just four years.  Talk to old people today who lived through that period, and you learn that life was not so bad.  Hulbert explains why, and we can expect a repeat of these same positive conditions as we muddle through this recession.

He starts with a discussion of deflation.  The consumer price index dropped 18 percent from 1929 to 1936, and the stock market dollar level never reflected that adjustment.  We see this today if we ignore official Consumer Price Index (CPI) figures and just look at the reduced prices of some of what we want to buy.  Starting with houses, the cost has dropped by almost half in some parts of the country.  Florida offers an elephant graveyard of used RV’s in great shape for next to no money.  Cars, new and used, have dropped in price substantially.  A lot of discretionary spending, even on basics like food, can be reduced dramatically.

Dividends were the next major factor contributing to economic well-being.  At the bottom of the market, dividends in the 1930’s were as high as 14 percent per year, and none of the statistics comparing market levels ever includes reinvested, compounded dividends. Today’s dividend rate is almost 4 percent on the S&P 500 index and that’s almost four times the average dividend over the past thirty years.   Reinvested dividends contribute twenty-five percent of any stock investor’s success over time.

Adjustments in the companies making up the Dow Jones Average caused a major distortion in those calculations as to when the market had returned to its 1929 high.  Removing IBM, for example, which then made huge gains in the forties, would have changed everything for the better. 

The conclusion is that the market is like Yogi Berra’s old restaurant — “it’s so popular, nobody ever goes there anymore.”  Those of us who make up what’s called “patient money” still find the food on Wall Street to be quite nutritious — and a good value — like Oatmeal.  The people who “don’t go there anymore” are sitting on the sidelines with their $9 trillion in cash.  At an amount equal to roughly 15 percent of the total value of the S&P 500 index, it is twice the 7 percent that it represented at the bottom of the last bear market.   When those picky eaters finally decide to gorge on stocks, they will all belly up to the feeding trough at once, and values will go through the roof.

Meanwhile, the average recovery time for bear markets is more like two years, and small company stocks generally lead those recoveries.   Considering the recent news that we hack into the computer systems of the Taliban to detect their troop movements, we can conclude that a global technology boom has gained a foothold with a long way to go and that investments outside the U.S. may offer some of the better returns in future years.  After all, while our rust belt struggles, how bad can the world be when the Chinese are still growing at 10 percent?  

Throughout the 1930’s, the Great Generation managed to hang in there.  Businesses like GM consolidated, the market in real terms rebounded and the financial system adopted constructive regulations.  Hearing first-hand accounts of life in those days leaves me feeling reassured — that we’ve been through this before and it turned out fine.