Making Cents

The Decade in Review

Posted by ICMC Staff on 28 January 2010 | 0 Comments

Tags: Lost Decade, Investing, Financial Planning, Economic, Commodities

A turbulent ten years. The 2000s gave us remarkable opportunity and remarkable volatility. They tested our patience, and many investment strategies. They taught us to hold on, hang in there and diversify.

Stocks. Was it really a “lost decade”? It depends on how you were invested. Yes, the Dow ended the 1990s at 11,497.12 and ended the 2000s at 10,428.05, amounting to a 9.30% slip. The S&P 500 lost 24.10% in the same interval. If you had invested a lump sum into an index fund tracking the S&P 500 on December 31, 1999 and left those assets untouched for ten years, you would have ended up with a sizable loss.(source)(source)

Well, that sounds dismal - but how many of us actually invest this way? Very few of us make one lump sum investment and just watch it for ten years. Thanks to diversification, rebalancing and constant inflows of new money, quite a few investors were able to grow their assets and/or outperform the S&P 500 in the past decade.

The fact is, five sectors of the S&P 500 gained 10% or more across the 2000s – health care (+10.85%), utilities (+10.92%), materials (+24.91%), consumer staples (+31.84%) and energy (+102.12%).(source)

Few articles about the “lost decade” mention this notable factoid: the Russell 2000 advanced 23.90% during the 2000s.(source) Mutual funds that focused on buying undervalued small-company stocks gained an average of 8.3% annually in the 2000s.(source)

Outside America, developing stock markets shattered all expectations while the developed markets mirrored American performance. Look at the decade-long gains in key indices in some of the BRIC nations, as measured by CNBC.com: China, +72%; India, +249%; Brazil, +301%; Russia, +863%. Compare those gains with the benchmark indices in Japan (-44%), France (-34%), Great Britain (-22%) and Germany (-14%) in the past decade.(source) Emerging market mutual funds gained an average of 9.3% per year in the last ten years.(source)

Commodities. It was a decade of amazing gains in the broad commodities market. From the end of 1999 to the end of 2009, gold advanced 278.52%. How about silver and copper? Silver gained 208.91% and king copper rose 287.78%. Crude oil rose 210.00% during the 2000s.(source)

How great a decade was it for the commodities sector? Only one notable commodity posted a ten-year loss from 12/31/1999 to 12/31/2009. That was palladium, which retreated 8.98%. On the other hand, we know that 16 commodities gained 100% or more across the decade.(source)

The two biggest gainers during the 2000s were a pair of crops: sugar (+340.36%) and cocoa (+293.31%).(source)

Highs and lows. We are 10 years past the bursting of the tech bubble – March 10 will mark the 10th anniversary of the NASDAQ’s all-time high of 5,132.50.5 And of course, a decade-defining geopolitical event rocked the markets 18 months later.

General Motors and Chrysler filed for bankruptcy protection in 2009; at the start of the decade, so did Enron - the company that Fortune Magazine ranked as “most innovative” each year from 1995-2000.(source) In 2008, Lehman Brothers, Morgan Stanley, Goldman Sachs, Merrill Lynch, and Washington Mutual either folded, mutated, or were bought up while AIG, Freddie Mac and Fannie Mae were bailed out.

The Dow hit a new high of 11,723 in January 2000, a post-9/11 closing low of 7,286 in October 2002, and then ended 2003 at 10,453 (as the DJIA gained 25.32% that year while the dollar lost 14.67%). The Dow hit new peaks of 11,727 on October 3, 2006 and 14,164 on October 9, 2007. A close of 11,215 on July 2, 2008 officially marked the start of a bear market.(source)

From March 9, 2009 closing lows to the end of the year, the Dow shot up 59.28% and the S&P 500 advanced 64.83%.(source) This led to some to entertain tantalizing thoughts about the birth of a new bull market. Or it is simply a cyclical bull in a secular bear? The jury is still out, as the saying goes; we can hope for the best.

What did we learn? The 2000s taught us lessons about irrational exuberance (companies that had never made a dime were probably not worth billions) and lessons about the value of diversifying your portfolio. We also learned lessons in perseverance – those who stayed invested have seen their portfolios make a strong recovery.

The 2000s put investors through some seemingly unimaginable financial headlines. It was a rare decade, an aberrant one in stock market history – for example, the Dow hadn’t had a negative decade since the 1930s, and it had advanced 228.25% over the 1980s and 317.59% for the 1990s.(source) Will we see it make a double- or triple-digit advance in the next ten years? We don’t know. Past performance is no indicator of future success. Yet the awesome potential of the stock market should not be dismissed – and with economies healing the world over, it is clearly time to look forward and stay invested.

0 comments | Read the full post

Managing Inflation Risk

Posted by Curtis A. Smith, CFP® on 22 January 2010 | 0 Comments

Tags: Inflation, Hedging, Total Return Strategies, TIPS, commodities, financial planning, investing, core series, economic

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This blog post explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.

As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.

Hedging vs. Total Return Strategies

Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return outpacing inflation over time.

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.

In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.

To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:

Stocks

Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year. (see end notes) To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.

Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income (Bonds)

Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.

Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

Treasury Inflation-Protected Securities (TIPS)

Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.

However, keep in mind TIPS prices have also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.

Commodities

Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.

Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary

While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

•    Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.

•    Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.

•    Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.

Complimentary related commentary include this Money Cents Newsletter article:
 
Managing Asset Allocation in Your Investment Portfolio 
 
Endnotes
Real return calculation:  (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.

Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.

The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.

Diversification neither assures a profit nor guarantees against loss in a declining market.

0 comments | Read the full post

2009: The Financial Year in Review

Posted by Curtis A. Smith, CFP® on 13 January 2010 | 1 Comments

Tags: economic, federal reserve, foreign markets, commodities, investing, inflation, quarterly update,

The year in brief. The market improved; the economy improved. The doomsayers with visions of “Dow 4,000” were disproven. The Great Recession in all probability ended. Unemployment reached  and remains at 10%, and major automakers went bankrupt, reorganized and shed brands. Stocks went on a nine-month rally of historical proportions. Major healthcare reform made its way through Congress. It was a hard year for Main Street but a gratifying year for Wall Street.

1 comments | Read the full post

Why Choose A Credit Union?

Posted by ICMC Staff on 8 January 2010 | 0 Comments

Tags: Credit Union, NCUA, ATM, Banking, Car Loans

Why do people choose a credit union over a bank? It isn’t just a matter of one’s profession or union encouraging the choice – though that certainly plays a role. People like credit unions for other compelling reasons.

A fundamental (and philosophical) difference. Credit unions are not-for-profit organizations owned by their members; retail and business banks are for-profit private enterprises. A bank seeks to maximize earnings as it serves its customers. The more income it can derive from you, the better for its future. Banks have to answer to shareholders. Credit unions must ultimately answer to members.

Credit unions commonly use profits to fund reserves. Excess earnings may be indirectly returned to members – they can translate into reduced loan rates, higher interest rates on savings accounts (which are called share accounts), and lower fees. Some CUs have even sent members bonus checks.

A chance to potentially save money over time. Money which banks might charge you, that is. Checking accounts are free at most credit unions. In most cases, a checking account at a CU requires no minimum balance, and there are no per-check fees or overdraft fees. Historically, most credit unions haven’t returned cancelled checks to their members – mostly because of the expense. However, many CUs provide them at request.

What about ATMs? Well, there are more than you might think. Many credit unions belong to the CO-OP Network, a credit-union only ATM network with more than 28,000 ATMs in America. Credit Union 24, a member-owned, full-service ATM cooperative, helps CUs offer their members more than 100,000 ATMs and more than 50,000 surcharge-free ATMs.(source)(source)

If you need to get a loan to buy a car or some other major item, the person on the other side of the desk may quickly ask you if you belong to a credit union. There’s a reason for that: loan rates at CUs are often better than those at banks.

Are your assets federally insured at a credit union? Yes, in almost all cases. Just as almost all banks are FDIC-insured, about 98% of credit unions are federally insured through the National Credit Union Share Insurance Fund, administered by the National Credit Union Administration (NCUA). No member of a federally insured credit union has lost a cent of their insured credit union savings in the NCUA’s history. (source)

A share account at a federally insured credit union is insured up to $250,000 through the end of 2013 as a result of the Emergency Economic Stabilization Act of 2008, the same level of insurance that the FDIC affords bank accounts.(source)

Credit unions may not be as numerous as banks, but these are some of the reasons why their members prefer them. If you have eligibility to join a credit union, it is worth seeing what that credit union can do for you and comparing the potential long-term savings of a credit union relationship against a bank relationship.

Please feel free to forward this article to family, friends or colleagues.
If you would like us to add them to our list, please reply with their address
and we will contact them and ask for their permission to be added.

0 comments | Read the full post

Positive Financial New Year's Resolutions

Posted by Curtis A. Smith, CFP® on 7 January 2010 | 0 Comments

Tags: Non-Mortgage Debt, Credit Card, Asset Allocation, Roth IRA, New Year's Resolutions

Okay. It’s that time of year - the time for New Year’s resolutions. They can include financial resolutions. Here are some possibilities for 2010.

Control non-mortgage debt. Experian says the average American carries about $17,000 in debt unrelated to home loans. Too much of this is simply credit card debt. So how about paying down, paying off and maybe getting rid of some cards?(source) How much financial ground can you lose to plastic? Well, if you have a credit card with a $17,000 balance and 10% APR and you pay $200 monthly on it, it will take you 12 years to pay it off.(source)

You may have so-called “good debts” as a consequence of your business or your professional career. Yet ultimately, debt is debt. You can certainly plan to build wealth and control debt at the same time, and why not plan to do both?

Play catch-up if you’re older than 50. All of us over 50 have the chance to make a catch-up contribution to our IRAs and 401(k)s. If you have a 401(k), you can defer up to $22,000 of your 2010 salary into it if you’re over 50 (an extra $5,500 above the usual limit). You also have the chance to contribute an extra $1,000 to your IRA (or among multiple IRAs if you have more than one). And if you’ve got an IRA, there’s no point in waiting until April 15, 2011 to make your 2010 contribution – if you wait that long, you’ll potentially lose 15 months of interest.(source)

Look into the possibility of a Roth IRA conversion. 2010 presents investors with a prime opportunity to convert traditional IRAs into Roths. The IRS has removed the income limitations on Roth conversions this year, and it will let you spread the taxes due on a 2010 Roth conversion across 2011 and 2012. However, you should definitely talk to a fiduciary fee-only financial planner or tax professional before you make this move. Review this newsletter post on our website for additonal information. As income tax rates could be raised for 2011 or 2012, you may want to take the tax hit on a Roth conversion in 2010 instead.(source)

Keep important documents where you can access them. Tax returns, wills, trust documents, deeds, insurance policies – you don’t want to have to hunt for this stuff, and neither should your heirs in a crisis. You may not want to keep these documents out in the open, but you should know where they are. Resolve to put them all together in a central place in 2010. Another option: you may want to store copies online. Some financial advisors offer their clients firewall-protected, password-only “web vaults” for this purpose, so you can take a look at these items away from home if needed.

Understand how your portfolio assets are allocated. A new FINRA survey finds that 79% of Americans regularly contribute to retirement savings plans. That’s the good news. The bad news? About a fifth of those people had no idea how those assets were invested.(source) Review this article on the firm's website about allocated 401k assets. 

When stocks do well, it is easy to become less vigilant about your investments. It is also easy for your portfolio to get out of whack and become overweighted in this or that asset class. So the first part of 2010 is a very good time to check in with your fiduciary fee-only financial planner. After all the volatility in the market the last couple of years, it is prudent to review your investments and see if your portfolio needs rebalancing to bring it back in line with your risk tolerance and investment horizon.

More people abide by financial resolutions than you might think. In late 2009, Fidelity surveyed a group of about 1,000 Americans and found that 60% of them had kept financial resolutions they made at the start of the year.(source) So it can be done. Resolve to change your financial habits for the better – and follow through on it.

0 comments | Read the full post

Fourth Quarter 2009 Economic Update

Posted by ICMC Staff on 6 January 2010 | 0 Comments

Tags: Economic, Commodities, Financial Planning, Foreign markets, Investing, Quarterly Update

The quarter in brief. The rally continued, the economy showed definite signs of improvement, and the biggest health care reform in decades inched toward reality. Stocks upwardly appreciated, with the S&P 500 rising 5.49% for the quarter.(source) Commodities experienced even higher gains. A wave of buyers rushing to take advantage of federal credits helped the real estate market. World economies were growing healthier.

Domestic economic health. Let’s look back at some key economic indicators during the quarter. Consumer spending, for one. Personal spending rose 0.6% in October and 0.5% in November; personal incomes rose 0.3% for October and 0.4% for November.(source) The jobless rate climbed to 10.2% for October, then declined to 10.0% with only 11,000 jobs lost in November, the tiniest payroll decline since the start of the recession.(source) Remember, the consumer is 70% of the economy, and it will be interesting to see if there really was a Christmas spending spree this year. This is doubtful, as consumers remain nervous about government spending and taxation legislation Congress may soon enact.

The key U.S. manufacturing index (the ISM) went 55.7, 53.6 and 55.9 across October, November and December – victories three, four and five, if you will, in a five-month winning streak.(source) Its sibling, the ISM service sector index, went from 50.6 in October to 48.7 for November (the new orders gauge came in at 55.6 and 55.1 those successive months).(source) Durable goods orders rebounded from a 0.6% decline in October to a 0.2% gain the ensuing month.(source)

The Consumer Price Index rose 0.3% in October and advanced 0.4% for November. For November, there was actually a year-over-year rise in CPI (+1.8%). PPI rose shockingly in November (+1.8%) after a 0.3% gain the previous month; the shock was mostly due to a 6.9% month-over-month jump in the price of energy goods.

The Federal Reserve kept interest rates at record lows while dropping occasional hints that rates might necessarily rise in coming quarters. After much contention, the House and Senate passed differing versions of health care reform legislation, with the bills yet to be reconciled as 2009 drew to a close.

Major indexes. The fourth quarter of 2009 was not as amazing for the market as the preceding quarter, but we’ll take it just the same. The fourth quarter brought a big descent in the CBOE VIX (the “fear index” fell 14.92%). With a strong concluding quarter, the Dow gained 59.28% from the March 9 close to the end of the year. The S&P 500 and NASDAQ respectively gained 64.83% and 78.87% in the same time frame.(source) Does it feel like a great year? These returns are amazing considering the collective mood of the country currently.

%Change	4QTR2009	3QTR2009	YTD 2009
Dow Jones	+7.37%	+14.98%	+18.82%
NASDAQ	+6.91%	+15.66%	+43.89%
S&P 500	+5.49%	+14.98%	+23.45%
10 YR TIPS	-5.13%	-12.36%	-30.84%

Global economic health. The data suggests a global recovery is in full swing, with Asia’s economies leading the way. By December, manufacturing indices in China, South Korea, India and Taiwan all showed growth (though Australia’s actually showed contraction).(source) The PMIs in Europe followed suit. The Eurozone PMI was 51.2 in November and 51.6 in December. PMIs in Germany, Italy, England and France were all above 50 for December, with France’s index the highest at 54.7. At the quarter’s end, manufacturing in the U.K. was growing at the fastest rate in two years.(source)

The IMF and the OECD respectively predict 3.1% and 3.4% growth for the global economy in 2010, with the bulk of emerging and developing economies heating up to 5% growth or better. In this quarter, we learned that China’s economy grew 9.0% in 3Q 2009 as India’s economy grew 7.9%.(source)

World financial markets. Investors cheered worldwide as stock indices made further impressive gains. Would you have guessed the Nikkei 225 would have climbed 4.08% in the fourth quarter? It did, and that index climbed 19.04% in 2009 – its first positive year since 2006. Hong Kong’s Hang Seng gained 4.38% in 4Q 2009, and the Shanghai Composite advanced 17.91%. The U.K. FTSE 100 rose 5.43%.(source) The MSCI World Index rose 4.11% in the quarter. The MSCI Emerging Markets Index rose 6.88%.(source)

Commodities markets. The hottest commodity of this quarter was orange juice: prices rose 41.04% in three months. Palladium prices rose 36.65%. Corn prices were up 20.49%. Many other commodities gained between 10-20% last quarter: sugar (+11.73%), copper (+18.71%), platinum (+13.54%), crude oil (+12.39%), heating oil (+17.97%), oats (+18.88%), natural gas (+15.10%), milk (+19.08%), wheat (+18.36%), gasoline (+15.15%) and diesel fuel (+13.63%). In fact, only two widely traded commodities went negative during the fourth quarter: coal (-4.64%) and cattle (-0.39%). Gold? Silver? Well, gold was +8.61% for the quarter and silver was +1.12%. Gold finished the quarter at $1096.20 per ounce. The U.S. Dollar Index gained 1.70% last quarter.(source)

Housing & interest rates. New home sales were down 11.3% for November after rising (a greatly revised) 1.8% for October; the numbers are up and down because first-time buyers thought federal housing credits geared to help them would expire this fall. Existing home sales rose (a revised) 9.9% for October and 7.4% for November.(source)(source) Pending home sales, which had risen for nine straight months, raised eyebrows by slipping 16.0% in December.(source) Housing starts reversed, diving 10.1% for October but rising 8.9% a month later.(source)

Mortgage rates of 30-year FRMs touched record lows but eventually climbed above 5% again. From the last 3Q Freddie Mac survey to the last 4Q Freddie Mac survey, the average interest rate on a 30-year FRM went from 5.04% to 5.14%. Across the quarter, averages on 15-year FRMs inched north from 4.46% to 4.54%. However, averages on 5-year ARMs moved south from 4.51% to 4.44%, and rates on 1-year ARMs went from 4.52% on September 24 to 4.33% on December 31.(source)

1st quarter outlook. For the first time in a long time, good news is nice to hear. Many analysts thinkwe are just two or three quarters into a U-shaped recovery that will play itself out across the next few years. Of course, there are concerns to watch: how the Fed and the Obama administration choose to wind down the stimulus effort, when and how the Fed finally makes a move with interest rates, and the indicators in the housing market. But barring a major geopolitical or economic event, much of the optimism (and federal support for the economy) will likely be sustained through the coming quarter and perhaps the next two. The Great Recession is slowly becoming a memory, and a classic “January effect” may kick off further upward movement on the major stock indexes. 

Please feel free to forward this article to family, friends or colleagues.
If you would like us to add them to our list, please reply with their address
and we will contact them and ask for their permission to be added.

0 comments | Read the full post