Stocks are Dead; Long live Stocks!

The S&P 500 is setting multiyear highs right now. It’s the economy right? Not really, the U.S. economy grew 1.7 percent in the second quarter, creating about 140,000 jobs a month on average this year. That is less than half of the monthly hires needed to bring the unemployment rate back to pre-crisis levels by 2015. Well then, it’s due to our government averting the so-called fiscal cliff—the spending cuts and tax hikes that could stall the economy next year. Not so fasr, our government has not addressed that issue yet – hey, they still have 100 days. Europe’s financial crisis is resolved! That’s not it, Europe’s problems, while getting better, remain unresolved.

So how is it that the Standard & Poor’s 500-stock index is up 25 percent over the past 12 months? Stocks have reached levels not seen since Lehman Brothers and Bear Stearns existed.

Over the long term, through all the noise, stock prices actually move relative to corporate earnings. S&P 500 profits estimates (Bloomberg) suggest earnings growth of 11 percent next year, and 12 percent in 2014; this may send the S&P 500 to record levels if earnings come in at or near expected.
Corporate America is lean and mean - think of great comapnies like Apple and Wells Fargo. We are also counting on help from the Federal Reserve, which is widely expected to start a third round of bond purchases to boost the economy.

With that said, the threats to the market remain (actually they never quite go away). Chief among them is the fiscal cliff. Under a law passed last year the failure of lawmakers to agree on some combination of spending cuts and tax increases would result in $1.2 trillion of automatic cuts and accompanying tax hikes in January 2013. That combination could shave 2.9 percent off economic activity in the first half of 2013, according to the Congressional Budget Office. While many economists believe the impact to be good for the economy long-term, in the short-term the market would likely hiccup, frankly creating a chance to buy on the dips.

Europe also remains a potent threat, Greece has yet to ratify the spending cuts necessary to receive life saving bailout funds and there is no guarantee that Spain, which is suffering through an economic depression, will agree to more austerity in exchange for the European Central Bank’s financial aid.

Individual investors could also decide to get with the program. While prudent managers have been suggesting to add equities to portfolios where appropriate, do it yourself investors have pulled money from U.S. equity mutual funds for a fifth straight year in 2011, moving $75 billion out of stocks this year alone. If these dollars come back to stocks it could raise stock prices even further – as individual investors usually buy high.

As always, talk things over with an accreditied investment manager or financial planner to see what proportion of high-quality equities make sense for you.

CBlakely CFP®, CTFA     Sept. 2012

Sources: Bloomberg LP.

The Financial Problem of Living Too Long - Solved!

If you are one of the 10,000 baby boomers retiring today (or in the next several years) then this post may be of some interest to you because for many, traditional asset allocation is inadequate at confronting retirement risk. Let me explain.

Trying to rebuild a retirement portfolio in a low return investment landscape has many challenges. Importantly there are two risks that really have taken center stage, investment-performance risk and longevity risk. Equity market returns have been lousy for about a decade, prompting new phrases into our vernacular such as, “the new normal” and “stocks suck.” Over the last generation life spans have increased to the point that the fastest growing segment of Americans is the over 100 age group – aka the Willard Scott gang. The odds of at least one spouse reaching the age of 86 is 25 percent.

Since the great recession of 2008 income losses for those nearing retirement, specifically households led by people between the ages of 55 and 64 have taken the biggest hit, a decline of 9.7 percent. During retirement, the income flowing from a portfolio made up of stocks and bonds is sensitive to market fluctuations.  This can significantly increase an investor’s longevity risk, or outliving one’s assets.

Creating a portfolio that confronts and diminishes these risks requires adding longevity insurance into the mix. Yep, you guessed it, I’m talking about annuities.  But wait, Ibbotson Associates research shows that investors can mitigate both longevity and investment performance risks with a carefully constructed combination of a guaranteed income stream and traditional assets such as mutual funds and ETF’s.

Annuities can be expensive (guarantees normally cost more) and hard to understand. Determining how and when to use them can be confusing too which is why few investments are as polarizing, but it is wise to set aside preconceived notions in response to this current challenging environment.  Many retirees should consider ways to turn a portion of their portfolio into pension- like income streams.

A fairly recent innovation in deferred variable annuity (VA) products is the guaranteed minimum withdrawal benefit (GMWB) rider. The GMWB rider for life gives you the ability to protect your retirement investments against downside market risk by allowing you the right to withdraw a fixed percentage of the benefit base each year until death. The benefit base can step up and resets to the high-water mark of the contract value on the rider anniversary date when the market has performed well. The remaining contract value at death will be paid to your beneficiaries, which removes concern about giving up liquidity to your heirs (i.e. if I die early, my family loses).

After deciding whether longevity insurance has a place in your retirement portfolio the next challenge is how much to allocate to this product versus traditional assets. The easiest way is for your advisor to follow up the strategic asset-allocation decision with a secondary “product-type” optimization.  Barring that, a recent Ibbotson study using  Monte Carlo simulation based optimization to find an optimal product-type mix of traditional products and a VA+GMWB by maximizing a utility function at the life expectancy  offers helpful guidelines to product allocation. See the major findings (below):

Ø  The higher the risk tolerance, the lower the VA+GMWB allocation;

Ø  The longer the life expectancy (subjective), the higher the VA+GMWB allocation;

Ø  The higher the age, the lower the VA+GMWB allocation;

Ø  The higher the ratio between wealth and income gap, the lower the VA+GMWB allocation; and

Ø  The preference for bequest has almost no impact on the VA+GMWB allocation.

By adding products that offer guaranteed income for life to your portfolio (if appropriate) you can avoid an extreme outcome (i.e. outliving your assets) and better enjoy your retirement. But, as case studies show investors and advisors must be careful when determining which products and allocation percentages.

CBlakely CFP®, CTFA          Auggie 2012

Sources: The New York Times; Allocation to Deferred Variable Annuities with GMWB for Life, Xiong, Idzorek, Chen (Ibbotson); The Impact of Skewness and Fat Tails on the Asset Allocation Decision, Xiong, Idzorek (Financial Analysts Journal, Vol. 67 #2)