Beware the Bond Bomb

The Federal Reserve has not been kind to retirees who tend to use bank CDs and other fixed-income investments to generate income for living expenses.  By pushing interest rates down and keeping them low it has forced retirees to take more risk since they can’t live on a 0.5% or 0.05% return.  The Fed has indicated that they plan to keep rates low for at least the next year, however, so don’t expect things to get any better soon.

We are also starting to see some signs of inflation.  It is true that housing prices have been depressed, but we have seen large increases in energy and food.  Indeed, February is traditionally the lowest priced month for gasoline, and yet we are seeing it over $3.50 per gallon.  A price that would have been unheard of just six years ago.  Expect $5 gas this summer.  Meat at the grocery store is also going through the roof, and produce isn’t far behind.  Maybe we haven’t seen wages grow yet, largely because workers are perennially scared of losing their jobs, but eventually wages will need to rise because people will not be able to buy food and gas to get to work if they don’t.

Because of the low interest rates, and despite the evidence of inflation starting to grow, bond prices have shot up dramatically.  Because bonds pay a fixed interest payment and because people buy them almost exclusively for their interest payment, they are very sensitive to interest rates.  If interest rates go down, as they have recently, people bid the price of bonds up since they are willing to take a lower return because at least it is better than the return they are getting from bank CDs.  When interest rates rise, however, or when inflation increases, wiping out the earnings of bond buyers unless they get a higher interest rate, people won’t buy bonds until the price drops to a point where the interest rate is high enough to justify the risk they take. 

Bond prices are currently extremely low as people have piled into them with money that used to be parked in bank CDs.  When the Federal Reserve raises interest rates to fight inflation, or even if they don’t and decide to let inflation grow, bond prices will fall once again hurting retirees.   Interest rates might remain low, and bond prices remain high, for another year or two. The thing about bubbles is that they last for a lot longer then you think they will.  Eventually, however, all bubbles pop.  It is just a question of the trigger.

Avoiding the bond bubble will be difficult for those who are on fixed incomes.  The fact is, they need to generate income somehow, and therefore they need to accept the high prices of bonds and meager returns because they are better than the returns they can get elsewhere and they need to make a certain amount to cover expenses.  One option would be to go into dividend paying stocks such as drug companies, household product makers, and utilities, as well as REITs, in addition to bonds.  While all of these will decline in price somewhat if interest rates rise, at least there is some diversification and growth in property or business value might offset some of the loss due to interest rate increases.  Because there is something of value that will grow in price with inflation underlying these investments, equities and REITs are better inflation hedges than bonds.

A second option, for those who have enough money to do so, is to invest more in equities and use capital gains for income.  This would involve keeping a portion of investments in equities and then selling off shares of equities for income periodically.  This can be risky because the returns on equities can be unpredictable.  One really needs to have a big enough account to keep several years’  worth of expenses in cash (bank CDs) and still be investing enough to generate enough income to replenish that cash periodically.  This would allow you to hold onto equities and use some of the cash to live on when stock prices decline in a year, and then replenish the cash by selling shares in years when the markets do well.  Overall you will do much better this way than you will with bonds, even in better bond markets, but it requires a substantial amount of savings or the risk is too great.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Protecting your Savings with High Inflation Looming

Inflation is a tax upon everyone who saves.  While your money may be safely locked up in a bank vault, the actions of the Federal Reserve, which has been flooding the economy with currency, may well be slowly wiping it away.  Soon it may not be all that slow.

The Federal Reserve, which is a corporation formed by the large banks with a Chairman appointed by the President, has the ability to create ir destroy currency at will.  (Note, “currency” in this case means the number of dollars available to be spent, as opposed to wealth which can only be created when someone creates or finds something of value to another person.)  If you add up all of the cash in people’s pockets, the balances of their bank accounts and in corporate bank accounts, and the money held in the banks available for loans, it is called the “Money Supply.”  The Federal Reserve, at the stroke of a key, can add or remove money available for loans, thereby changing the Money Supply.  They can also produce money to buy things like long-term Treasury notes or mortgage-backed securities, which they have been doing for some time.  This also puts more money into the economy.

The Federal Reserve is supposed to use their power to create growth in the economy while limiting inflation.  When the Federal Reserve creates currency, it provides more funds for banks to loan which can help spur the economy, but it can also create inflation since it is increasing the number of dollars available without increasing the amount of value in the economy.  When the Federal Reserve withdrawals funds from the economy, it can slow inflation by reducing the number of dollars available, but it also reduces the amount of credit available and increases interest rates, which can cause a recession.

For a long time the Fed has been creating money in an attempt to cause the economy to pick up speed, but there has not been a big demand for loans and the banks are requiring strong credit before they will make loans.  Eventually, when the economy starts to pick up and businesses decide to expand again, all of this money could come flooding out into the economy, leading to high inflation.  We have already seen inflation in gas prices, food prices, and gold.  The lack of spending and the depressed home market has restrained prices in other areas, but this will not last forever.

One of the best ways to combat inflation is to place money in assets such as real estate and stocks.  While the value of any given piece of property will be influenced by local conditions such as the amount of crime and new businesses that are built in the area, overall the value of property will be about fixed.  This means that the price of land, in dollar terms, will increase at the rate of inflation.  This is because the things that can be produced by the land, like crops or sales, will increase in value with inflation as well.  One will also be able to charge more for rent for an apartment if people are paid more dollars.  Likewise, if a home is located on a place with a great view, people will be willing to pay more dollars for the home when they are paid more dollars at work.

Equities (stocks) are an even better inflation hedge because they will grow profits with time along with seeing the number of dollars they collect grow due to inflation.  If there is inflation, forcing businesses to pay more for goods and employees, they can raise the prices they charge.  They can also open more locations or increase the number of items they sell.  Land does not become more valuable with time (in relative dollars) unless there are changes in the local conditions.

A final hedge against inflation is to buy foreign stocks.  If the value of the dollar declines against the Euro, for example, the profits of foreign companies will increase in dollar terms, and the dividends they pay in dollars will increase.  Likewise, their price of the shares of the foreign company will increase in dollar terms.  One should spread the money over different regions when investing internationally since there can be the risk of inflation in other countries as well, along with unique risks such as government actions and political instability.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Kind of Stocks Should You Buy Now with the Fiscal Cliff Looming

Chances are very good that we will go over the “fiscal cliff,” and even if we don’t the long recession we find ourselves in will continue.  The current environment of higher taxes, more regulation (especially environmental regulation like a carbon tax), and an unpredictable environment created by unprecedented government action in the housing market, energy sector and food sectors will continue to make investors very cautious.  The effects of the new taxes imposed by the health care law and new regulations that will make hiring and keeping employees far more expensive will also have an unpredictable effect on hiring.  Fewer people working means less production of goods and wealth, fewer paychecks and less spending, which could affect a wide range of consumer companies.

This type of environment discourages investment.  Many investors may feel like selling everything and burying their wealth in a mason jar in the backyard or buying a brick of gold and a shotgun to protect it.  Such markets also provide opportunities, however, for those who are able to take advantage.

The fact is, it is very difficult to predict what the markets will do over short periods of time.  We saw a big selloff Friday when it became clear that taxes will go up next year, but we could very well see a rally next week if people figure that it may not be so bad or begin to expect for the tax increases to be reversed shortly after the new year starts.  The best strategy remains buying stock in good companies and holding them long-term.  There will be periods of great growth, periods of declines, and a lot of periods where the price of the stock stagnates.  The trouble is that it is difficult to predict when these big rallies will occur, and if you miss one or two your 20% return could be reduced to a 5% return.

Now, if you have some cash built up, or if you regularly put money away for investing and have enough to invest every few months or a couple of times per year, I wouldn’t be diving into the market right now.  I would wait for opportunities where there is a good decline in the markets that take all stocks, good and bad, down with them.  I would find a set of stocks to watch and snatch up some shares each time the price declined by 5-10% or so.  I know that I would not be buying at a bottom, but I also would know that I was not buying at a top.  I would not wait too long, however, since inflation will quickly reduce the value of cash sitting on the sidelines.  Three to six months will probably not make a lot of difference, but three to six years would.

I would also avoid buying bonds or stocks that primarily are purchased for their yield right now.  The reason is that low interest rates have caused the price of these investments to spike recently as investors look for ways to get a higher current yield with money markets paying nothing.  If inflation spikes that Federal reserve will be forced to raise interest rates.  This will make the price of these investments decline rapidly.  The fact is, unless you are investing short-term, there is a lot more opportunity in appreciation than there is in current yield.  The fact that taxes on dividends may also return to 25-40% rates soon also doesn’t make then attractive.

In the next post I’ll talk about strategies to keep your taxes low.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are You on a FIscal Relative Maximum?

In mathematics there is a concept of a relative maximum.  A relative maximum is a region in a function where the function decreases in every direction,but it is not the highest peak.  For example, if you were on top of a mountain in North Carolina, you might think that you were on the highest place on Earth since the land as far as you could see all around you sloped downward.  There are peaks in the Rockies, however, that make the highest peaks in the Appalachians seem like hills.  Then there are peaks in the Himalayas that make the Rockies seem like hills.

People tend to also find relative peaks financially.  There are many people who are on unemployment who could start working again, but think they have it better not working.  They would only make a little more, or even maybe make a bit less, if they went back to work.  They would need to pay for clothes and gas, and miss out on time with friends.  People may stay on welfare their whole lives because if they make too much money, they lose their welfare benefits.  It seems like they are stepping down in their situation.

Likewise, many people have good jobs, but spend all of their money on stuff.  They eat out a lot.  They take lavish vacations.  They have every technology device known to man and spend thousands each year on subscriptions.  They spend every dollar they have each month and then run up the credit cards to finance the rest.  They think that if they were to buy an older car, or eat in more often, or drop their cell phone plan, they would be reducing their standard of living.  They see any reduction as leaving the peak.

The thing is, there is always a decline when you leave a peak.  It is also a hard struggle to climb up to the next peak.  It is difficult to leave a job to get an advanced degree.  It is hard to leave welfare and start working for a living.  It is difficult to eat in and drive used cars when everyone around you is eating out and buying new cars every three years.

But when you do so, you find higher peaks.  You leave welfare, work your way up in a company, and suddenly are earning $80,000 per year instead of getting $20,000 per year for “free” from the government.  You leave a clerical position paying $35,000 per year, spend a couple of years in school earning nothing while you get an MBA but then land a management job paying $60,000 per year.  You move out of your parents home and suddenly need to pay for your own rent and food, but you get the freedom and sense of pride that comes from being an adult rather than a 20-something teenager.

You drive an older car, eat your lunch at your desk, cook at home most nights, and stay in an apartment for a few extra years while you save and invest.  When you are 40, however, you have a paid-for house and $500,000 in investments when all of your friends have no equity in their homes at all and $30,000 in credit card debt.  You buy a vacation home for cash while your colleagues are all wondering how they can get rid of their time shares.  You have $5000 in extra income coming in each month from investments and can send your kids to college with your cashflow while your friends kids are taking out student loans.  You have the peace of mind that you could be just fine if you lose your job, while your friends are trapped working, knowing that their lifestyle would start to come crashing down if they missed a single paycheck.

Are you really on top of the world, or are you just at a relative maximum.  Would things be better through that valley on the peaks on the other side?  Are you able to make that climb?

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

photo:  Martyn E. Jones

The Fiscal Cliff and the Debt Bomb

Much todo has been made about the Fiscal Cliff.  For those who have been in a cave for the last month, the fiscal cliff occurs at the end of the year when both the tax cuts enacted under the Bush administration in 2003 and the peanut-butter spread spending cuts enacted last summer by Congress go into effect.  This is expected to have a severe effect on the economy.

The expiration of the tax cuts mean that the tax rates will go up for everyone, since the tax rates were cut in all brackets.  There were also increases in things like the child tax credit, increases in the amounts that could be invested in IRAs, and other tax breaks that will also expire.  Probably the most important for readers of this blog is the increase in divided tax rates from 15% back to ordinary income levels.  This means that for some of the taxes on dividends will go from 15% to almost 40% – pretty tough on grandma who is living off of her investment account.

On the spending side, there are large cuts to the Defense budget.  These will hit government contractors the hardest, even though they are only a small part of the workforce, since the ones allocating the money will probably opt to let contractors go before cutting civil servant positions.  The effect on defense readiness also has been called into question by defense personnel up to the Defense Secretary himself.  Certainly increasing the likelihood of an attack and reduced national security will not be good for the economy.

The current spitting match is between Democrats, who want to raise taxes and raise spending, and Republicans, who don’t want to raise taxes and don’t want to see Defense cuts.  It is very likely that Republicans will agree to tax increases, maybe just deduction elimination for those making above a certain income level in exchange for reducing or eliminating the Defense cuts.  Democrats will declare that the increased taxes will help reduce the deficit and allow for “investment” in things like education and jobless benefits.  There will also be promises of spending cuts, but these will never come.

The fiscal cliff, however, is really not important, when compared to the debt bomb.  Unless spending is actually cut – not just cuts in the amount of spending increases planned in the future, the country will face a real problem in about four years.  The tax increases proposed are advertised to bring in about $1 T over the next 10 years.  Note that this predicts that the tax increases will not affect earnings and incomes, which is probably not the case, and that a future administration won’t just change tax rates again, which is also probably not the case.  Even if the taxes really do bring in another $1 T, however, the amount added to the debt over that time will be between $10 T and $15 T.

To put this into perspective, imagine that your family has an income of $35,000 per year and debt of $160,000.  You are spending $45,000 per year, so each year your debt increases by about $10,000.  Even though you have incredibly low interest rates, you are still paying about $4500 in interest every year, which is difficult on an income of $35,000.  It will get worse if interest rates go up, which is very likely given how much debt you have and that interest rates are currently historically low.

Now let’s say that you start selling baskets at a craft fair and start making an extra $100 per year.   You now make $35,100 per year, but you are still spending $45,000 per year, so your debt is still increasing by $9,900 per year.  In ten years, your debt will be $259,000 instead of $260,000, as it would have been if you had not started going to that craft fair.  This is exactly the effect that the increase in taxes of $100 B per year will have.  You are increasing revenues by $1 T over 10 years, but you are overspending by $10 T-$15 T over that same period.

The real debate that should be going on is what spending will be cut to eliminate the deficit within the next 3 years.  Otherwise, within 4-5 years we will no longer be able to borrow more and the interest payment on the debt will start to approach the amount spent on Social Security.  This will jeopardize national defense and all social services, including Social Security and Medicare.  Inflation may soar, wiping out the savings of those who keep their money in the bank and money markets.  This will be particularly hard on those in retirement living off of their savings.

This is the real cliff, and both Republicans and Democrats are stepping on the gas, Thelma and Louise style.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Photo credits:  Colin Broug