The pervasive themes were the huge disconnect between market fundamentals and market movements as well as concerns pertaining to ongoing currency wars, global quantitative easing, and persistent global economic headwinds.  Fiscal solutions to the growing debt problem in the US were discussed at length, with no apparent fix for the invariable political gridlock and resistance to structural reforms (on both sides of the aisle). The core issue repeatedly stated was that we are in uncharted waters of massive monetary expansion across the globe, meant to stimulate primarily overly indebted developed nations.

The current growth is assisted by the central banks and is at odds with fundamental factors that are necessary for economies to transition to self-sustaining growth.  The expansion of liquidity (continued lowering of interest rates) is also unprecedented in its breadth and scope and has the potential for unsavory, unintended consequences, as it promotes currency devaluations, deflation, and antagonism between nations.

My net takeaway was that this is the not the time to be layering on additional risk. In fact, I was talking about this subject to a colleague of mine, and he said that he was getting several calls from clients wanting to take on more exposure to stocks since they were “going up”.  That is normally a tell-tale sign of a market top.  Apparently, these investors have very short memories.

PIMCO’s Mohamed El-Erian used the metaphor of a surfer on a wave to describe the current market conditions:

“The wave of the moment, of course, is central bank liquidity. And everyone is riding it.” “It’s a really crowded, artificial wave.   Extraordinary central bank activity means that markets become very distorted, price signals no longer function because there is a large “noncommercial player” in the markets.” ”We’re facing a 50-50 outcome.  It all depends on whether genuine growth comes back.” Mohamed El-Erian

In other words, you catch the wave and ride it; the wave is crowded right now; and, if you surf too long you may get pulled down when it crashes.  Know when to “kick out”.  Or in other words, know how much risk you can realistically endure and don’t get too greedy.

Whereas US equity markets appear to be the “least dirty shirt in the wash bin,” prolonged optimistic sentiment suggests a pullback could occur at any time. There are likely to be one or two major episodes in front of us over the next decade that will test our risk tolerance and our discipline in the face of panic. However, trying to time the market is always a difficult proposition and this time is no different.

As I ponder the investment implications and how I can help my clients best navigate these troubled waters, I recognize the conundrum presented by low interest rates on cash and historically low bond yields.  Low risk assets are expensive right now, and don’t yield a heck of a lot of income.  But when the market appears overstretched and overvalued, it is imperative that you consider the implications of extending your exposure to the stock market.  Irrespective of yield, there is no substitute for high quality bonds in your portfolio, that act as ballast in the face of gale force winds that prevail in market storms.

The Signal and the Noise

The Shiller PE 10, a measure of how expensive the stock market is as represented by the S&P 500 Index, is now 22.5.  By historic measures, this is expensive, with the ratio approximately 37% above its average of 16.5. While reading Nate Silver’s book The Signal and the Noise recently, I was once again reminded that these valuations methods, “become meaningful only in the long term, telling you nothing about what the market will be worth one month or one year later.” We know that there will be subpar returns going forward, or worse, a correction that allows the market to revert to the mean; but bubbles form and persist, because it is in everybody’s interest to keep markets going up.

Clearly, the herding instinct is alive and well.  As Nate suggests, “In the market, prices may occasionally follow the lead of the worst investors. They are the ones making the most trades.”

A To-do List for Your Financial Plan

So what actions can an investor take in the midst of this unprecedented period of financial uncertainty and monetary experimentation? Here are some suggestions for my clients.

One time-tested way to “de-risk” is to re-balance your holdings.  In doing so, you sell your appreciated assets and buy assets which have been under-performing.  If you have not been in for a check-up in over a year, please schedule a review.  This is an easy and effective method for improving your returns over time.  It helps prevent you from drifting too far from your target allocations, especially when markets are moving quickly.

Second, review your investment policy statement that was prepared with your initial financial plan.  It illustrates the potential for loss by listing the worst three month period over the last 10 years for your investment portfolio.  Are you comfortable with that possibility and willing to maintain your composure by not selling in a panic?  If you are concerned about this, or if your personal situation has changed, schedule a review so we can reevaluate your asset allocation and possibly revise it to a more conservative position.

Third, enhance your awareness of your cash flow needs.  Know how much you spend and how much you will need to withdraw from your funds for large purchases or income over the next five years.  Keep these amounts in FDIC insured accounts and/or short term bond funds.  This will help you feel like you have more control of your near future and prevent you from having to sell your funds at inopportune moments, such as after a large decline. It also gives your portfolio more time to recover from an inevitable market downturn.

Fourth, avoid locking up a lot of your savings in personal real estate as it is non liquid and often does not provide income(unless you rent it out), especially if you need these funds for retirement.  Consider contacting me if you are interested in purchasing real estate, so that I can run your analysis to determine if this makes sense for your situation and assist you in determining the most appropriate way to finance.

Finally, schedule an appointment if you want to review your situation, especially if you have had major changes in your life. Those people who are successful in attaining their financial and life goals are the ones who are committed to the financial planning process.  They make their finances a priority, follow up on their action plan, and see me regularly for reviews. I can rerun your projections with the most recent tax rates and assumptions, to help provide you with peace of mind about your retirement and other savings goals. Studies continue to show that individuals who use a financial planner have greater confidence about their financial future.

This reality hit home again recently when my husband needed to get a routine cardiac stress test.  His cardiologist, who he had been seeing for some time, had just been bought out by a local hospital.  Since we have an HSA (Health Savings Account) tied to a high deductible health plan (HDHP), his individual out of pocket costs are $7,000 a year, after which medical expenses are paid in full.  Due to a concern over exorbitant costs for the test, my husband switched to a private cardiologist who performed the stress test in his office at a cost of  $2000.  The cost for the procedure administered via the hospital—–$8,600!  We would have unnecessarily gone out of pocket $7,000 for a standard treadmill nuclear stress test that could be obtained for a fraction of the cost. Thankfully, we knew enough to shop around and are happy to report that the test was perfectly normal.

So how does a patient protect himself?

The best way to combat medical inflation is to compare prices among the options you have in your area. Ask your doctor if he or she can recommend a private (non-hospital owned) practice   that can perform the prescribed procedure.  Call each of the billing offices and ask them what their approved charges for the procedure or service are with your insurance company, as each insurance company negotiates a different rate with each provider.  (Note that it is unlikely that your insurance company will give you this information as they are not allowed to disclose it, so it requires more leg work on your part).  Compare the differences in the stated cost with other qualitative factors such as your comfort level and confidence in your physician as well as location, admitting privileges, etc.

Also, it is important to realize that if your doctor is in a practice that is hospital-owned, he or she will likely be only referring you to other physicians in the hospital network.

It appears that, contrary to intentions of this act, cost containment will not likely be achieved if this is the new paradigm.  Keep your health costs low by investigating all of your options and being an informed consumer.

Note that, for most Baby Boomers, during of our lifetimes we have primarily experienced rates moving lower.  As bond yields go down, prices of bonds go up.   But the past 40+ years was a bit of an anomaly when you look at the peak in the context of historical yields.  What does it mean for investors today?  Total bond returns (a combination of yields and capital appreciation) will be lower going forward and it will be tougher to derive income from a bond only portfolio.

The implication is that bonds will be valued more for their ability to act as a portfolio “shock absorber” as opposed to an integral source of retirement income.  This is important due to the volatility and current relatively high stock market valuations.

It also suggests, that investors will likely want to move toward higher equity allocations (stocks and stock mutual funds) once valuations are more favorable, to achieve higher total returns from their investment portfolio.  Although losses on high quality bonds were rare in most recent history, future interest rate increases will result in losses to bond portfolios.  Holding individual bonds (especially for conservative portfolios) may be one way to immunize yourself from this risk.

Lately, there appears to an epidemic of “Baby Boomers Burnout”.  Corporations are asking for more productivity per worker so folks are working longer and harder but, after inflation, are being paid less for their efforts.  Small businesses are deciding to close their doors rather than face increased complexity and costs of government regulation.  Employees that engage in physical labor may not be able to keep up the pace as their health declines.

An early retirement sounds great on paper, but in reality, it can be tough emotionally as well as physically, not to mention the increased risk of possibly outliving your money in the “new normal” world of longer lifespans, lower expected investment rates of returns, and possible Medicare and Social Security reform.  Here are some items you should consider before making the decision to retire early.

Do the Math Before Your Decision to Retire.

According to the EBRI (Employee Benefit Research Institute) most Americans don’t even attempt to do the math in preparation for retirement; and, when they do, they simply guess at a number they think they will need to retire comfortably.  It is essential to conduct an analysis BEFORE you make the decision to retire.  A CFP® professional will ensure you understand the impact of pertinent factors such as when to take your pension and Social Security or how much you will be spending for medical insurance and costs.  All too often, prospective retirees come to planners after they have made the decision to retire, and this often results in less flexibility regarding important decisions that could maximize retirement wealth.

Max the Money from Uncle Sam.

Social Security payments are a key leg of the three legged stool of savings for retirement(pension, Social Security and personal investments).  The first impulse is to start payments as soon as possible, but doing so results in a permanent drop in your potential income over your lifetime and your spouse’s lifetime.  As long as clients are healthy, generally delaying as long as possible is the new norm in order for people to hedge for longevity and maximize spousal income at death.  Each year you delay taking your check results in approximately an 8% higher return per year until age 70. If you delay until 70 from your full retirement age it will increase your monthly payment by at least 24% for life.  That is a valuable inflation-adjusted lifelong stream of income.

If you delay Social Security, you will also need to determine the best way to make withdrawals from your tax advantaged and taxable accounts.  Once again, working with a financial planner will help provide clarity and potentially reduce the overall impact of taxes through your retirement.

Make an Accurate Assessment of Your Retirement Spending.

Cash flow is extremely key in retirement.  Most retirees underestimate what they will spend.  Early retirees are especially prone to increased spending due to travel and large expenses for kids, such as weddings and college.   You will need a clear understanding of annual spending requirements so that you can manage your withdrawal rates to acceptable levels.   If you overspend in the early years you will have a greater chance of having to penny pinch in the latter years.

Understand the Impact of Inflation.

Most pensions are not inflation adjusted; and recently, the State of SC approved legislation that will possibly limit inflation adjustments to state pension to $500 a year.  Inflation over time reduces you purchasing power so that over time you will need to withdraw more from your investments.  Medical inflation is even more corrosive as retirees spend more on medical costs as a percentage of their overall budget in the latter stages of retirement.

Analyze the Impact of Large Purchases and Gifts in the Early Retirement Years.

The early years of retirement are particularly critical.  A large loss at the beginning of your retirement is worse than in the later stages of retirement.  Reducing your risk in those first years will mitigate your potential for loss.  Understanding your capacity for handling risk and volatility will enable you to stick with your investment plan, as opposed to selling when markets are falling and locking in your losses. Having a good three to five years of net cash needs on hand in cash reserves or short term bonds will help prevent reverse dollar cost averaging or selling investments when they are down.

Keeping an eye on your spending can also enable you to better manage portfolio volatility.  In fact, if you are willing to cut back your expenses in years when your portfolio has suffered large losses, you will be able to withdraw more on average during better performing years.  This concept of dynamic withdraw rates is consistent with human tendencies.  We tend to pull back on spending during times of economic stress and ratchet up spending when the economy and financial markets are on the upswing .

To further minimize large outlays in the early years, you may want to consider gifting to kids after your required minimum distributions have started age 70+ and or you have paid off all of your debt.

Take an Emotional Inventory.

The most underestimated impact of an early retirement is the emotional toll it can take on your physical and mental health and relationships.  Make sure you will be engaging in social and intellectually stimulating activities.  Have a bucket list of hobbies and interests that are important to you.  Make sure your spouse is ready for your transition.  Increased rates of depression, substance abuse, and divorce are often the byproducts of early retirement.   “Forewarned is forearmed”.

If you are contemplating retirement and want assistance working through these issues, contact me at laura@ascendfinancialplanning.com.

Maybe you’re in way above your head …

….I’m sorry but it don’t make sense

You’re pullin’ just right out on first offense

Ooh, baby, play it smart….

Boz Scaggs- Breakdown Dead Ahead

The Federal Reserve’s quantitative easing program (QE) has lowered treasury bond yields to historically miniscule levels.  Retirees are struggling to squeeze income out of a very dry lemon of a bond portfolio.  Safe high quality bonds and CDs don’t even account for inflation.  This prolonged QE dance has forced many investors to substitute their high quality bonds for high yielding bonds such as junk bonds and floating rate bonds. They have also ventured into dividend paying stocks and mutual funds as a replacement for bonds. While this may increase their “yield” or income, it also increases the risk of their overall portfolio.  These lower quality bonds tend to behave like stocks when markets are under stress.

In addition to providing reliable income, bonds are meant to act as “shock absorbers” for your investment portfolio.  If you stretch for yield via higher risk alternatives, these substitutes will let you down when you most need them.  For example, the Vanguard High Yield Bond Fund dropped 21% in 2008.  Dividend stocks dropped 25% in 2008 (a lot better than the S&P which suffered a 37% loss, but terrible when compared to short term treasuries which returned over 6% and intermediate treasuries which returned over 13%). Once again, you need to understand the reason for bonds in your portfolio.

Ironically, the very architects of quantitative easing are becoming uneasy with the potential effects of prolonged low interest rates.  Fed Governor Jeremy Stein recently expressed concern over the stretching for yield theme and potential for the formation of an asset bubble.   Janet Yellen, Ben Bernanke’s presumed replacement, recently admitted that the Fed “has not taken off the table” that it might have to react to an asset bubble.

Danger: Bumpy Road Ahead

Increased exposure to lower quality bond issues and stocks will increase the potential for loss.  When I present an investment policy statement to a client, I make sure to underscore the potential for loss based on the overall allocation of stocks to bonds.  It is not a matter of if a large loss will occur; it is a matter of when.  Even John Bogle, founder of Vanguard and pioneer of low cost index investing, warned of significant declines in the future.    His point is that severe declines can be expected, as they are part of the overall business an d economic cycle.

For example, say you have a portfolio comprised of 50% bonds and 50% equities (stocks and stock mutual funds).  Over the last 10 years, the worst decline over a 3 month period was roughly 20%.  If you could not possibly stomach that decline, you may want to consider reducing your equity exposure.  The important thing is that if you know it is a possibility, you are more mentally prepared when it occurs and are able to weather the storm through patience, not selling when markets drop.  The average investor has a hard time doing this, because there is an innate tendency is to want to flee from the pain of loss.  Selling when markets fall just locks in the loss.  That is why most planners advise their clients to hold a good three to five years’ worth of net cash flow needed in safe cash reserves or short term bonds.  This eliminates the need to withdraw from funds at an inopportune time—after an investor has experienced a loss.  It also is important to rebalance periodically to maximize opportunities to buy low and sell high.

The best way to combat this issue is to develop and or review your investment policy statement with a CERTIFIED FINANCIAL PLANNER^TM professional.  He or she will reaffirm your risk tolerance and determine if you can stomach the volatility of your current portfolio.  He or she can also recommend appropriate mix of bond funds that reduce the risk of interest rate increases and perhaps even suggest individual bond ladders.

Educating investors about the above issues enhances awareness of market volatility, so that clients are more prepared for that inevitability.  This helps reduce their anxiety and ultimately improve their peace of mind about their finances.  Are you ready for a breakdown ahead?  If not, you may want to adjust your portfolio.