Warren Buffett hates bonds, but we don’t

When Warren Buffett, the so-called “Oracle of Omaha,” makes a bold statement about investing, people’s ears perk up. While his May 6^th declaration that fixed income is “a terrible investment right now” might have made more than a few headlines, his sentiment was hardly anything Earth-shattering, as some pundits have been claiming for years that investors should rethink their fixed income investments.

It’s an understandable position: interest rates are at extreme lows, and if they rise due to change in Fed policy or inflation expectations, bonds could lose a lot of value.

While we agree that on a relative basis, stocks look more attractive than bonds right now, and that bonds seem riskier than they used to be, we don’t think that you should get rid of your entire fixed income allocation. We believe that:

1. A prudent investor should still hold some bonds, and
2. Your bond portfolio should be diversified, just like your stock portfolio.

Why you should hang on to your bonds

While no one can predict the future with 100% accuracy, an effectively diversified portfolio can help minimize the shocks of a volatile economy. Consider this scenario: if the market suffers another downturn, you need something that can perform well in a recessionary environment – something like bonds. In such a situation, if interest rates fall even further, bond prices will rise, and this gain might help offset some of the losses that may occur in your equity portfolio. If you react to some of these headlines and sell out of all your bonds, your portfolio might suffer more dramatically in a recession.

Of course, we have to consider what may happen on the other end of the spectrum: if there’s a period of growth and inflation, interest rates will likely rise. In this scenario, you could potentially lose money in bonds, but if you’re effectively diversified, the strength of your equity portfolio may offset some of those losses. That being said, there’s no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Not all bonds are the same

Keep in mind that while some pundits are talking about Treasuries, those aren’t the only bonds out there. Just like there are many different kinds of stocks – growth, value, small cap, large cap, etc. – there are many different kinds of bonds.

For example, US government bonds look expensive at the moment, but emerging market local currency bonds still offer good returns with acceptable levels of risk when added to a well diversified portfolio.

The bottom line?

The Oracle of Omaha may have gotten everyone’s attention, but there’s more to the story than the headline. While there may be heightened risk in fixed income, we believe that careful exposure to fixed income is a key component of an effectively diversified portfolio that prepares your portfolio for a variety of economic environments.

 

Social Security Survivor Benefits: Do you know how much you’re eligible to receive?

Americans contribute a significant portion of their lifetime earnings to Social Security, and for many, these benefits are their sole source of income throughout their retirement years.  So what happens when an individual dies before or while collecting their monthly benefits?  Thankfully, those entitled benefits don’t just disappear. The U.S. government has formulated a way to pay out benefits to surviving loved ones, even before their own retirement. This could amount to an important figure, especially for a widow(er) who did not work outside the home.

You may already be aware that a spouse can receive 100% of the benefit at Full Retirement Age (FRA) as a survivor (FRA is determined by year of birth; if born in 1962 or later, FRA is 67 years old). But did you know that benefits can also be paid to the surviving children? Most surviving children are eligible to receive a monthly benefit if they are under age 18 (up to 19 if they are still in high school), or any age if they were disabled before age 22. This amount may be added to the spouse’s survivor benefits, but the maximum total family benefit is limited, generally speaking, between 150% and 180% of the deceased’s benefit amount.

Divorced? As a former spouse, you may be entitled to benefits. As long as your marriage lasted 10 years or more and you do not remarry before age 60, you could get the same benefit as a widow(er). However, if you are caring for you and your former spouse’s child who is under 16 or disabled, the length-of-marriage rule does not apply. It’s also important to note that the benefits paid to a surviving divorced spouse will not affect benefits that other survivors could receive.

In order to plan an adequate cash flow analysis that incorporates survivor benefits, it’s crucial to know what percentage of survivor benefits one is eligible to receive, as this varies from situation to situation:

• Widow(er), full retirement age or older =  100% of deceased spouse’s benefit amount
• Widow(er), age 60 to full retirement age = 71% to 99%
• Disabled widow(er), age 50 through 59 = 71%
• Widow(er) at any age caring for a child under age 16 = 75%
• A child under age 18 or disabled = 75%
• Your dependent parent(s), age 62 or older:
•         One surviving parent = 82%
•         Two surviving parents = 75% to each parent

If you find yourself in more than one of the above categories, you will receive the higher of the two benefits.

If a spouse or parent were to die, applying for survivor benefits might not seem like a top priority, but it’s important to consider that these benefits are paid from the time of application, not the time of death.  There’s no need to wait for certain documents in order to apply, as the Social Security office works on survivors’ behalf to facilitate this progress.  For more information regarding Social Security survivor benefits, please visit www.socialsecurity.gov, or speak with your financial advisor today.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

The Resilient Consumer

If you’re trying to know where the American economy is going, your first step should be to put yourself inside the head of the American consumer.

According to The Wall Street Journal, almost half of American consumers are unaware that the return to higher Social Security tax withholding on January 1 meant an effective 2% pay cut. About 48% of workers didn’t notice the change in their 2013 paychecks; 59% of lower-income workers, those most likely to have no cushion, didn’t notice. Only 26% of low-income households, and only 30% of all households, have reduced spending in response.

Add in uncertainty about the future course of government policy, both in America and internationally, and you’d expect consumer spending, which is responsible for roughly 70% of GDP, to be static, if not falling. Instead, after adjusting for inflation, it grew at roughly a 3% annual rate in January and February. The numbers may be skewed by a few anomalies, but even with March’s slight downtick, spending growth in the first quarter was relatively strong. What’s more, the Thomson-Reuters/University of Michigan index of consumer confidence rose more than expected in March, likely because of the strength in hiring and housing.

But there are downsides. March’s job growth was an anemic 88,000, dramatically smaller than the consensus view that non-farm payrolls would grow by 200,000. And the effects of the sequester’s large cuts in jobs and pay, directly on government workers and indirectly on the employees of government contractors, have yet to be felt.

We think that further growth in consumer spending, and therefore further GDP growth, is dependent on the private sector adding jobs at an accelerating pace through the spring. Stay tuned for April’s numbers at the end of the first week in May.

The Eurozone and Investor Confidence: What’s the connection?

Volatility and uncertainty in Europe persist. How sensitive are investors to the European situation? When the troubles of a nation that makes up only 0.2% of Eurozone output is blamed for downward movement of the U.S. stock market, that’s a sign of tremendous sensitivity. More on that country and why it has made investors skittish later, but first let’s look at current state of Europe and especially those nations that use the Euro currency (commonly called the Eurozone).

There are two interrelated issues we need to consider when evaluating the European situation: the state of the economy, as well as the severe financial pressure brought on by the enormous debt obligations of governments. This is the vicious circle that Eurozone countries find themselves in: there is a need to reduce government spending in order to improve the debt obligations, and this reduced spending weakens the economy. The weakened economy reduces tax receipts, and the reduced tax receipts make it more difficult to pay the debt obligations they were seeking to reduce. This not only keeps the debt obligations high, it also makes investors demand a higher interest rate on the debt, which makes it more difficult for the country to afford the payments. In the end, the real fear is that governments will default on their bonds and that these defaults will have a fatal effect on the banks that own the bonds. The banks going under would then have a domino effect and cause more and more banks to become insolvent. Because the consequence could be disastrous, even a small move toward that scenario has a large impact on investor confidence.

So, what is the current state of the Eurozone? The Eurozone as a whole has entered another recession after a short period of meager growth coming out of the global financial crisis.  The combined economic output of the 17 countries that make up the Eurozone shrank by 0.6% in 2012 and is projected to lose another 0.3% this year. Unemployment has been steadily increasing and is now at an alarming 11.9%.  In summary, the economy is not in great shape, but, to date, it is still your typical garden-variety recession—not a sign of Armageddon.

On a slightly better note, the debt side of the equation has been showing some improvement. The countries on the periphery that have been under the most stress are showing some improvement in their account deficits. In a normal situation, the financial condition of a country would have led to a weaker currency, thereby supporting export growth and foreign investment. But because these countries share a currency and such devaluation is not possible, other market forces must ultimately work. In this case, market forces have gradually reduced wages, making goods cheaper. Also, the European Central Bank’s pledge to support the Eurozone’s banks “at any cost” helped to lower the interest rates of government debt, enabling countries to better afford their debt payments and reducing investor concerns.

Even with the improvements, the immediate outlook remains challenging. Political turmoil reduces investor confidence. As we’ve seen, reduced confidence increases the interest rates that investors demand for a country’s debt. Italy, Greece and Spain abound in such political turmoil. Additionally, the record high unemployment in several countries further deteriorates their economies and sends them deeper into recession. Then there are events such as the one plaguing Cyprus, the aforementioned nation that makes up only 0.2% of Eurozone output. The Cypriote situation is one in which banks actually were fatally harmed by the defaults of Greek government debt. Cyprus was forced to close the country’s second-largest bank and inflict large losses to its biggest depositors. Because this was a visible step toward the disastrous outcome that investors have long feared, markets reacted. The real economic effects of the Cyprus situation are negligible, but the real damage was to investor confidence: “If it can happen there, who is next?”

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

The Wealth Effect

This is one of those cool academic ideas that resonate with non-academics. If you’re an armchair economist you’ll nod and say, “oh yeah” when you read about it. I’m talking about the wealth effect. The wealth effect is the change in consumers’ attitude and spending behavior caused by the perception of increased wealth.

When a 10% tax hike to pay for the Vietnam War failed to slow consumer spending in 1968, economists attributed the behavior to the wealth effect. Disposable income actually fell, but paper wealth was rising sharply with the stock market, and consumers continued to spend.

We’re living through a good example right now. Most economists expected the January 1, 2013 2% tax hike from elimination of the temporary Social Security tax cut to reduce consumer spending because of reduced disposable income. It hasn’t, and the most likely cause is the current rebound in the housing market and the rise of stock prices; this may be leading consumers to feel more secure with their personal finances and ultimately spend more.

It’s important to note that the concept is that perception of increasing wealth trumps the reality of declining income. Don’t confuse the wealth effect with Alan Greenspan’s “irrational exuberance” which was fueled by a real increase in disposable income based largely on the housing bubble.

Of course, a rising stock market that goes on long enough should eventually lead to increased business confidence, hiring, falling unemployment, and a rise in disposable income. That would be great, because then we won’t be depending on perception, but on real prosperity.

 

The New Milestone

The Dow Jones Industrial Average rose above its all-time intraday and closing highs on March 5, ending at 14,253.77. That’s more than 100 points above the 14,164.53 record it hit in October 2007 before the Great Recession. The almost-four-year bull market is the eighth longest in the last 100 years, and the sixth strongest in terms of the return of the S&P 500.

Wow! So what? Or something in between? Here are some perspectives on the market for the long-term investor.

This upward trend for the markets continues against a backdrop of monetary policy decisions and continuous (albeit slow) economic growth. The Fed and other central banks continue to pursue a policy of easy money and low interest rates, and economic growth is unspectacular but solid: corporate earnings and dividends are rising, the U.S. housing market is growing, the unemployment rate is gradually declining, and the auto industry is healthy again.

Low interest rates and low bond yields mean investors seeking income are increasingly turning to stocks. And periodic reminders of continued weakness in the euro zone, like the recent Italian elections, give investors worldwide a reason to move money into the United States. Demand increases price, so the Dow is rising.

Now for two reality checks.

First, since the end of 1994 and the beginning of the 1990s stock boom, consumer prices have risen 55%. The Dow has more than doubled since 1994, but after adjusting for that 55% inflation, it shows no gains since the first part of 1999. Investors planning for retirement have to remember that ignoring inflation overstates the value of future investments and understates the amount of money needed for retirement. Second, the four-year bull market and the “lost decade” that preceded it yielded a total return on stocks less than half the historical norm.

And a reminder.

There’s still a lot of money sitting on the sidelines, and a lot of people who are getting ready to jump in. If you’re one of them, remember that a new all-time high is just a number, so don’t get swept up in an emotional reaction to highs or lows.

The fundamental things apply as time goes by, the first of which is that even the pros can’t time the markets in the short term. You should have a long-term plan that integrates your investments, savings, taxes and risk management. Adjust it periodically as markets and the economy warrant. And, stay invested because investments work; investors don’t.

 

The Dow Jones Industrial Average is an unmanaged index which cannot be invested into directly.  Past performance is no guarantee of future results.

 

Headwinds and Tailwinds

One pundit, and he’s not alone, said at the end of last week that “tailwinds we had at the end of the 4th quarter 2012 and into 1st quarter 2013 may be disappearing and turning into headwinds.”

Really?

The long-term trends on unemployment, hiring and housing are all positive. The Fed remains committed to a long-term easy money policy. The 4^th quarter’s 0.1% contraction is likely to disappear when revised GDP numbers come out next week. Steadily rising auto sales and wage concessions from labor are leading to new manufacturing investments and hiring by the three Detroit automakers. And even with a bad two days last week when Fed minutes revealed disagreement over how long to keep buying bonds, the markets remain strongly positive for the year. Those are the tailwinds, and while they’re not fabulous, they’re good.

The headwinds, however, are definitely blowing.

The sequester now appears inevitable, but opinions about the consequences of cutting $85B at one stroke vary widely. Some economists think it could send the economy into recession. Others predict it will cut 2013 GDP growth from 2.6% to 2.0% and cost 700,000 jobs. And the most sanguine contrarians point out that similar government cutbacks in recent years have been anything but catastrophic, and the economy is strong enough to weather the blow. Wherever one falls on the spectrum of sequester seriousness, uncertainty about it is weighing on consumer confidence, as are higher gas prices and the end of the 2% cut in the payroll tax, the functional equivalent of a pay cut. Remember that consumer confidence drives consumer spending, and that consumer spending is the biggest single driver of the economy.

Europe is our largest trading partner; the European Union is warning that its economy will shrink for the second year in a row in 2013, and that France and Spain will miss fiscal targets designed to ensure stability of the Euro. For the first time since 2009, the combined GDP of 34 major developed countries is shrinking, indicating widespread weakness. A major reason for the decline, and for the weakness of the recovery from the Great Recession, is the decline in government spending. During the first decade of the 21st century, government spending in the Euro zone and the U.S. grew every year. Budget cutting at all levels of government is now epidemic in the U.S.; austerity is now the norm in Europe.

As always, your best strategy in the face of winds from any direction, and from the unpredictability of the markets in the short term, is a portfolio diversified by both asset class and risk. And a determination to remain invested for the long term, without being swayed by emotion.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.