Thanksgiving greeting

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At this time of Thanksgiving, we are thankful for wonderful clients and associates like you.

Your business and referrals have helped us to grow over the years and we are grateful for your support.

Sincerely, DWM

Dow Tops 16,000: Are We in a Bubble?

bubblesOn Monday, the DJIA reached the 16,000 mark. Another record. And another flurry of news articles about potential bubble trouble.

There are plenty of reasons for caution. So far, the rise that started in the stock market in March 2009 has lasted 56 months and produced gains of 166%. Margin debt has risen to record levels, investor sentiment is quite upbeat (55% bullish and only 16% bearish) which often foretells a correction, and warnings are coming from the likes of Warren Buffet and Carl Icahn.

Let’s put this in perspective. The S&P 500 is valued at 16 times projected 2013 earnings and 15 times estimated 2014 earnings. According to Barron’s report on Saturday, those price/earnings (P/E) ratios are about equal to the long-term average. Equities are currently trading at 2.5x book value- far below the peaks of prior bubbles. P/E ratios were 23, 30, and 17.5 before the bubbles popped in 1987, 2000 and 2007.

Perhaps a better measure for valuation other than P/E is CAPE. CAPE or cyclically-adjusted-price-earnings ratio is the brainchild of recent Nobel Prize winner Robert Shiller. Instead of focusing on one year of earnings, it averages the past 10 years, and adjusts them for inflation using CPI. Inflation is a powerful force that is often ignored when looking at nominal all-time highs. Dr. Shiller used CAPE valuation in his book “Irrational Exuberance” published in March 2000 which demonstrated how markets were overvalued during the internet boom. The dotcom bubble burst the same month.

Today, CAPE is at 24. The long-term average is 16. Dr. Shiller cautions against using CAPE to time crashes and make short-term trades. Rather, CAPE is more useful in predicting longer-term returns. Looking at stocks today, Dr. Shiller recently said: “The market is somewhat high, but it’s not a time when I would be writing ‘Irrational Exuberance’”. He continued: “Stocks are merely expensive, rather than bubbly.”

What Dr. Shiller does say, though, is that high CAPE historically produces lower returns in the following three years than years following low CAPE amounts. That’s understandable- it’s the old “reversion to the mean”. Good to reflect upon after such a banner year in stocks in 2013.

Perhaps a better question to ask, other than “Are we in a bubble,” is “Am I comfortable with how my portfolio would perform if there is a significant correction in stocks?” As we pointed out in our seminars last month, it’s all about stress testing your financial plan and your portfolio and focusing on what you can control.

Let’s say you have a balanced risk profile and have an asset allocation of 50% stocks, 25% fixed income and 25% alternatives. If there is a 15% stock market correction, what will be the likely short-term impact on your portfolio? Based upon what happened in 2008, the impact might be a decline of 5%-10%. Of course, past performance is no guarantee of future results. Can you live with such a decline? The answer should be yes for someone with a balanced risk profile.

We can’t tell you whether we are in a bubble or not. We do watch the markets very carefully but we can’t control them. What we focus on is making sure every client’s asset allocation is consistent with their risk profile. We also focus on the components within each asset class, rebalancing the investments on a systematic basis in an effort to produce enhanced performance. That’s the way we protect and grow our clients’ net worth and legacy and give them peace of mind.

Social Security: Show Me the Money!

showmethe money3Should you wait until age 70 to collect social security? Some say yes, I say no. I’ll take the money early.

Generally, the earliest you can collect social security is age 62. However, if you are making more than $15,120 per year, social security will withhold $1 of benefits for every $2 in earnings above the limit. In addition, there is a 25% reduction in benefits for taking them early. Current “full retirement age” is 66. You can also wait until age 70 to start collecting. Social Security provides a “guaranteed” 8% increase per year if you wait to age 70.

So, many financial advisers do a simple calculation and conclude that you should wait to age 70 and get a slightly larger monthly check. I believe they are missing four key factors in analyzing this important decision.

  • COLA.  Social security payments increase each year by a Cost of Living Adjustment (COLA). This amount was 1.7% for 2013 and will be 1.5% in 2014. Historically, COLA has been close to 3%.
  • Time value of money.  If I take the money early and spend it, that means I didn’t need to draw those funds from my investment accounts. Alternatively, I can invest it. Either way, the social security funds have a 5-8% annual return (economic) benefit to me.
  • Potential changes to social security.  The Social Security Disability Insurance Trust Fund will likely be exhausted in 2016. The Social Security retirement program reserves are expected to run out in 2033. One of these days, Congress may actually deal with the problem. Changes could include extending full retirement ages, cutting back on the COLA, means testing to eliminate/reduce payments to those with substantial income/assets or other methods to reduce future benefits.
  • We don’t know when we are going to die.  Social security stops when you die. However, spouses may be able to take over their deceased spouse’s benefits if they exceed their own.

Here’s an example on how this works and why I think it is worthwhile to take the money.  Let’s assume a person reaching full retirement age of 66 could receive $2,500 per month now. Alternatively, they could wait until age 70 and receive $3,400 per month then.  If they take the $2,500 per month at age 66, invest it at 5% and get a COLA adjustment of 3% each year, their monthly benefit when they reach 70 is $2,813.  In addition, they will have accumulated $136,000 in four years. Yes, if they waited four years, the monthly payment would be $587 more.  However, it will take another 24 years (age 94) before the person waiting until 70 will have as large a pot of money (or economic benefit) as the individual starting at age 66.

Secondly, there are going to be changes in social security. If they introduce means testing, many of us will have our social security benefits reduced or eliminated. Let’s take the money now. If they push out the “full retirement age” that could mean fewer years of payments. Furthermore, none of us knows our “eventual age”. Hence, while many of us hope and expect to live beyond age 94, there is no guarantee that we will. When we die, our benefits die as well.

We’ve done the same calculations for people who want to start collecting early, at age 62. Again, this doesn’t apply if you still have earned income above $15,120 per year. Similarly, taking benefits at age 62 instead of age 66 or 70 is likely advantageous. In addition, there are still some very nice strategies that couples can use to maximize their social security benefits and still start early. Of course, everyone’s situation is different and it is possible that delaying social security may, in some cases, be better. Working with sophisticated software programs such as www.maximizemysocialsecurity.com and an experienced financial adviser like DWM can be quite helpful in customizing this analysis for you.

Don’t delay collecting social security. The gravy train may be slowing down soon.

DWM Seminar Recap

Bond Interest Rate Graph
(Click above for full size image)

We just wrapped up our fall seminar series and based upon feedback it was a great success. Both venues – the Wolfe St Playhouse in Charleston and Emmett’s Brewery in Palatine – served as Graphgreat places to not only deliver an important financial presentation but also as a great place to just hang out and visit with one another.

In case you missed one of the October seminars entitled “Rising Interest Rates: Should I Be Concerned?“, here is a quick recap of what you missed:

The Bond bull market may be over.

  1. The last 3 decades saw declining interest rates. Because of the inverse relationship between rates and bond prices, this created a nice tailwind for bond prices.
  2. With interest rates recently bouncing off historic lows and expected to gradually increase as the Fed tinkers with tapering their Quantitative Easing Program, these tailwinds are becoming headwinds.
  3. This doesn’t mean that bonds will necessarily have negative returns but expected returns should be significantly lower than the 8.5+% returns they have exhibited since September of 1980 when 10-Year Treasury rates peaked at 15.8%.

Bonds still play a vital role within an overall portfolio as do all of the asset classes.

  1. As a diversifier which creates lower volatility to the overall portfolio- bonds not only have smaller corrections than equities but have consistently held up during equity market corrections.
  2. As a capital preservationalist.
  3. As an income provider.

Traditional and major index (like Barclays Aggregate) bond funds may not be the best way to go.  Make sure to ‘get under the hood’ of your bond portfolio and ‘check the fluids’.

  1. Duration (essentially the amount of time until a bond matures) – the bigger the duration, the more sensitivity the bond price will change. Because of this, consider reducing the overall duration of your bond portfolio.
  2. Consider adding floating rate exposure – one of the few subsectors within bond land that enjoys a rising interest rate environment given that they rely upon loans that reset in periods usually less than a year at the new current interest rate environment.
  3. High Yields – with default rates near historical lows, these securities can enhance an overall bond portfolio.
  4. Look to areas outside of the US – international developed and emerging bond markets can provide diversification and enhanced yields/returns.
  5.  Utilizing low cost ETFs and mutual funds for the above exposure helps eliminate company-specific risk.

Use of multiple asset classes lead to non-correlation benefits that ultimately lead to better long-term results.

  1. Non-correlation leads to a tighter range of outcomes for the overall portfolio
  2. Tighter range of outcomes puts a smoothing effect on your return profile
  3. Smoothing effect leads to smaller downsides
  4. Smaller downsides lead to better geometric compounding
  5. Better geometric compounding leads to BETTER LONG-TERM RESULTS
  6. Note: Investor psychology studies and personal experience remind us that not everyone is a fan of non-correlation when stocks are roaring, but the fact is one cannot count on 20%+ stock returns year in and year out. Not to mention that the 30yr+ bond bull market may be over.  One must look elsewhere for proper diversification, for real positive returns and for protection to the portfolio.
  • The world has changed…and will keep changing.
  • Don’t try to control the things you cannot, but take advantage of the things you can control.
  • The markets cannot be controlled, but Asset Allocation can be. Asset allocation is the primary driver of returns.
  • Make sure you are prepared for a rising interest rate environment or whatever environment is thrown your way by working with a wealth management professional firm like DWM.

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