Old Adages Die Hard: What Worked in the Past May Not Work Today!

More people are renting (not buying) houses, particularly millennials. The old adage that “paying rent is foolish, own your house as soon as you can” is no longer being universally followed.  Lots of reasons: cost of college education, student debt, relative cost of houses, flat wages, more flexibility and others.  Today we 327 million Americans live in 124 million households, of which 64% (or 79 million) are owner-occupied and 36% (or 45 million) are renter-occupied. In 2008, homeownership hit 69% and has been declining ever since.

It starts with the increasing cost of college.  Back in the mid 1960s, in-state tuition, fees, room and board for one year at the University of Illinois was $1,100.  Annual Inflation from 1965 to now has been 4.4% meaning $1,100 would have increased 10 times to $11,000 in current dollars.  Yet, today’s in-state tuition, room & board at Champaign is $31,000, a 28 times (or 7.9% average annual) increase.  Yes, students often get scholarships and don’t pay full price, but even a $22,000 price tag would represent a 20 times increase.

It’s no surprise that in the last 20 years, many students following the old adage “get a college education at any price” found it necessary to incur debt to complete college.  Today over 44 million students and/or their parents owe $1.6 trillion in student debt.  Among the class of 2018, 69% took out student loans with the average debt being $37,000, up $20,000 each since 2005.  And here is the sad part: according to the NY Fed Reserve, 4 in 10 recent college graduates are in jobs that don’t require degrees.  Ouch. In today’s changing economy, taking on “good debt” to get a degree doesn’t work for everyone, like it did 50 years ago.

At the same time, houses in many communities have increased in value greater than general inflation.  Elise and I bought our first house in Arlington Heights, IL in 1970 when we were 22.   It was 1,300 sq. ft., 3 bedrooms and one bath and cost $21,000.  I was making $13,000 a year as a starting CPA and Elise made $8,000 teaching.  Today that same house is shown on Zillow at $315,000.  That’s a 15 times increase in 50 years. At the same time, the first year salary for a CPA in public accounting is now, according to Robert Half, about $50,000-$60,000. Let’s use $60,000.  That’s less than a 5x increase.  Houses, on the other hand, have increased at 5.6% per year. CPA salaries have increased 3.1%.  The cost of living in that 50 years went up 3.8%. Wages, even in good occupations, have lagged inflation. Our house 50 years ago represented about one times our annual income.  Today the average home is over 4 times the owners’ income.  That makes housing a huge cost of the family budget.

In addition, today it is so much more difficult to assemble the down payment. We needed 20% or $4,200; which came from $3,500 savings we accumulated during our first year working full-time and a $700 gift from my mother. A “starter” house today can cost $250,000 or more.  20% is $50,000, which for many is more than their first year gross income.  And, from that income, they have taxes, rent, food and other expenses and, in many cases, student debt, to pay before they have money for savings. Saving 10% is great, 20% is phenomenal.  But even at 20%, that’s only $10,000 per year and they would need five years to get to $50,000.  No surprise that it is estimated the 2/3 of millennials would require at least 2 decades to accumulate a 20% down payment.

Certainly, houses can become wealth builders because of the leverage of the mortgage.  If your $250,000 house appreciates 2% a year, that is a 10% or $5,000 increase on your theoretical $50,000 down payment. But what happens when real estate markets go down as they did after the 2008 financial crisis?  The loss is increased.  Many young people saw siblings or parents suffer a big downturn in equity 10 years ago and are not ready to jump in.

Furthermore, young people who can scrape up the down payment and recognize the long term benefits of home ownership, may not be willing to commit to one house or one location for six to seven years.  With closing costs and commissions, buying, owning and selling a house in too short a period can be costly and not produce positive returns.

Lastly, many people want flexibility and don’t want to be tied to a house. They want flexibility to change locations and jobs.  They want flexibility with their time and don’t want to spend their weekends mowing the grass or perform continual repairs on the house. In changing states like Illinois, with a shrinking population and less likelihood of significant appreciation, their house can be a burden.  For them, renting provides them flexibility and peace of mind.

It’s no surprise then that the WSJ reported last week that a record number of families earning $100,000 a year or more are renting.  In 2019, 19% of households with six-figure income rented their house, up from 12% in 2006.  Rentals are not only apartment buildings around city centers, but also single-family houses.  The big home-rental companies are betting that high earners will continue renting.

Yes, the world has changed greatly in the last 50 years and it will keep changing.  When I look back, I realize we baby boomers had it awfully good.  The old adages worked for us. But today, buying a house is not the “slam dunk” decision we had years ago, nor is a college degree.  The personal financial playbook followed by past generations doesn’t add up for many people these days.  It’s time for a new plan customized for new generations and that’s exactly what we do at DWM.

Equity Trades are Free – But there is no Free Lunch

Broker price wars

Before 1975, brokers had it really good. Commissions were fixed and regulated-at very high levels. It would sometimes cost hundreds of dollars to buy 500 shares of a blue-chip stock. That changed in 1975 when the SEC opened commissions to market competition.   A young Chuck Schwab and others became discount brokers- often charging ½ or less of the old rates. Since then, fees have continued to fall and earlier this year, trades could be made for $5 or less. Now, Charles Schwab & Co. as well as TD Ameritrade, E*TRADE and others have cut stock and ETF trades to zero. Free trading of equities has arrived.   Please be advised, though, that there is no free lunch- brokers profit from you even if they don’t charge for equity trades.

Here are some the main sources of income for brokerage firms:

  • Trade commissions
  • Brokerage fee- to hold the account
  • Mutual fund transaction fee-charges when you buy or sell a fund
  • Operating Expense Ratio-an annual fee charged by mutual funds, index funds and exchange-traded funds (“ETFs”)
  • Sales load- A sales charge or commission on some mutual funds paid to the broker or salesperson who sold the fund
  • Uninvested cash- brokers become bankers and lend it out

Let’s focus first on uninvested cash. In 2018, 57% of Schwab’s income came from loaning out its customers’ cash. As is typical in the brokerage business, uninvested cash is swept to an interest bearing account. However, sweep accounts typically earn almost nothing- usually ½ to ¼ of 1% or lower to the investor.

Schwab had a total of $3.7 trillion of deposits, with about 7% of it ($265 billion) in cash earning nice returns for them. Assuming a return of 2.5 % on the uninvested cash, that’s a return of $6.6 billion. The cost of that money was likely ½% or about $1 billion, with Schwab netting about 2%. $5.7 billion of Schwab’s $10 billion net revenue in 2018 was earned on its customers’ cash. Virtually all the brokers use the same model with uninvested cash.

Robo- advisors generally use the same format. Virtually all of them charge lower fees but require a certain amount of cash, between 4% and 30% in their pre-set asset allocations. Yes, there is a small sweep account interest paid on those funds, but not much. And, this is all typically disclosed. The rate paid on clients’ cash “may be higher or lower than on comparable deposit accounts at other banks” is a typical warning.

The use of uninvested cash is income for the brokers and reduction in performance for the investors. Let’s say your portfolio has 10% cash generating a 0% return. If your annual return on the invested 90% in your portfolio is 6%, then the return on 100% of the account is only 5.4%. A huge difference over time. As an example, the difference between earning 5% per year versus 6% a year on $100,000 for 30 years is $142,000.

Now, let’s look at the operating expense ratio (OER). OERs are charged by mutual funds, index funds and ETFs. If a fund has an expense ratio of 1%, that means you pay $1 annually for each $100 invested. If your portfolio was up 6% for the year, but you paid 1% in operating expenses, your return is actually only 5%. The OER is designed to cover operating costs including management and administration.

The first mutual funds were actively traded, meaning that the portfolio manager tried to beat the market by picking and choosing investments. Operating expenses for actively managed funds include research, marketing and significant administration with OERs often at 1% or more. Index funds are considered passive. The manager of an index fund tries to mimic the return of a given benchmark, e.g. the S&P 500 Index. Index funds should have significantly lower operating expense ratios. Evidence shows that actively managed funds, as a whole, don’t beat the indices. In fact, as a group, they underperform by the amount of their OER.

Operating expense ratios, primarily because of increased use of index funds and ETFs to minimize costs, have been getting smaller and smaller. In fact, we have seen some funds at a zero operating expense ratio. However, for these funds, a substantial amount (10% to 20%) of cash is maintained in the fund.

Conclusion: Set a target of 1-2% cash in your portfolio. Stay invested for the long term.   In addition, the investments in your portfolio should have very low OERs, wherever possible. However, in selecting investments, you need to look at both the OERs and the typical cash position of the mutual fund, index or ETF. Even if the OER is zero and the security holds 10% in cash, your performance on that holding will likely only be 90% of the benchmark, at best. Remember, when equity trades are free, brokers will continue to look for ways to make money, often at your expense.

DWM 3Q19 Market Commentary

“Fancy a cuppa’?” “Anyone for tea?” Even though our beloved Chicago Bears were “bloody” unsuccessful in their visit to London this past weekend, I’m “chuffed to bits” to put a little “cheeky” British spin on this quarter’s market commentary… Let’s “smash it”!

After a volatile three months, the third quarter of 2019 is officially in the history books. The S&P500 finished only 1.6% below its all-time high, bonds rallied as yields lowered, and alternatives such as commodities and real estate rallied. It’s been a rather “blimey” year for investor returns so far, but there’s a lot of uncertainty out there about if these “mint” times can last. Let’s look at how the asset classes fared first before turning to what’s next.

Equities: Equities were about unchanged for the quarter, as evidenced by the MSCI AC World Index -0.2% reading for the quarter.  Domestic large cap stocks represented by the S&P500 did the best relatively, up 1.7%, but underperformed in the final weeks of the quarter. Recent trends show that traders are gravitating toward stocks with cheaper valuations instead of pricey, growth ones. International equities* underperformed for the quarter, down -1.8% but had a strong showing in September. Even with this so-so quarter, stocks, in general, are up over 15%** Year-to-Date (“YTD”)! Yes, “mate”, this bull market – the longest on record – continues, but at times looking “quite knackered”.

Fixed Income: The Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index ascended even higher, up 0.7% and 2.3%, respectively for the quarter and now up 6.3 & 8.5%, respectively YTD. “Brilliant!” Yields continue to fall which pushes bond prices up. But how far can they fall? The 10-year US Treasury finished the quarter at 1.68%, a full percentage point below where it started the year. For yield seekers, at least it’s still positive here in the States as the amount of negatively yielding debt around the world swells. Sixteen global central banks lowered rates during the quarter including the US Fed, all of them hoping to prop up their economies. As long as they’re successful, all is good. But what if our slowing US economy actually stalls? We could be “bloody snookered”…

Alternatives: The Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, showed a +0.3% gain and now up 6.1% YTD. Lots of winners in this space. “Lovely!” For example, there is a lot of money flowing into gold***, +4.4% on 3q19 & +14.7% YTD, as it is seen as a safe haven. And real estate, +6.3% 3Q19 and +23.5% YTD, has rallied from investors looking for yields that are more than the bonds like those mentioned above.

Frankly, it’s been a pretty great year for the balanced investor who’s now looking at YTD returns that around double-digits. But it’s not all “hunky-dory”. The main worries are the following:

  • The US-China trade war continues affecting the global economy. Sure, since the US exports less than every other major country, this shouldn’t affect us as much. But given the uncertainty, many companies are choosing to hold off on capital expenditure until we get clarity on this issue. Reports earlier this week that US manufacturing momentum has seriously slowed down led to one of the worst fourth quarter starts for the stock market in years. Politics will continue to make it volatile.
  • The Fed’s path of monetary easing. It’s gotten “mad” – it seems every time there is bad news, it’s good news for the stock market because traders are betting on the central banks around the world to support the markets. Seems “dodgy”, right?!? So the Fed must play this balancing act, always wanting to keep the economy humming along. Quite frankly, there really is no economic reason for a rate cut right now if it weren’t for the trade conflict. Figure we’ll have at least one more cut, possibly two, in 4Q19 and hopefully that’s it. Otherwise, if they keep lowering, it means we have fallen into a recession.

It’s in a lot of peoples’ interest to get a trade deal done. If it does, markets will celebrate it. The longer a deal plays out, the more volatility we’ll see and the higher the risk of recession becomes. The US economy is not “going down the loo”, but it won’t continue to go bonkers with everything mentioned above as well as the Tax Reform stimulus fading away in the rear-view mirror as quickly as a Guinness at the Ye Olde Cheshire.

This all isn’t “rubbish”. Actually, there is a lot of turmoil out there. So don’t be a “sorry bloke”. In challenging times like this, you want to make sure you’re working with an experienced wealth manager like DWM to guide you through.

Don’t hesitate to contact us with any “lovely” questions or “brilliant” comments, and Go Bears!

“Cheerio!”

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

 

*represented by the MSCI AC World Index Ex-USA

** represented by the MSCI AC World Index

***represented by the iShares Gold Trust

****represented by the iShares Global REIT ETF

Climate Capitalists to the Rescue?

Record heat has hit the South. On October 1, it was 101 in Montgomery, AL. Record highs were hit in AL, TN, MS and KY. An acute lack of rainfall has dried out the Southeast as well and residents and farmers are hurting. Planet Earth continues to get warmer.

Look at the chart above showing the changes in temperatures from the 1850s until now. Each stripe is one year. Dark blue years are cooler and red stripes are warmer. The period 1971-2000 is the base line. At the same time, extreme events like Dorian are becoming more severe, more glaciers have died and seas and lakes are getting higher. The climate has changed.

The past century has seen major changes in the world. The Industrial Revolution has brought riches to some, higher standards of living to many, and the population has increased from 2 billion to 7 billion in that last century, and carbon dioxide (“CO2”) emissions have skyrocketed. Fossil fuels have been used to produce industrial power, electricity, transportation, heating, fertilizers and plastic. In 1900 about 2 billion tons of CO2 went airborne. For 2019, 40 billion tons per year will be emitted, with the biggest increase in the last 30 years.   Expanding use of fossil fuel and related increasing emissions of CO2 have gone hand in hand with the expansion of world growth. See the chart below.

GDP CO2

We humans also produce CO2, breathing and eating.  Trees and plants absorb CO2 and, with sunlight and water, convert it to food.   Compared to 1900, we have 5 billion more humans, expanded use of fossil fuels and, because of deforestation, we have less flora to absorb the CO2.

The first half of the 20th century scientists believed that almost all of the CO2 given off by industry and humans and not absorbed by plants would be sucked up by the oceans.  By 1965 oceanographers realized that the seas couldn’t keep with the CO2 emissions.   Climate change shouldn’t come as a surprise; we’ve known about it for decades.

There are lots of predictions about the impact of climate change in the future. No one can predict the future. But certainly, as our beloved Yogi Berra always said, “The Future is not what it used to be.”

The Economist recaps it this way: “Climate change is not the end of the world.”  Humankind is not poised teetering on the edge of extinction.  The planet is not in peril.”  However, climate change could be a dire threat to the displacement of tens of millions of people, it will likely dry up wells and water mains, increase flooding as well as producing higher temps and more severe weather.  The Economist concludes that “the longer humanity takes to curb emissions, the greater the dangers and sparser the benefits-and the larger the risk of some truly catastrophic surprises.”

Addressing climate change will also provide substantial business opportunities in the coming years.  Already some countries are abandoning coal to generate electricity. Britain, e.g., has developed a thriving offshore wind farm industry used to generate power. Germany recently announced that it will spend $75 billion to meet its 2030 goals to combat climate change, primarily in the transportation area with electric vehicles.

In addition, “climate capitalists” want to do good for the planet and well for themselves.  Elon Musk has invested billions into batteries and electric vehicles.   Chinese BYD’s Zhenzhen sprawling campus is a major provider of solar cells, electric cars, heavy machinery and other items needing energy storage.  Warren Buffet has invested $232 million into BYD.  American billionaire Philip Anschutz has spent a decade promoting a $3 billion high-voltage electric grid. Bill Joy, a co-founder of Sun Microsystems, is now backing Beyond Meat, a maker of plant-based alternatives to burgers.  Microsoft’s Bill Gates established a $1 billion company to bankroll technologies that “radically cut annual emissions.”  Even Pope Francis is using the Vatican Bank’s $3 billion fund to help fight climate change.

The UN’s one day climate summit last week concluded with a number of new announcements.  65 countries and the EU have committed to reach net-zero carbon by 2050.   Unfortunately 75% of the emissions come from 12 countries and 4 of them, India, American, China and Russia made no commitment.  However, certain businesses such as Nestle, Salesforce and have made commitments to reach net-zero by 2050 or before.

2050 will be here before we know it.  Yet, technological change can be adopted quickly, particularly when people are provided a better alternative.  In America, the shift from horse-drawn carts to engine-driven vehicles took place within a decade, from 1903 to 1913.  Let’s hope climate capitalists all over the world do well for themselves and good for planet as soon as possible and we humans and our countries do our parts as well.