Category Archives: debt

First Fed Hike & Stock Market

Interest RateGuest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

There has been a lot of discussion about the Federal Reserve (Fed) and when it will move its interest rate to something higher than the present 0 to 0.25%. The Fed has been at the zero bound for years. My friend Jeff Saut at Raymond James noted that there are people who have been in this business over eight years and have never experienced a Fed rate hiking cycle. We have to look back more than a decade to recall what sequential hikes were like.

The questions are, when they will do it, by how much, in what sequence, for how long, to what level, and with what effect on the markets?

Bond market pundits think the Fed may raise rates quickly, as they did in other hiking cycles. Others, like our team at Cumberland Advisors, think they will take gradual steps in view of the fact that the US dollar is the strongest currency in the world. It is getting stronger, and worldwide interest rates are low and going lower. Approximately $4 trillion in total sovereign debt worldwide is now trading at negative interest rates. Additionally, the Fed does not see an inflation threat. It does see gradual recovery in the US and healing labor data.  Today’s employment report will add to the list of monthly improvements.  But the labor markets still have a long way to go to get to normal.  The Fed remembers the 1937 experience when they hiked interest rates too soon and dumped a recovering economy back into recession.

All that said, there is one question that remains. What happens to the stock market when the Fed raises interest rates?

Talley Léger is the co-author of our new book, the second (and revised) edition of From Bear to Bull with ETFs. He has published a study entitled “Don’t be too spooked by Fed rate hikes,” dated January 31, 2015. Talley has given us permission to share this Macro Vision Research piece with our readers. The link to his commentary is here.

We do not know what will happen in this particular cycle, since we are now in uncharted waters. We are coming out of the zero-interest-rate regime. We do know that the market has spent a lot of time and energy fretting about the prospect and the timing of rising rates. Our internal view at Cumberland Advisors is that the first rate hike will not trigger a market selloff. Further, we do not expect the bond market to sell off and interest rates to go shooting up when the Fed raises the interest rate from zero by an eighth or a quarter percent. And we expect the first rate hike to take place in the very latter part of this year or in early 2016.  In a few hours we shall see the newest labor data for the US.  We expect that it will validate this gradualist approach in our Fed forecast.

 

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Oil, Markets, Volatility

Guest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

Oil, Markets, VolatilitySharply lower oil prices have occasioned a huge discussion about their impact. We see it play out daily in newspapers, on TV and radio, at websites, on blogs, and in market letters. The range of forecasts runs from one extreme to another.

On one side, pundits predict a recession resulting from a US energy sector meltdown that leads to credit defaults in energy-related high-yield debt. They predict trouble in those states which have had high growth from the US energy renaissance. These bearish views also note the failures of Russian businesses to pay foreign-denominated debt held by European banks. And they point to sovereign debt risks like Venezuela.  These experts then envision the geopolitical risk to extend to cross-border wars and other ugly outcomes.

Geopolitical high-oil-price risk has morphed to geopolitical low-oil-price risk. That’s the negative extreme case.

The positive forecasts regarding oil are also abundant. American’s Consumer Price Index (CPI) drops robustly due to energy-price ripple effects of $50 oil. We are still in the early stages of seeing these results in US inflation indicators. There is a lot more to come as the lower energy price impacts a broad array of products and service-sector costs.

A big change in the US trade balance reflects the reduced imported oil price. We are also seeing that appear in the current account deficit plunge. In fact, both of those formerly strongly negative indicators are reaching new lows. They are the smallest deficits we have seen in 15 years. Action Economics expects that the current account deficit in the first quarter of 2015 will be below $80 billion. That is an incredible number when we think about gross flows history.

Remember that the current account deficit is an accounting identity with the capital account surplus.  Net $80 billion goes out of the US and turns around and comes back.  These are very small numbers in an economy of $18 trillion in size.

Think about what it means to have a capital account surplus of $80 billion, driven by a current account deficit of $80 billion. That means that the neutral balancing flows into the United States because of transactional and investment activity are now small. Therefore the momentum of US financial markets is driven by the foreign choices that are directing additional money flows into the US.

In the end the equations must balance. When there is an imbalance, it affects asset prices. In the present case, those asset prices are denominated in US dollars. They are desired by the rest of the world.  They are real estate, bonds, stocks, or any other asset that is priced in dollars and that the world wants to accumulate. In the US, where the size of our economy is approaching $18 trillion, the once-feared current account deficit has become a rounding error.

How bad can the energy-price hit be to the United States? There are all kinds of estimates. Capital Economics says that the decline in the oil price (they used a $40 price change, from $110 to $70 per barrel) will “reduce overall spending on petroleum-related liquids by non-oil-producing businesses and households by a total of $280 billion per year (from $770 billion to $490 billion).” Note that the present oil price is $20 a barrel lower than their estimated run rate.

That is a massive change and very stimulative to the US non-energy sector. The amount involved is more than double the 2% payroll-tax-cut amount of recent years. In fact it adds up to about 3/4 of the revised US federal budget deficit estimate in the fiscal year ending in 2015.

Let me repeat. That estimate from Capital Economics is based on an average price of $70 a barrel in the US for all of 2015. The current price of oil is lower. Some forecasts estimate that the oil price is going much lower. We doubt that but the level of the oil price is no longer the key issue.  It is the duration of the lower price level that matters.  We do not know how long the price will fall, but there is some thought developing that it will hover around $55 to $60 for a while (average for 2015).

There is certainly a negative impact to the oil sector. Capital spending slows when the oil price falls. We already see that process unfolding. It is apparent in the anecdotes as a drilling rig gets canceled or postponed, a project gets delayed, or something else goes on hold.

How big is the negative number? Capital Economics says, “The impact on the wider economy will be modest. Investment in mining structures is $146 billion, with investment in mining equipment an additional $26 billion. Altogether investment in mining accounts for 7.7% of total business investment, but only 1% of GDP.”

At Cumberland we agree. The projections are obvious: energy capital expenditures will decline; the US renaissance in oil will slow, and development and exploration will be curtailed. But the scale of the negative is far outweighed by the scale of the positive.

Let’s go farther. Fundstrat Global Advisors, a global advisory source with good data, suggests that lower oil will add about $350 billion in developing-nation purchasing power. That estimate was based on a 28% oil price decline starting with a $110 base. The final number is unknown. But today’s numbers reveal declines of almost 50%.  Think about a $350 billion to $500 billion boost to the developing countries in North America, Europe, and Asia. Note these are not emerging-market estimates but developing-country estimates.

It seems to us that another focal point is what is happening to the oil-producing countries. In this case Wells Fargo Securities has developed some fiscal breakeven oil prices for countries that are prominent oil producers. Essentially, Kuwait is the only one with a positive fiscal breakeven if the oil price is under $60 per barrel. Let’s take a look at Wells Fargo’s list. The most damaged country in fiscal breakeven is Iran. They need a price well over $100 in order to get to some budgetary stability. Next is Nigeria. Venezuela is next. Under $100 but over $60 are Algeria, Libya, Iraq, Saudi Arabia, and the United Arab Emirates.

Let’s think about this oil battle in a geopolitical context. BCA Research defines it as a “regional proxy war.” They identify the antagonists as Saudi Arabia and Iran. It is that simple when it comes to oil. Saudis use oil as a weapon, and they intend to weaken their most significant enemy on the other side of the water in their neighborhood. But the outcome also pressures a bunch of other bad guys, including Russia, to achieve some resolution of the situation in Ukraine.

There are victims in the oil patch: energy stocks, exploration and production, and related energy construction and engineering. Anything that is tied to oil price in the energy patch is subject to economic weakness because of the downward price pressure. On the other hand, volumes are enhanced and remain intact. If anything, one can expect consumption to rise because the prices have fallen. Favoring volume-oriented energy consumption investment rather than price-sensitive energy investment is a transition that investing agents need to consider. At Cumberland, we are underweight energy stock ETFs. We sold last autumn and have not bought back.  We favor volume oriented exposures, including certain MLPs.

We believe that the US economic growth rate is going to improve. In 2015, it will record GDP rate of change levels above 3.5%. Evidence suggests that the US economy will finally resume classic longer term trend rates above 3%. It will do so in the context of very low interest and inflation rates, a gradual but ongoing improvement in labor markets, and the powerful influences of a strengthening US dollar and a tightening US budget deficit. The American fiscal condition is good and improving rapidly. The American monetary condition is stabilizing. The American banking system has already been through a crisis and now seems to be adequately protected and reserved.

Our view is bullish for the US economy and stock market. We have held to that position through volatility, and we expect more volatility. When interest rates, growth rates, and trends are normalized, volatilities are normalized. They are now more normal than those that were distorted and dampened by the ongoing zero interest rate policy of the last six years.

Volatility restoration is not a negative market item. It is a normalizing item. We may wind up seeing the VIX and the stock market rise at the same time. Volatility is bidirectional.

We remain nearly fully invested in our US ETF portfolios. We expect more volatility in conjunction with an upward trend in the US stock market.

High volatility means adjustments must be made, and sometimes they require fast action. This positive outlook could change at any time. So Cumberland clients can expect to see changes in their accounts when information and analysis suggest that we move quickly.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Am I Better Off Investing or Paying Down Debt?

Emergency Fund vs. Paying Off Debt - Which should you contribute to first?This is the fourth installment in our series on how individual investors can assess their financial health.

A common dilemma in personal finance is whether to use funds to pay down debt faster or to invest more. The question crops up in various forms:

 

  • Should I pay off all credit card debt or make smaller payments while saving more for retirement?
  • Should I pay extra on my mortgage or invest in securities?
  • Should I pay down my student loans faster or invest more?

Financial health requires both savings and control over debt. But when these two goals seem to be in conflict, what’s the best way to balance them? Consider these six ways to prioritize.

  1. Make sure you get your employer match. If you’re lucky enough to have an employer that matches your contributions to the workplace 401(k) plan, your first priority is to maximize the employer match. It’s too good to pass up. Contribute any less than what’s matched, and you’re refusing the offer of free money.
  2. Tackle costly credit card debt. Once you are saving enough to secure your entire employer match, you can focus on paying down debts faster. The goal is to pay off all credit card debt as quickly as possible. The interest rates on credit card debt are typically so high that nothing else you do with your money is likely to be as profitable.
  3. Beef up your emergency fund. When you’re beyond the hurdle of credit card debt, consider building out your emergency fund.  If you don’t have sufficient emergency savings to cover a serious car repair, a trip to the emergency room or other not-so-infrequent disasters, this is the next focus.
  4. Save enough in retirement accounts. Assuming you have no credit card debt and decent emergency savings, you can move on to the next set of priorities. If you are saving less than 10% of your pretax income in retirement accounts, ramping up your contributions is probably a better bet than paying extra on your student or auto loans or mortgage. Contributions to retirement accounts are tax advantaged, and it is almost impossible to catch up if you delay retirement savings.
  5. Decide whether to save more or pay down your mortgage. Only when you have no credit card debt, a healthy emergency fund, and you’re saving at least 10% of your pretax income should you consider making additional investments or speeding up your mortgage payments.

But when you compare the cost of having a mortgage to the possible returns from investing elsewhere, don’t forget the tax deduction on mortgage interest. Because of that deduction, your effective (after-tax) interest rate on your mortgage is lower than your actual mortgage rate. There are handy online calculators that can quickly calculate the effective interest rate on your mortgage, accounting for tax benefits.

If you are confident that you can invest at a rate of return that’s at least as high as your effective mortgage rate, you may want to hang on to the mortgage and invest more.  Over the past few years, many consumers have taken out mortgages with effective interest rates of 3% or less.  At this level of interest, there are investment alternatives that make more sense.

Also remember that extra principle payments come with liquidity risk. That is, if you need a source of cash, it may be easier to sell a security investment. To take cash out on your mortgage, you will have to refinance or open a line of credit.  Either of these may come with a higher cost than your current mortgage, not to mention origination fees.

  1. Decide whether to save more or pay down college debts. If your income is below $75,000 per year ($155,000 for a couple filing jointly), some or all of the interest that you pay on college loans may be tax deductible. So the effective rate of interest on your college loans may be lower than the actual rate. Take that into account when you compare your loan interest with potential investment earnings.

An additional consideration may be whether a parent or grandparent cosigned your student loans.  If you become disabled or die—or you’re simply unemployed for a long period of time, your consignors may have to pay your college loans.  That risk may make it worthwhile to pay off college loans faster.

Accounting for Uncertainty

If you could be sure that you’ll never lose your job and that you’ll always be able to open a low-cost line of credit, the decision to pay off debts would be much easier.  But you have to look beyond comparing interest rates on debt to the expected returns from investments. You have to consider that credit may not always be available at today’s rates.

With mortgage rates as low as they are now, paying down a mortgage does not look like the most attractive choice. Once you’ve paid off all high-cost revolving credit (e.g. credit cards), have a solid emergency fund, and you’re saving 10% of your income in retirement accounts, however, it’s worth considering paying down college debts.

Putting non-retirement money into risky investments like stocks before you have accomplished the milestones listed above makes your overall financial situation more risky.  Whether or not this is too much risk depends on you.

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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What Happens in A Nation of Renters?

Time magazine has a new article on changes in the home ownership in America.  The article, titled A Nation of Renters: Should We Be Worried That Fewer Americans Own Homes?, explores the substantial decline in the fraction of Americans who own their own homes.  I have followed this issue for quite some time and the implications for investors may be substantial.  Continue reading