Tag Archives: Behavioral Finance

Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

 

REITs and the Rally of 2014

There have been a number of surprises for investors in 2014.  Bonds have markedly out-performed stocks for the year-to-date.  The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%.  Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD.  Interestingly, REITs have been also experienced a substantial run-up in 2014 so far.  The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class.  REITs are neither stock (equity) nor bond (fixed income).  A REIT uses investor money, combined with borrowed money, to acquire real estate.  The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR).  The returns vary between the specific types of property owned.  REITs make money from renting their facilities out.  Please note that I am discussing only equity REITs (those which own property).  There is a secondary form of REITs that buy baskets of mortgages.  These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year.  For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance.  Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO).  A notable feature of REITs is their exposure to interest rates.  In general, stocks go up when interest rates rise, while bonds fall.  When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value.  REITs tend to have a fairly neutral response to changes in interest rates, although this varies.  To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise.  REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation.  In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

Chart 1

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends.  Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500.  The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa).  These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes.  The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example.  The high beta is only one factor that determines the returns from these REIT index funds, however.  Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years.  The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Chart 2

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa).  This effect is evident in the table above.  S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield.  The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM).  In 2013, Treasury bond yields rose and stock indexes gained substantially.  By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield.  The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation.  When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment.  The selling continues until the yield on the bonds is in line with new rates.  This is why returns on the two bond funds are so negative correlated to Treasury yield.  When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields.  While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014.  If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits.  The higher the correlation, the less diversification benefit you can expect.  The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value).  As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio.  This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this.  REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral.  While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates.  REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge.  In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive.  The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class.  Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier.  For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends.  The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

 

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.

Continue reading

Economic Inequality

Income inequality is increasingly acknowledged as a key economic issue for the world.  The topic is a major theme at Davos this year.  Economic inequality is also an increasingly common topic in U.S. politics.

A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously.   The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult.  The numbers have not changed in three decades.

On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale.  The richest 1% of Americans now own 25% of all of the wealth in the U.S.  The share of national income accruing to the richest 1% has doubled since 1980.  In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.

Why is this happening?

Continue reading

Apple’s Share Price and Behavioral Finance

The price of a share of Apple (AAPL) is almost 30% below the high that it set back in September 2012—about five months ago.  Even before its peak, the price of Apple shares had already made it the most valuable company in history.  In those heady times, Apple shares reached $702.  Today, they are at $503.  Even today, however, Apple remains the largest single holding in the S&P 500 at about 3.6% of the total index.  It is mind boggling to consider that the market value of the most valuable public firm in history could decline by 30% in five months, without some sort of catastrophic event.  But this is the situation and there are some lessons to be drawn. Continue reading

Game Theory, Behavioral Finance, and Investing: Part 1 of 5

Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related.  Game theory is the study of how a rational person makes decisions in uncertain situations.  As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome.  Game theory focuses on how rational players can make the best decisions to maximize their satisfaction.  Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker. Continue reading

The High Cost of the July 4th Cookout

Many Americans will be feeling the effects of higher commodity prices this 4th of July.

If you have been to the grocery store lately, you’ve probably done a double-take at the register as your outdoor grilling essentials are being scanned. Steak and ground beef prices are up almost 6% over the last 12 months and a persistent drought in the mid-West is driving corn prices up dramatically. USDA recently reported that the average price that Americans pay for food will be up between 2.5% and 3.5% vs. what we paid in 2011.

However, before you ration the hot dogs and burgers and put a hold on serving steaks at your BBQ this year, lets take a look at the long-term history of food prices in the U.S.

Don’t Blame Inflation This Time

The good news is that Continue reading