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Notes ALong the Path April 2021

Notes ALong the Path April 2021

April 08, 2021
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Dear Friends,

Welcome to another edition of Notes Along the Path!

This month's topics:

  • Covid—A Year Later
  • Big Picture Market Update
  • Avoiding 7 Retirement Traps

Please consider sharing this with someone you know who might be asking themselves (or you!) questions about their financial future.

Covid—A Year Later

This time last year, the World Health Organization recently had declared that the spread of Covid-19 constituted a worldwide pandemic.

Stringent measures in the U.S. were being taken to slow the spread of Covid and "flatten the curve." The lockdowns and shelter-in-place orders dealt a body blow to U.S. economic activity.

Investors, who attempt to price in economic activity over the next six to nine months, had no prior experience to handicap a shutdown and eventual reopening of the economy. It was as if we were driving through a dark and foggy night with no headlights to guide our path.

Consequently, investor reaction was swift, and the first bear market since 2009 descended upon investors. Volatility was intense. On March 16, 2020, the S&P 500 lost 11.89% - nearly 325 points.

That day accounted for over 28% of the S&P's nearly 1,150 point bear market loss.

The major market indexes bottomed on March 23 as the S&P's deline lasted barely over a month. It was a big decline, but it was the shortest bear market in histoty.

The ensuing rally has been nearly unprecedented. Since bottoming, the S&P 500 Index advanced an astounding 77.6% through March 31. Its 3,972.89 close at the end of the first quarter '21 put it within 1.65 points of the March 26 closing high. And that is on top of a series of new highs since the beginning of the year. Since the end of the quarter, the S&P 500 has gone on to top 4,000.

Let's examine some historical context and see if there is a pattern.

If we review the six longest bull markets since WWII, the S&P 500's advance over the first year tops all other prior bull markets. In second place after 2020-'21, at 72.4%, is the bull market that began in March 2009. That run lasted into February 2020 (St. Louis Federal Reserve).

I noticed what's happened in the second year of bull markets that were born out of bear markets that saw the S&P 500 Index fall at least 30%.  Since World War II, there have been six other bear-market selloffs of at least 30%. In each case, the market posted strong returns in the first year, with an average gain of 40.6%. Gains ran into year two, with an average increase of 16.9%; however, the average pullback at some point along the way to those gains: 10.2%.  

My crystal ball is broken.  I don't know when such a correction might happen.  But it's reasonable to say that a bumpy ride is likely this year.

Treasury bond yields have jumped as the government has embarked on the $1.9 trillion stimulus package, and talk of new spending from Washington is gaining momentum. Further, bullish enthusiasm can sometimes spark unwanted speculation.

Might the economy overheat and spark an lasting rise in inflation?  Unlikely.  Might rising bond yields temper investor sentiment? Yes, eventually.  Until now, however, investors have focused on the rollout of the vaccines, the reopening of the economy, and the benefits these are providing.

Today, momentum favors bullish investors, but valuations seem stretched, at least over the shorter term. When markets are surging, there is a temptation to load up on risk. That is a mistake.  The riskiness (volatility) in your investment portfolio needs to stay firmly grounded in your life circumstances and temperament, not the market's ups and downs.   

Just as an investment plan takes the emotional component out of the investing decision when stocks are falling, it also erects a barrier against the impulse to load up on riskier investments when shares are quickly rising.

Life changes, and when it does, adjustments may be appropriate. Ups and downs in stocks are rarely a reason to make emotion-based decisions in our portfolios.

Big Picture Market Update

50,000-foot View

My Outlook for Stocks:

                   1    2    3    4    5    6    7    8    9    10

Bearish     -----------------------------X--------       Bullish  (8+)

A "10+" would indicate certainty that prices are going to go up, whereas a "1" would indicate certainty that prices are about to go down.

Reasoning:

1. The Fed's Current Position

                      1    2    3    4    5    6    7    8    9    10

 Hawkish    ------------------------------------X-       Dovish (10-)

Hawkish: the Fed believes the economy needs to be cooled down to fight inflation and will raise the rates they control or keep them high.

Dovish: the Fed believes the economy needs stimulation to reach full employment and will cut the rates they control or keep them low. Also known as accommodative.

The Fed and the bond market (both the supply of bonds issued by the Treasury and the demand to buy them) together drive...

2. The Treasury Yield Curve

The two most common types of yield curves are "normal" and "inverted."  A "normal" yield curve has an upward slope – the interest rates (yield) generally get higher as the bond term gets longer.  The Treasury yield curve is said to be "inverted" if the yield on 10-year Treasury Note's yield, or longer-term Bond yields, are lower than the 1-year T-bill or shorter-term Treasuries. 

Current Status: Normal yield curve, trending steeper

About a year ago, on March 9, 2020 (blue columns), the 10-year hit a historic low, dipping below even the 1-month T-bill rate.  This type of inverted yield curve is considered an extremely strong sell signal.  Sure enough, the S&P 500 dropped another 16% over the next two weeks until the Fed and Treasury Department took decisive action to stop the slide.

As you can see in the graph, from the first trading day of the year to the first of March to this week slope of the curve is getting steadily steeper. This is an indication that the Bond market thinks economic growth and inflation will accelerate.

Commentary:

The yield curve matters because it tells us what's coming: accellerating economic growth and more inflation (not the same as high inflation.)  These usually lead to rising stock prices.

There will come another time when I say, as I did in 2007, that we are in a bubble.  While certain stocks are probably overvalued, I think a solid case can be made for a rising market prediction or a falling market prediction.  Multiple record-breaking fiscal stimulus bills and ongoing Fed monetary stimulus, along with pent-up consumer demand, has me convinced that the economy will grow rapidly for the remainder of 2021. The stock market usually does not go down when economic growth is accelerating unless there is an external shock like an oil embargo, a terrorist attack, or a pandemic.

Almost a year ago, Chairman Powell said that the Fed would do whatever it takes to keep the economy afloat.  I see no change in his maximally accommodative posture, although a minority of the members of the Fed's rate setting sommittee want to put an end date on this policy.  All of these factors have me feeling bullish about the stock market in the near to medium term.

30,000-foot View:

Note: the following is not investment advice, but represents thoughts for a theoretical average investor.  I would need to know your personal situation to make asset allocation recommendations.

Age*      Recommended Allocation

              (Stocks – Bonds - Cash**)

20's         100 – 0 – 0

30's         90 – 5 – 5

40's         80 – 10 – 10

50's         70 – 10 – 20

60's         65 – 10 – 25***

Retired   60 – 10 – 30

* If you started saving late, you need to be investing like a 20-year-old for the first 10 years.

** A portion of your "Cash" may include other hedges, such as a combination of funds with differing hedge strategies.

*** Retirees that have accumulated more than enough to live well may consider an even lower stock allocation. (If you have already won the game, you can stop playing)

Commentary:

Usually, there is no need for cash in efficient portfolios.  We are in the midst of an unusually risky time for bonds.  What I mean is that the probability of interest declining (which increases bond values) is near zero, and the probability of interest rates increasing (which hurts bond holdings) is near certain.  Therefore, at least half of what would generally be allocated to bonds is recommended to the cash allocation.

It is reasonable to ask, "What about stocks? Aren't their valuations so high that they are also risky?" My answer is that it depends on how you define risk.  Stocks are volatile, but a diversified portfolio has an effectively near-zero risk of default and a near-zero inflation risk if held over 3 years.  I don't know when the next market correction or bear market will start, but I do know that we will recover from it over time.  If you are working and accumulating assets, you need to remember that risk (volatility) ensures you get a lower-than-average price when you buy stocks through the advantage of dollar-cost-averaging. As Peter Lynch said, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves."(As quoted in "The Wisdom of Great Investors: Insights from Some of History's Greatest Investment Minds, by Davis Advisers, p. 7)

Avoiding 7 Retirement Traps 

You have saved and invested for decades, and you are gearing up for retirement, or maybe you have already left your job. While the idea of leaving your career behind may be appealing, it is a monumental change that can also be unsettling for some folks.

You will be sailing in a new direction, and you will take on new challenges. Your daily routine will dramatically change, and you'll begin to rely on a lifetime of savings.

What should you do?  What should you not do?  Either way you phrase it, watch out for these traps.

  

  1. Failing to assess your risk tolerance, risk need, and risk appetite:

There was little reason for concern when you were 30-years old, and volatility struck. The idea of dollar-cost averaging and buying shares at a lower price may have been appealing. Besides, the market has a long-term upward bias, and it would be decades before you would tap into your 401k or IRA.

But if you are about to retire or newly retired, market volatility can be much more disruptive. A significant decline in stocks at the onset of retirement could create serious problems down the road.

Risk tolerance is the maximum amount of risk you can tolerate and stick to your investment plan; risk need is the amount of risk you need to generate enough growth and income to meet your basic retirement needs.  Risk appetite is the middle ground, the sweet spot between all you can handle and the minimum you need.  Finding that spot is as much art as science and requires a good relationship with your financial planner and the time to talk over the context and implications for your life. 


  1. Taking Social Security too early:

There are some valid reasons to opt for Social Security when it becomes available at 62. For most, however, that will reduce their lifetime earnings from Social Security.

Today, the full retirement age runs between 66 and 67 years old, depending on the year you were born.

Individuals who collect Social Security at age 62 receive 25% less in monthly benefits than if they had waited until full retirement age. This assumes a full retirement age based on a date of birth between 1943 and 1954.

Delaying Social Security until 70 allows you to receive the maximum available benefit. It will provide you with an additional ~32% over what you'd pocket at full retirement age, assuming full retirement age based on a birthdate between 1943 and 1954 (both examples are estimates for illustrative purposes only).

Rules governing Social Security are complex, particularly for spouses with significant differences in their income histories, and the information we've provided is simply a general overview. Much will go into your decision to begin collecting your monthly benefit. We are happy to lay out various strategies to best position you when the time comes.

 

  1. Not implementing the correct distribution strategy:

If all your retirement assets are locked up in a Roth IRA, taxes are much less an issue when you withdraw for living expenses. However, many of us have our savings in a traditional IRA or 401k. Distributions will be taxed at your marginal tax rate. You may also be liable for penalties if you withdraw before the age of 59 ½.  

Watch out for the required minimum distribution, or RMD, for your IRA, which now begins at age 72 (70½ if you turned 70½ before Jan 2020). You may decide to leave your IRA alone until RMDs are required.

Some may choose to take withdrawals before age 72 to reduce future RMDs and the potential tax implications of large withdrawals when they become mandatory.

It's a complex topic that could be explored in depth. My goal is to make you aware of the idea. There are ways to maximize your benefits and minimize costs. We will tailor our recommended strategies to your specific needs.

 

  1. Spending too much or spending too little:

When you retire, your lifestyle will change. You'll have the opportunity to enjoy new experiences and enjoy them on your terms.

But let me gently caution you not to overspend in the early years of retirement. Recognize that you'll be living on a mostly fixed income, and you have a finite ability to earn extra cash. This is especially true as you get to later retirement.

At the same time, some retirees can be too cautious about spending. They have ample reserves but sometimes guard them too closely. We applaud those who want to leave a financial legacy to their children but balance that desire and have some fun in retirement.

 

  1. Falling for scams:

I won't spend much time on this as I've written about fraud in the past and will gladly provide you with more information if you would like.

But be very suspicious of individuals and companies that prey on the elderly and their desire to grow their savings. We are always happy to provide you with an objective review of any investments you are presented with. Remember, if it looks too good to be true, it usually is.

 

  1. Not watching out for medical expenses:

You have Medicare, and you probably have a supplemental policy. But deductibles and health expenses that are not covered by insurance are always a challenge.

It's essential to budget for insurance and medical expenses that will likely occur as you get older.

  

  1.  Not recognizing you may live longer than you expect:

Don't let your retirement plan's success be predicated upon saying goodbye to your loved ones shortly after leaving the workforce. Life expectancy and longevity can only be estimated.

Some folks will live well into their 80s, 90s, or beyond. Get an honest health assessment like this one (blue point) and continue to plan as if you'll be tapping your savings long after you have retired.

Lastly, stay active and volunteer. It will help keep you physically fit and mentally sharp. Just as we have a plan for your finances, it's critical to have a plan that keeps you active and helps you enjoy retirement.

 

I trust you've found this review to be educational and informative.

If you have any questions or would like to discuss any matters, please feel free to give me a call.


If you like it this newsletter I encourage you to pass it on to any contacts you have that might benefit.

 

I remain honored and humbled that my clients have allowed me to serve as their financial advisor. Thank you for your support.

All the Best!

Gordon Achtermann
T: 703-573-7325