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In This Issue: Inverted Yield Curve An Oddity 401(k) Loan Requires An Exit Strategy
After viewing “The Crash,” a documentary on the History Channel a few weeks ago, I asked a friend in his 80s what the experience was like. Age 13 in 1929, he remembered it well. “We lost our car,” he said, “but we were able to keep our house in Berkeley. It was an awful time for my family.” The Crash and the ensuing Depression scarred an entire generation. It influences their investment habits to this day. Can learning about the Crash offer insight that would make us more effective investors? The crash on Oct. 24, 1929, was a shock to the system. It was actually a two-part crash that started on a Thursday, with an even larger drop the following Tuesday. Many people were wiped out because so much money in the market was borrowed. Goldman Sachs Trading Corp., for example, had only 2 cents of its own money invested for each dollar of shares it owned. Leveraged investment pools invested in other leveraged investment pools, resulting in a dizzying amount of risk. To appreciate leverage, remember the Bay Area housing market in the early ‘90’s. If you had to sell a house that you had only owned for a few years, you sold it for 20 percent less than you paid for it. If you had made a 20% down payment and the bank had loaned 80 percent, you lost your equity in that transaction. Similarly, the stocks owned by Goldman Sachs only had to lose 2 percent for the trading partnership to be wiped out. Leverage works both ways. If stocks went up 2 percent in value, the partnership doubled its equity investment. This ability to borrow money and to buy on margin is what made the 1920s roar. On Oct. 24, the market wiped out almost anyone out who had been trading on margin. People in New York City’s financial district walked in the middle of the street to avoid being hit by the falling bodies of suicides. At first, the market recovered. By Nov. 14, stock prices seemed to have reached bottom and then climbed 25 percent. By April 1930, it was back to its pre-crash level. Then, the slow inexorable slide began that lasted throughout the Depression. In about 10 years, the total stock market had recovered and returned to its original levels. The Dow Jones Industrial Average, however, required almost 25 years before it regained its pre-crash value. There are no clear indications that the stock market crash caused the Depression. The basis for the crash was a combination of events leading up to it, and here is where we may identify similarities with today. The sale of Liberty Bonds to finance World War I represented the first retail sales of an investment product to the general public. Before this, only wealthy people purchased stocks and bonds. Everyone else kept their money in mattresses or opened savings accounts at banks. Compare this with the widespread adoption of mutual funds today. Remember, the money market fund was only invented in 1972, and this sparked the explosion in mutual fund popularity. Together with tax laws that have established mutual funds as the most popular investment vehicle for 401(k)s, mutual funds have propelled the increased interest in the stock market among the American public. Is this uncomfortably similar to the sale of retail investment vehicles during World War I? By any historical measure, today’s stock prices are off the charts when compared with company earnings. We might call this a “bubble,” but only after it pops. A “bubble,” after all, is a historical term that describes what just deflated. Until the deflation occurs, we don’t know exactly what we have, and this is what confounds rational thinkers in the investment community today. A fundamental problem impacting the market is that there are new industries having no track record of earnings. In this environment, there is nothing to refute an optimistic expectation of future earnings. Almost all industries become infected with this virus to some extent, because we all benefit directly or indirectly from new technology. For the stock market to perform well, mutual funds need to have high levels of cash with which to buy stocks. It is the financial equivalent of keeping powder dry. The markets tend to suffer when the mutual fund industry invests all its cash and runs out of buying power. Right now, the mutual fund industry is maintaining record levels of cash. This is good for the market, because sooner or later, those funds that are supposed to be investing in stocks for us will have to start buying. Will this be smart or will it represent a bubble getting bigger? Imagine your personal best bubble-gum effort. That giant bubble that became a liability when you realized what it was going to do to your face when it popped. There are two lessons in all this. First, don’t borrow to buy stocks. Second, reduce risk by diversification. Remember, we shouldn’t expect any single investment or advisor to time the market nor protect us on the downside. At the same time, we can’t afford to be out of the market as it continues to climb that proverbial “wall of worry.” Keeping track of the time-frame of our investment goals and preparing ourselves for periodic disappointments will contribute to better long-term results. “The Crash” is a splendid documentary that provides a compelling look at the dark side of the institution we are trusting for financial security. A splash of cold water on our boundless optimism may lead to better investment decisions over time.
Inverted Yield Curve An Oddity This has been quite a year for statistical oddities. Internet stocks are swinging in either direction by 90 percent and a presidential election is decided by a few hundred dimpled ballots. Now there’s another quirky event: we are currently experiencing an economic phenomenon known as the “Inverted Yield Curve.” Your reaction to this might be as if a bird-watching friend had breathlessly announced sighting a red-billed double-crested humdinger. You are happy for your friend, but you can’t see that this has much impact on your life. Think again. An inverted yield curve has important implications for your financial health and retirement planning. So let’s investigate what Sherlock Holmes and Dr. Watson might have called “the strange and mysterious case of the inverted yield curve.” A yield curve is a standard measurement of the bond market. It shows on a graph the rate of interest being paid compared to maturity (the length of time before a bond re-pays principal). The usual circumstance is for a yield curve to slope upward, which is called a positive curve. That simply means investors expect to get paid a higher rate of interest as the time to maturity increases, and a lower rate for less time. The person borrowing the money (i.e., selling the bond) has to reward the buyer for assuming more risk over a longer period of time. For example, if you lock up your money in a five-year CD, you expect the bank to pay you a higher interest rate than if you put the same amount of money in a six-month CD. That’s what makes the current circumstance so noteworthy. The yield curve is sloping downward, which is called a negative or inverted curve. This means that your money market fund, which is invested in short-term debt and which carries virtually no risk, is paying a higher rate of interest than long-term bonds. Money funds are paying about 6.3 percent today while five year bonds are paying 5.5 percent. An inverted yield curve should concern us, because historically it has been a forward indicator of a declining stock market. Interest rates are the single most important influence on stock market values. When rates go up, it costs companies more to borrow the money they need to operate. This additional interest cost cuts into profits and eventually translates into lower stock prices. What’s causing the yield curve to behave so strangely? It seems to be a case of supply and demand. Awash in cash, the U.S. government is paying off its debt rapidly. It is not issuing as many long term bonds as it did during the deficit years. Supply is drying up. A government surplus is a good thing. Yet a serious question arises about whether the financial markets can function smoothly without the tool of government bonds. What else will allow money to be loaned and invested over long periods with predictable and guaranteed rates of return? Meanwhile, demand for bonds is surging among institutions and individuals. After a year of flat or negative stock market returns, big and small investors are searching for safety. Money market funds at 6.3 percent suddenly look attractive. If you think that the economy is slowing down, then you might assume that long-term yields will drop still further pretty soon, and today’s long-term bond rates may be the best investment alternative for the next 10 years. The professionals seem to be keeping their powder dry. Cash positions at equity mutual funds are high today as managers wait to see what will happen. Look at this another way. Businesses that are borrowing don’t want to borrow long term at today’s rates if they are convinced that tomorrow’s long-term rates will be even lower. The demand for short term debt is greater than the supply of investors who want to loan short term. Therefore, you have to pay higher interest rates to get this suddenly-precious short term money into your business. Remember, the stock market is dwarfed in size by the bond market. The engine that drives the bond market is the question of present and future interest rates. Because interest rates in the bond market are the single most powerful determinant of future stock values, rate gyrations can offer a clearer picture of the future than the stock market, with all of its surrounding hype. What does it mean as we struggle to make sense of our retirement plan investment mix? In some ways, an inverted yield curve confirms what we already know. The stock market is volatile and will have to correct sooner or later if it is to revert to the norm. As a signal, today’s inverted yield curve may be the bond market’s equivalent of the stock market’s grossly inflated price earnings ratio. Two ways to deal with risk are to a) ignore it or b) reduce short-term volatility by moving into bonds and cash. For those with a long-term financial goal, Plan A may be the best bet. Hold on to your stocks, prepare for some gut-wrenching twists and turns, and wait for clearer days ahead. For those with a shorter-term goal, or whose stomach churns uncomfortably on a roller coaster, a version of Plan B may be worth considering. At the very least, you should expand your perspective beyond Nasdaq, the S&P 500 and the Dow, and develop an appreciation for interest rates and yield curves. Whether or not you choose to have bonds in your portfolio, a comprehension of their basics will make you a far better and more resilient investor.
401(k) Loan Requires An Exit Strategy Most retirement plans permit some type of participant loans. The best 401(k)s allow loans for any reason, and simply charge a set-up fee that dissuades excessive borrowing. Other plans allow loans only for home purchases or financial hardships. Whatever your plan’s rules are, 401(k) loans can be a good way to raise cash under the right circumstances. However, there’s one pitfall that requires advance planning in order to avoid a painful tax hit. This pitfall has to do with repaying the loan if you leave your job. You’ll need what venture capitalists call “an exit strategy.” Why? Because the loan’s unpaid balance gets attributed to you as taxable income after 90 days of no loan payments. If you have left your job, there is no salary for your employer to use to keep your loan from going into default. In the old days, before most plans were valued daily with 800 phone numbers and Internet access, you likely could continue to make loan payments after leaving your job. Today, though, loan repayments in these highly-automated programs require a seamless, electronic link between the retirement plan vendor and the company payroll service or HR department. Practically speaking, there’s no way for you to casually send in a check for two or three months of payments. What’s the answer? Use whatever resources you can get your hands on to pay back a retirement plan loan before or shortly after you leave a job. You should even look at some of those credit card solicitations that are flooding your mailbox. Remember, you may not have to replace the loan for very long. If you are moving to another job, you’ll probably be able to roll your old account balance into the new employer’s plan. In many cases, you will not have to wait until you are eligible to contribute to the new plan. Many plans allow rollovers immediately as a convenience for new employees. On paper, at least, your loan from a new credit card may only be for a few months until the paper work is straightened out. Then you borrow from the new plan and pay off the credit card loan. If you resort to other after-tax resources, look for ones with no exit costs. For example, try not to collapse a mutual fund that has already charged you a commission to get in or that will charge a back-end load to get out. If you do sell a mutual fund, pick actively managed ones that have high turnover. These are the funds that have been sending you 1099’s at the end of each year telling you how much you owe in taxes on the gains on their trades. An index fund, by comparison, would not be a good candidate for selling. With little stock trading, gains have been building up in this fund. That fund will only trigger a taxable event on all the years of gains when you sell it, so it is better to let that sleeping dog lie. If you and your spouse both have 401(k) plans, consider dividing a loan request up between both plans. That way, if one of you changes jobs, your problem will be reduced by 50 percent. If you are on good terms with the boss, ask if there is any consulting or part-time work that will provide at least enough salary to cover the loan payment amount. With enough advance notice, you may be able to spread the last paycheck over a number of months. Once you are eligible for a plan and you have at least a $5,000 account balance, you can’t be kicked out as long as you still have at least some income to service the loan. The worst possible outcome is when people leave a company and let their unpaid loan balance twist slowly in the wind. They move the remaining money into (hopefully) a rollover IRA and ignore what they’ve already borrowed and spent. In January of the following year, they receive a Form 1099 that says, “You owe taxes on the $10,000 unpaid balance of your 401(k) loan.” For a single person making more than $35,000, or a married family with taxable income of more than $45,000, this means federal and California taxes and penalties adding up to almost 50 percent, or $5,000. How are you going to get that money by April 15? Once paid in taxes, it will be gone forever. The $10,000 unpaid loan is a block of money that will never be in your plan again. Better preparation could have kept that $10,000 intact as a retirement asset. Twenty years later at retirement, assuming growth of 12 percent, it could have accumulated to more than $100,000. What a tragic waste. None of this should scare you away from considering a 401(k) loan. It can be a prudent and sensible thing to do. About 35 percent of all 401(k) participants have loans outstanding from their plans. At any given time, about 5 percent of all plan assets are “invested” in loans to participants. There is nothing wrong with this. There is no shame in being your own banker. In fact, if markets remain flat this year, your participant loan may turn out to be the best-performing asset in your plan, because the interest you are paying goes back into your own assets. To sum up: If you take a 401(k) loan, consider the consequences if you leave your employer. That credit card solicitation in today’s mail may be an arrow in the quiver of your smart exit strategy.
Here are some tables to help with quickly figuring out 1) how long a program of regular investment of given amounts will take to grow to one million dollars; and 2) where to put some of your money based on changing priorities. The following table shows how much you would have to save at various ages to have a million dollar retirement fund, assuming an average annual yield of 11%. In recent months, with the decline of certain parts of the market, it is becoming difficult to believe that 11% is a safe assumption. However, this is the historical rate of return for the market as a whole during the 20th century. Again, this makes an excellent planning tool for anyone beginning an investment program.
To use the table above, find your age at your nearest birthday and then see what you need to save at 11% to have a million dollars by age 67. That’s the “official” retirement age for anyone born after 1960. Finally, for people considering redirecting a portion of their investments out of stocks because of concern for the direction of the stock market or due to changing needs, here are some recent yields on liquid investment vehicles to consider.
The numbers tell the tale: after gaining 300 percent since December 1994,the Dow nearing the end of 2000 is down 6% from December 1999. The NASDAQ is on its way to having its worst year ever, and the total market as measured by the Wilshire 5000 index stands at 12,216—a full 12% below December 1999. On the heels of such bad news, let’s ask the usual question: does this mean that we should sell all of our stocks? Not at all. The economic fundamentals remain healthy, and while the economy is slowing, it seems to be doing so in an orderly manner. It even seems that a measure of relative sanity is returning to the equities markets. The experienced long-term investor knows that even the most abrupt and widespread market swings even out over time. In the 20th century, the best long-term investment for anyone wishing to accumulate wealth has been equities (that is, stocks). Not real estate, not precious metals, not bonds or T-bills, not oil wells. In the near term, it is evident that market gains of the 1990s will not continue and that there will be a tendency for market growth to return to historic averages. In plain terms, the market will decline until the long-term averages are restored. However, whether you are just beginning or are already investing, you should make sure that your portfolio is as “bear proof” as possible. To do this, follow these guidelines:
In the current highly valued market, with the high rate of company earnings slowing, you need to be a little defensive, so look at what your current or prospective mutual funds invest in. A balanced portfolio might consist of 50% stocks, 35% bonds and 15% cash. Ask your 401(k) plan administrator what the asset allocations are for each of the funds offered and go from there. Or ask the same question of any mutual fund that you may be interested in outside of your 401(k) plan.
Indexes Prime Rate - 9.5% Fixed Mortgage 30 Year - 6.84%, 15 Year - 6.55% Home Equity Loan 9.64% New Car - 48-Month Loan 9.4% Internet Sites Dow Jones Average History
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