2020 3rd Quarter Update

Top Headline for Q3: “Winners” and “Losers” Continue to Separate

Unfortunately, the COVID-19 pandemic remains with us and continues to affect nearly every aspect of our lives. This includes the financial markets where the most obvious impact is the dispersion of results in the US equity market. There have been clear “winners” with over 25 companies now up more than 400% for the year – a cluster of success that we haven’t seen in twenty years. This group includes Zoom, the most obvious pandemic success story, that has become a household name. On the flip side the pandemic has had a massive adverse impact on certain industries. The most obvious of these is the energy sector where the economic lock-down and reduction in travel has crushed the global demand for oil. To highlight the overall separation, the technology sector (ticker: XLK) is up 28.6% on the year while the energy sector (ticker: XLE) is down 47.5% through Q3. We can’t recall ever seeing such a pronounced gap in sector performance. The market dynamics are contributing to social unrest related to economic inequality as we are seeing a surge in new tech-entrepreneur billionaires at the same time that unemployment is spiking in traditional industries.      

General Market Update

US Equities:  The S&P 500 Index finished up 8.5% for the quarter while the technology-heavy Nasdaq Composite continues its year-to-date outperformance by rising 11%. The Russell 2000 Index finished up 4.6% and continues to substantially lag the larger-capitalization indices. As mentioned above, there were substantial differences in equity sector performance during the quarter. As we recently highlighted in a blog post from early August (Midsummer…..), the S&P 500 and Nasdaq Composite are up for the year but there has been very little “breadth” in this market surge. A lack of market breadth means that the stock market is being carried higher by a minority of high-performing companies.  It is generally not a sign of market strength. As mentioned above, the year-to-date rally has happened mainly on the back of one sector (i.e., Technology) and more specifically on the back of “Megacaps” like the “FANGMAN” group (i.e., Facebook, Amazon, Netflix, Google, Microsoft, Apple and Nvidia) – now collectively worth more than $7 trillion dollars. To further highlight how much these mega cap companies are driving market performance you can compare performance of the S&P 500 Index, which is “market cap weighted” to its “equal weighted” counterpart (ticker: RSP). The S&P 500 Index gives greater influence to larger companies mentioned above while the equal weighted holding RSP gives every company in the index the same weighting. Through Q3 the S&P Index is up 4.1% YTD while RSP is -5.3%.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 5.5% in Q2 and the Schwab Emerging Markets ETF was up 9.9%. The developed international market continues to lag the US mainly on account of the industry composition of the European market (i.e., it has a lower percentage of technology companies). This allocation also helps to explain why these markets trade at much lower earnings multiples relative to the US at the moment. Emerging markets are starting to see a surge as economies continue to re-open, leading to a sharp rebound in manufacturing and trade.     

Fixed Income and Credit: The bond market has entered a new dimension of unprecedented price stability. The “MOVE Index,” which measures volatility in Treasury Bonds, is sitting at all-time low levels as bond prices trend sideways. The Federal Reserve entered these markets by buying corporate bonds and ETFs during the year to encourage price stability, and it worked. Corporate bonds would normally be selling off in a recessionary time but we’re seeing very little downside price movement as investors perceive the Federal Reserve as a “backstop” against price declines. Moreover, the Federal Reserve is driving the market in treasury securities where it has become, by far, the largest purchaser. This market is largely in the hands of the Federal Reserve at this point. If one believes they will continue to support it, price stability will likely remain. Without government intervention, we’d likely see a pull-back in prices as rising bankruptcies and the threat of inflation, combined with no room for further interest rate decreases, creates downside risk.  

A Look Ahead

The US stock market performance continues to surprise to the upside. There are some reasons for concern including (1) valuations are high, (2) the market is riding to new highs with very low market breadth, (3) technology is leading the market high and can be highly volatile, (4) the adverse economic impact from COVID continues with no clear end date and (5) we will enter 2021 with high economic-policy uncertainty given the ongoing social unrest. On the positive side, we are likely to continue to see a massive amount of ongoing government support in the way of direct subsidies to individuals and a continued zero interest rate policy (“ZIRP”). We continue to believe that the biggest winners of ZIRP and the Federal Reserve’s intervention are public corporations. With interest rates near zero, combined with the Federal Reserve’s direct purchases of corporate bonds, the cost-of-capital is at record lows. Not surprisingly, corporations are making 2020 a record year for bond issuance and are locking in rates for the long-term. The large-cap group looks to be the best positioned as companies like Amazon, Microsoft and Apple are able to issue bonds at rates that are barely above US Treasuries. They’re likely to resume share buy-backs with this money as soon as economic stability appears – a huge driver of shareholder return in recent years. It’s also noteworthy that the stimulus checks and PPP actually increased personal income during Q2 and would do so again when/if further rounds are approved. This likely helps corporations in the short run but may lead to inflation over time. To say the least, it’s a tricky time for projections – especially when the government has taken such an active role in affecting outcomes. 

With the upcoming Presidential election and headlines regarding ongoing additional stimulus negotiations, the stock market will likely see increased volatility. Historically speaking, the market hasn’t liked uncertainty. Not knowing who the next President will be will likely influence short-term market moves more than who actually wins the election.

On the bond side, it would seem that we’re in a position where all the risk is to the downside (i.e., rates are not likely to go any lower and inflation is only likely to go higher – neither of which would be good for bonds). So, why are prices not trending lower? For one, the Federal Reserve has indicated that ZIRP is here to stay for a while so investors are not perceiving much interest-rate risk. Moreover, the Federal Reserve is in full price-manipulation mode in this market. As the primary buyer of US Treasuries, they can likely control price. This has been done in other countries (e.g.,  Japan) as a form of stimulus and is known as “yield curve control.” And, the direct purchase of corporate bonds has curbed any selling.  Giving the Federal Reserve’s willingness to provide a virtual “blank check” to create stability in these markets, near-term stability is probably a good bet. Still, bonds are not likely to provide substantial overall yield going forward. Rather, a small dividend with stable price is likely where we’ll stay for the foreseeable future. Of course, any stock market panic could drive treasuries higher as we’ve seen in the past.

One interesting dynamic at work right now in the marketplace is the tension between inflationary and deflationary pressures. Recessions are inherently deflationary as are productivity enhancements driven by technology. Moreover, demographics (i.e., the aging “baby boomer” population) is driving less economic demand in the US as we’ve seen play out in “aging” countries like Japan. Deflation is generally considered bad for an economy because it discourages investment and spending (i.e., participants prefer to wait until prices are lower). Given this dynamic, the Federal Reserve, like most central banks, has a target inflation goal of 2%. Moreover, they’ve recently stated that the goal is to “average” 2% and intend to let inflation run above 2% to achieve that goal. The effective “money printing” by the government by issuing Treasury bonds that are then bought by the Federal Reserve can contribute to inflation as economic activity picks up. And, it can happen quickly. We’ve seen this occur historically in the US around World War II and also during the 1970s to the early 1980s. Given the threat of inflation, real-assets (e.g., land, real-estate, commodities and precious metals) become a more interesting investment. We plan to continue to monitor the inflation dynamic and will consider additional allocations to these types of investments.     

Stay safe and, as always, feel free to reach out if you have any questions or if we can help with anything.

Gold Rush 2020

We are all familiar with traditional stock and bond investments as they provide the nucleus for most of our investment portfolios.  However, we often neglect other “alternative” investments that can provide key types of exposure during challenging investment periods.  Gold, and other precious metals, is one such investment category that can act as a hedge against inflation and provide a safe haven in times of crisis.  At Patina Wealth, we actively look for opportunities to deploy precious metals in portfolios and have added to the category in 2020 for most investors.  We generally prefer using Gold over other precious metals as the former generally has lower price volatility.

So far in 2020, gold and silver have surged and now stand among the top performing investments year to date.  From December 31st through August 31st, the exchange-traded-funds tracking gold and silver (GLD and SLV) are up 29.3% and 57.3% versus 8.3% for the S&P 500 Index and 6.8% for the aggregate bond market (as measured by AGG).  It’s also noteworthy that precious metals tend to not be highly correlated with either stocks or bonds meaning they can enhance the risk-adjusted performance of portfolios.

Precious metals are part of an investment category known as commodities.  Commodities generally refer to raw materials or agricultural products.  The price of commodities, like most assets, is determined by supply and demand.  When the price of a commodity is trending in a particular direction, it usually means there is an imbalance in supply and demand.  So far in 2020, there has been a massive surge in demand for precious metals.  Let’s explore why this imbalance has existed and where it may be headed from here.

Precious metals have a commercial use, however, this has had very little to do with the recent price surge.  Rather, investors are piling into the category as a form of defense against the uncertainty of the current investment landscape.  In general, precious metals prove to be great investments when certain conditions are present.  These conditions include, (a) periods of high inflation, (b) an environment of socio-economic or currency instability and/or (c) negative “real” interest rates (i.e., interest rates net of inflation). 

Currently, we have two of the above conditions present (i.e., negative real interest rates and currency instability).  Moreover, while inflation is not currently present, many economists believe that we are headed for an inflationary period in the coming years given that central banks are aggressively seeking to kick-start economic activity with very accommodative policies which are inherently inflationary.  It’s also noteworthy that the Federal Reserve targets 2% inflation, on average, as a matter of policy and has said they are comfortable letting it run above that target level in the near term.  Still, targeting inflation and achieving it are two different things and many developed nations (e.g., Japan) have generally failed to achieve their inflation targets for over a decade. 

Regarding the conditions that are present, let’s first look at negative real interest rates.  Real interest rates are negative when the rate of inflation exceeds the rate of interest paid on a given fixed-income investment.  Presently, it is estimated that over $15 trillion in bonds globally are paying a negative real interest rate (i.e., net of inflation, allocating money to these bonds would effectively cause your wealth to shrink over time).  It’s noteworthy that we have never had such a high percentage of the global bond market effectively losing money net of inflation.  In such an environment, gold becomes an attractive alternative to bonds because it is perceived to move more in line with inflation which, even if low, is perceived to be above zero.  What is further fueling investors is the fact that central banks of developed nations are providing guidance that they have no intention of raising interest rates anytime soon and are aggressively looking to increase inflation.  In other words, they are clearly and emphatically signaling that negative real rates are not likely to go away for a long time and, in fact, are likely to worsen. 

Gold is also perceived as a potential remedy to currency instability.  The amount of gold at any point in time is generally fixed.  More can be mined but this doesn’t happen quickly.  Currency, on the other hand, can be printed by central banks and can change dramatically from year to year.  In fact, in 2020, we’ve seen a massive increase in the money supply in the United States and other developed countries.  This is a further tailwind to gold as the dollar price of gold stands to gain as more “fiat” (i.e., paper) currency is created.  Moreover, as fears are stoked about the credibility of a currency investors can pile into gold as a form of shelter.  Although we’re a long way from destroying the credibility of the American dollar, the rampant money printing globally is causing uncertainly and contributing to gold demand.

As we look to the future, one would expect some pull-back in the prices of precious metals.  The prices have risen so far and so fast that some consolidation would be expected.  However, the medium to long-term case for precious metals, and for gold in particular, remains bullish.  Regarding the money printing by central banks, it’s hard to see an end in sight.  COVID-19 has caused substantial unemployment and central banks are aggressively providing support which is dramatically increasing the money supply.  Moreover, things are likely to get more accommodative from here.  For example, any prolonged economic downturn is going to mean a prolonged period of government assistance.  Moreover, in the mid to long-term it’s hard to see how all of our “unfunded” obligations like social security and state pensions are going to be met without further money printing.  Perhaps the strongest argument for a continued rise in gold demand is the expected real interest rate forecast.  It’s tough to find an economist who thinks we’re going to see positive real rates in the next few years.  Gold feels like a good bet because centrals banks, like the US Federal Reserve, have indicated that they intend to keep short-term rates at zero and target inflation at 2%.  In other words, their goal for the foreseeable future is to target -2% real short-term interest rates which would keep the vast majority of the bond market in negative territory.  As always, we will continue to monitor the situation and look to make adjustments as more information becomes available.

Midsummer Thoughts and Observations

While the pandemic has prevented face-to-face meetings, communicating with clients in other ways has become more important than ever. There are some very interesting things happening in the market right now and I wanted to share some thoughts and observations with you. 

It seems like just yesterday the stock market was plunging at a record pace. From February 19th through March 23rd, the S&P 500 Index dropped a whopping 35.4%. Since then, the S&P 500 has *almost recaptured its losses and as of July 31st, was within 4% of its intra-day all-time high set in mid-February. 

However, the rebound of the S&P 500 Index doesn’t tell the whole story though. While the S&P 500 Index has long been seen as a broad market barometer to gauge how the overall stock market is performing, it may not be as good of an indicator as it once was. The S&P 500 is “market cap weighted,” meaning companies in the Index who are larger represent a bigger part of the Index. For example, the top 5 positions in the Index as of July 31st (as represented by the ETF “SPY”) were Apple, Microsoft, Amazon, Google and Facebook. These 5 companies represent a whopping 21.55% (!!!) of the Index. That’s not a whole lot of diversification. The other 501 companies (the ETF actually holds 506 stocks), represents the other 78.45%. In fact, the smallest 19 companies in the S&P 500 Index (according to SPY) each represent 0.01% or less.

These mega cap technology companies have driven the S&P 500 Index’s performance so far this year into slightly positive territory. SPY is +2.52% YTD through July 31st. But, the S&P 500 “equal weighted” ETF, ticker: RSP, is -6.35% through July 31st. So, if every company in the S&P 500 had an equal weight in the Index and you ignored the size of the company, the Index is actually negative YTD. This is a great illustration showing just how much those mega cap technology companies are holding up the market. Another interesting data point is the Russell 2000’s YTD performance. This index represents 2000 small cap companies and is underperforming the broader market even more so far this year. The ticker IWM, iShares Russell 2000 ETF, is -10.42% YTD through July 31st.

Separately, there has been a distinct divergence between “Growth” companies and “Value” companies through July 31st. Schwab’s Large Cap Growth ETF, SCHG, is +18.19% YTD while its Value counterpart, Schwab Large Cap Value, is -12.29%. Technology’s YTD dominance has also played a part in this as the top holdings in SCHG are, you guessed it, Apple, Microsoft, Amazon, Facebook and Google. This is a great example of why we hold a separate Value and Growth position in most client portfolios. Such divergence creates rebalancing opportunities.

While the S&P 500’s performance has been rosy lately, there are some troubling signs in other areas of the market. Often seen as a safe haven, Gold closed at a record high on Friday, July 31st, and crossed $2000/ounce for the first time in its history. As the Fed has pumped the system with liquidity, Gold has benefited as it is often viewed as a protection from inflation. Many clients’ portfolios have benefited this year from the addition of Gold through the ticker GLD.

Also, the 10-year Treasury note had a record low close on Friday, July 31st, of 0.5282%. It did, however, have a lower “intra-day” low back on March 9th when it hit 0.39%. But, even going back to the financial crisis of 2008, it never closed the day as low as it did on Friday. Lower bond yields generally signal trepidation over the U.S. economy’s health.

The stock market surge from the recent market bottom in March seems like a different story than what the economy and recent COVID-19 cases are telling us. The unemployment numbers continue to be high and recent economy reopening setbacks are raising some red flags. While we don’t think investors should attempt to time the peaks and valleys of the market, we have slightly increased cash and fixed income positions in an effort to manage portfolio volatility.

If I can answer any questions, please don’t hesitate to reach out.

2020 2nd Quarter Update

Top Headline for Q2: Stimulus Wins Round 1

Unfortunately, Q2 ended much as it began with the COVID-19 pandemic disrupting our lives in unprecedented ways.  Our thoughts continue to go out to all those families directly affected and the many healthcare professionals who are risking their lives each day to support them.    

As we reflect on the market performance for the quarter, it’s hard not to be somewhat in awe of the resiliency of the market, given the economic backdrop.  The equity market “bounced” off the lows and saw one of its best quarters ever.  While the S&P 500 Index did not quite fully recover its drawdown, the Nasdaq Composite now sits at an all-time high.  The surge was led primarily by its largest constituents (Amazon, Apple, Microsoft) each regaining an all-time high during the quarter and each finishing with a market capitalization near $1.5 trillion. There were clear sector winners and losers with certain technology sectors booming amid the “stay at home” requirements while others like energy and real-estate struggled to gain footing.  What is most shocking about the overall rebound is that there has been very little good news.  For example, during Q2 companies adjusted earnings down 37% (the highest drop ever recorded by Factset), some jobs returned but the news is still bad as Refinitiv reports that we’ve recovered less than ¼ of the lost jobs and July 1 marked the largest number of new COVID-19 cases (over 50,000) since the crisis began.  So, why does the US equity market not seem to care about the negative news?  The two most common explanations are (1) that the market is reacting favorably to the stimulus and looking at earnings 2-3 years out, and (2) that some of the excess capital from the stimulus is finding its way into the equity market. 

General Market Update

US Equities:  The S&P 500 Index finished up 20% for the quarter while the technology-heavy Nasdaq Composite surged 30.6%.  The Russell 2000 Index finished up 25%, but, after falling more than 30% in Q1, it continues to substantially lag the larger-capitalization indices.  There were substantial differences in equity sector performance during the quarter as the market attempted to assess “winners” and “losers” from the crisis.  The tech sector (measured by the ETF XLK) surged during the quarter and finished up about 15% year-to-date whereas a few of the big losers included energy (XLE) which is now down over 35% year-to-date and financials (XLF) which is down nearly 24%.  Certain sectors of the REIT market continue to struggle, including retail and hospitality, with over 50 companies already slashing dividends to improve cash flows.  The equity market is a bit of a paradox right now as it has been awhile since we’ve seen such a disconnect between market valuations and the present economic realities.

International and Emerging Market Equities:  International equity markets continue to lag US markets.  Not only did they fall further during Q1 but they recovered less in Q2.  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 16.0% in Q2 and the Schwab Emerging Markets ETF was up 18.2%.  International markets continue to trade at much lower earnings multiples relative to the US. 

Fixed Income and Credit: The economic fear hitting the equity markets also appeared in bonds where rampant selling led to substantial drawdowns in corporate bonds.  However, the “bounce” in this segment was even more dramatic.  As the government stepped in to buy corporate bonds, money flooded back into the market where suddenly yields seemed high and risk low.  The long-term corporate bond market crashed about 30% but has nearly fully recovered.  This market also leaves one perplexed as the economics are not good for many highly-leveraged corporations.  Bankruptcies are rising along with bond downgrades but both are being overshadowed by the perception that the government with continue to support corporates.  Treasury bonds have also performed well with the massive tailwinds of falling interest rates, economic uncertainty and government buying.

A Look Ahead

In our opinion, it has never been harder to assess the near term direction of the equity market.  There are many factors that point to “bubble-like” conditions (e.g., the US market is at an extreme valuation relative to foreign markets, the US market is squarely in the “high” range of almost any valuation metric and economic conditions are horrendous).  However, we’re dealing with a level of stimulus that is truly unprecedented.  No one benefits more than large corporations from a zero interest rate policy and we’ve seen a surge in bond issuance as corporations have taken the opportunity to lock in low rates and extend due dates.  This refinancing will improve margins for the survivors coming out of the downturn and the large-cap group looks to be the best positioned.  It’s also noteworthy that the stimulus checks actually increased personal income during Q2, despite the record unemployment, so we don’t have a clear picture of the impacts.  Moreover, we don’t know what additional stimulus may be coming and how long it will last.  It’s hard to imagine a time when our economy and equity markets were not more closely linked to the actions of our federal government. 

To compound the forecasting problem, we are dealing with a number of large unknowns.  The biggest, of course, is the ongoing pandemic.  Cases are still rising but we’re getting better at mitigation techniques and treatment methods.  Moreover, many companies are at work on vaccines.  Still, the near-term direction of the crisis in the US couldn’t be more unclear.  The second massive unknown is the upcoming November presidential election.  Aside from not knowing the winner, we can only guess about the policies that will take priority as the election approaches.  Will social issues be the focus or, for example, will tax reform move to the forefront?  The recent tax cuts have benefitted corporations, and any reversal will certainly have an adverse impact.  Lastly, the massive stimulus has led to an enormous growth in our money supply.  This is an experiment without precedent, and economists can’t seem to agree on the inflation impacts or when they’re likely to hit.     

In closing, it’s hard to not comment on the “moral hazard” aspect of the stimulus and its unknown impact on our capital markets.  In 2008, there was, appropriately, significant debate about having the government step in to “rescue” companies deemed “too big to fail.”  During this crisis, there was little debate or delay before supporting a wide swath of corporations through bond buying.  Some of these companies are “zombies” (i.e., negative cash flow companies) that perhaps shouldn’t survive and, in fact, should be absorbed by companies that are more productive with capital.  The current talk is now around the possible direct purchase of equities.  The general perception right now seems to be that the US government is protecting corporations and it’s driving up equity and bond prices.  In other words, it’s at least partially artificial which will likely lead to further volatility in the future when perception changes.  While we’re supportive of intervening to a certain extent during a crisis, one is left to wonder how to get this genie back in the bottle without a massive market disruption.

COVID-19: Current Economic Climate

After studying the economic data over the last few weeks, unprecedented is a word that often comes to mind.  The most striking example of the unprecedented economic impacts from COVID-19 appears in the employment data.  In a span of merely six weeks, we have seen over thirty million people in the United States file for unemployment.  That total equates to roughly one in five American workers – a staggering total.  As we can see from the chart below (courtesy of the Wall Street Journal), the claims are slowing but we saw over three million in the last week and will likely see many millions more before returning to more normal levels.

To put these job losses in context, let’s compare the job losses to the “Great Recession.”  If we look at chart below showing “Continuing Jobless Claims” (i.e., folks that haven’t landed a job and continue to file state unemployment claims),  we can see that we’re already at levels about three times higher than what we saw following 2008 and it’s still projected to get worse.  So, in summary, you’d have to return to our worst economic collapse ever (i.e., the “Great Depression”) to find numbers like this.

On the bright side, unlike the Great Depression, there is reason to believe that many of these job losses will be reversed quickly as businesses are hoping to quickly ramp back up following the pandemic.  Many “unemployed” workers are, in fact, “furloughed” (i.e., still employed, often with benefits, but not being paid) and are fully expecting to return to their prior employer in the coming months.  Social distancing measures have been effective in slowing the growth of the virus and there is reason for optimism that more businesses will begin to open – albeit with some revised standard operating procedures.  It’s also been impressive to see American ingenuity at work as many businesses have reinvented themselves quickly during the crisis (e.g., restaurants ramping up take-out operations and “gig economy” delivery apps like Instacart and DoorDash becoming household names).  We’ve also been impressed with the speed at which schools have moved to virtual learning platforms and healthcare has adopted telemedicine.  It’s clear that we will emerge from this pandemic in much better shape to combat future outbreaks with less disruption.

It is a little scary, however, that the American economy, like many in the developed world, has steadily become more and more service-oriented.  The U.S. Bureau of Labor Statistics, for example, indicates that we now have about ten million workers each in education and health care, over seven million in personal care and over thirteen million in food preparation and serving related.  This shift is normal and consistent with other developed nations.  Productivity gains simply allow us to meet basic needs with fewer workers.  For example, the New York Times reports that over 30% of U.S. workers were in farming/agricultural in 1920 (the first year of the Census) compared to less than 3% today.  It’s also noteworthy that less than 15% of our workforce are in manufacturing.  While we believe this shift is an encouraging advancement (e.g., basic needs are able to be met by fewer workers leading to lower costs and higher standards of living), it does show the fragility of our current service-based economy.  The reality is that many service-related jobs are considered “non-essential” and inevitably more vulnerable to short-term impairment or permanent elimination. 

The additional danger of the current situation, is that it can become a negative cycle that feeds on itself.  The American economy is driven first and foremost by consumer spending.  Americans that don’t have jobs simply don’t have the discretionary income to spend.  Moreover, even employed Americans become cautious as uncertainty spreads.  We are seeing this caution manifest immediately as a massive spike in the “savings rate” (i.e., the percentage of disposable income that is set aside for savings).  The savings rate nearly doubled in the last month to over twelve and one-half percent – the highest rate seen in thirty years.  A high savings rate can be scary for businesses that become reluctant to invest and/or hire thereby perpetuating the cycle.

As we mentioned in our quarterly update, the unprecedented challenges presented by COVID-19 have been met by massive stimulus by central banks around the world.  The news has been well-received by the stock and bond markets which have rapidly recovered much of the drawdown.  At this point, it’s impossible to know how this situation will play out from here as many companies have “pulled their guidance” for the remainder of the year. In other words, it is hard for them to predict short-term future earnings.  If consumers and businesses continue to gain confidence that the worst is behind us, we may see a rapid rise of employment and a return to pre-Pandemic consumer spending levels.  The outlook may be even brighter on the business spending side where investment may exceed pre-Pandemic levels given the return to a zero-interest-rate environment.  However, if uncertainty remains and caution persists, we could see many jobs losses become permanent.  A resurgence in positive COVID-19 cases or a delay in the development of a vaccine would be potentially devastating – an outcome that would lead to a much more prolonged downturn and likely further stimulus.  In either scenario, in our view, it’s likely that more short-term volatility will persist as markets rapidly try to digest each new wave of data.  Of course, we plan to continue to monitor the situation and will adjust plans accordingly.  If we can be of any assistance during this difficult time, please don’t hesitate to reach out.

2020 1st Quarter Update

Top Headline for Q1: “COVID-19”

As we’re all aware at this point, the COVID-19 pandemic has affected our lives in unprecedented ways. Our thoughts go out to those families afflicted with the illness and the many healthcare professionals who are bravely working to help them. We hope that all of you are safe and finding comfort among friends and family.

As would be expected from such a crisis, corporate equity and bond prices have been under tremendous strain. The pandemic led to the fastest bear market (i.e., 20% decline) in US stock market history with the S&P 500 Index falling 35.4% between its intraday high on February 19th and its intraday low on March 23rd before recovering to finish down 20% for the quarter. This drop marks the worst quarterly drop since the Great Recession and officially ends the 11-year bull market run.    

General Market Update

US Equities:  Along with the S&P 500 Index being down 20.0%, the Nasdaq Composite was down 14.2% and the Russell 2000 Index finished down 30.9%. According to Dow Jones Market Data, the Dow had its worst first quarter in its 124-year history. There was no safe-haven in the equity market during this downturn as widespread “panic selling” caused declines in all sectors of the market. It is noteworthy that there were significant differences by sector and size. As evidenced by the Russell 2000 Index performance, the market is, probably correctly, assuming that the economic downturn will be harder on small companies. In the large company space, dire economic forecasts led to more pronounced drawdowns in cyclical sectors such as Industrial and Energy. And, as one would expect, we’re seeing massive drawdowns in areas directly hit by the lockdown such as retail, hospitality and airlines. One factor contributing to the rapid overall decline was the fact that corporate earnings were already projected to be flat for 2020 before the outbreak. Of course, the pandemic has led to near constant downward adjustments in analyst earnings projections such that corporate profits are expected to show a substantial decline year-over-year from 2019 to 2020. 

International and Emerging Market Equities:  International equity markets performed even worse than the US market as the number of COVID-19 cases and deaths climbed at alarming rates in several European countries. The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 23.2% in Q1 and the Schwab Emerging Markets ETF was down 24.4%. International markets continue to trade at much lower earnings multiples relative to the US - nearing record lows after the most recent decline.   

Fixed Income and Credit: The economic fear hitting the equity markets also appeared in bonds where rampant selling led to substantial drawdowns in corporate bonds and long-term treasuries. Corporates were hit especially hard as economic fears led to uncertainty over defaults. In fact, long-term “investment grade” corporate bond averages spiked down over 25% and remain well below Q1 highs. Continued volatility is expected as rating agencies rush to digest economic information and adjust bond ratings appropriately. Many downgrades have already occurred and more are expected. The Federal Reserve’s announcement that they would be buying corporate bonds appears to have been critical in stabilizing the market. Long-term treasuries saw a more moderate downward spike during the sell-off but recovered quickly and rose to new highs as investors favored the security of government-backed loans and government bond buying created upward pressure. 

A Look Ahead

Regarding the US stock market, it is likely that volatility is here to stay for a while. Economists are still assessing the economic impact as the virus continues to spread. Many more negative headlines are expected as companies continue to adjust earnings downward and various federal governments release negative economic data. For example, on April 2nd we saw weekly unemployment claims in the US spike to over 6 million which is 10X worse than anything we had seen before the virus. On the positive side, the US Government has met the unprecedented circumstances with unprecedented aid. The Federal Reserve has deployed massive amounts of stimulus including (1) dropping interest rates back down to a target range of 0 - 0.25%, (2) resuming “quantitative easing” with the purchase of treasury bonds, mortgage-backed securities and corporate bonds and (3) injecting liquidity into the banking system via increased re-purchase operations and reduced liquidity requirements. The President and Congress also moved quickly to pass trillions of dollars in aid that is intended to directly benefit those workers and employers that are most affected.

It’s important to note that market volatility and panic selling is nothing new. In recent history, the overall US equity market fell over 50% during the “Great Recession” and “Dot-Com Bubble” before recovering to new highs. American corporations have historically proven resilient at adjusting to new demands and growing earnings in the long run. Our belief is that equities continue to be a great long-term investment but that more near term volatility, and possibly further drawdowns, can be expected as negative economic information is released and digested. Large companies with strong balance sheets are well-poised to emerge stronger from the crisis. Interest rates are likely to remain low for an extended amount of time and quality companies should be able to borrow at very attractive rates – thereby reducing cost of capital and improving long-term margins. Some small highly-leveraged companies may face difficult times ahead as high-yield bond rates are likely to remain elevated leading to a challenging funding environment for that group. If rates remain high and funding is tight, bankruptcies among Russell 2000 constituents are expected.    

The next 3-6 months should be interesting for the corporate bond market as it fights for price stability. Poor economics and continued uncertainly are weighing it down while the zero-interest-rate policy and government buying creates upward pressure on prices. If the government continues its commitment to ad hoc buying, short-term stability is likely to be maintained until economic clarity emerges. It looks to us like bonds of companies with good balance sheets are underpriced while the high yield market may suffer further damage. While shorter-term government bonds will continue to be used as shelter from the volatility, longer term bonds will likely see price swings as investors assess the inflation impacts from the stimulus. Looking long-term, it continues to be tough to get excited about the long-term bond market. Interest rates have returned to historical lows and record-breaking stimulus is likely to, eventually, push inflation higher. As such, it feels like longer-term bonds are set up for downside risk.   

We will continue to monitor market conditions and rebalance portfolios where opportunities present themselves. If you have any questions, or if we can help in any way, please do not hesitate to contact us.

The Secure Act - Stretch IRA a bit Less Stretchy?

In December 2019, a new law was passed named “Setting Every Community Up for Retirement Enhancement Act” or “Secure Act” for short.  While the new law brings a few positive changes to the IRA landscape, I would say the positive changes are overshadowed by a very negative change for taxpayers related to inherited IRAs.  In this article I’ve listed a few pros and cons of this new law and how it may affect IRA owners.

Before diving into the changes, let’s take a minute to review the rules for IRAs before the Secure Act.  There are two main types of IRAs – Roth and Traditional.  Traditional IRA contributions are made from pre-tax dollars meaning that Traditional IRA contributions reduce your taxable income in the year contributions are made (subject to certain limitations).  The money inside a Traditional IRA gets to grow (tax free) until retirement.  The government had set the age at 70 ½ as the age at which one must begin withdrawing assets from a Traditional IRA.  So, in the year in which one turned 70 ½ there was a “required minimum distribution” (RMD) that must be taken that is computed using life expectancy tables and the overall value of the IRA.  When cash is withdrawn from a Traditional IRA it is taxed like income in the year withdrawn.  The Roth IRA is a more recent innovation that was created as part of the Taxpayer Relief Act of 1997.  Roth IRAs are different than Traditional IRAs in that contributions are made with after-tax money and, consequently, withdrawals in retirement are not taxed.   The main similarity with Traditional IRAs is that the Roth IRA also has tax-free growth.  Roth IRAs also have the distinct advantage of not being subject to RMD rules so withdrawals can be delayed indefinitely for the owner.

The Secure Act brings a few positive changes for Traditional IRA owners.  For one, the age was changed for RMDs – moving it back from 70 ½ to 72.  This change applies only to IRA owners that turn 70 ½ after 2019.   So, this is some good news for Traditional IRA owners who can delay taking distributions for bit longer if no distributions are needed.  It’s also noteworthy that the law removed the age limit on making Traditional IRA contributions.  The previous limit was 70 ½ and now there is no restriction thereby allowing IRA owners to continue contributing indefinitely if desired.  These changes don’t affect Roth IRAs as Roth IRAs have no RMD and already permitted contributions after 70 1/2.  In my opinion, while these changes are positive, their impact is not expected to be material.  More specifically, moving the RMD age back 18 months allows for a bit more tax-deferred growth but isn’t expected to materially change a taxpayer’s financial circumstances.  Moreover, it doubtful that the removal of the age restriction on contributions will have a significant impact given that IRA owners are more likely to be withdrawing than adding at that time.

While there are a few positives, the Secure Act also contains a HUGE negative related to inherited IRAs which applies to both Traditional and Roth IRAs.  Prior to the Secure Act, if someone inherited an IRA, they effectively were able to stretch the payments over their lifetime – often referred to as a “Stretch IRA.”  In other words, distributions were required upon inheriting the IRA but the recipient was able to use their life expectancy to compute a distribution amount.  This rule allowed heirs to receive payments for a lifetime and enjoy years of tax-deferred growth.  The Secure Act generally requires inherited IRAs to be fully withdrawn within 10 years.  This change has enormous tax implications as billions in IRA money is expected to be passed down by baby boomers in the coming decades leading to substantial withdrawal requirements and tax bills.  The 10-year withdrawal requirement does have some exceptions.  Thankfully, the rule does not apply to spouses of IRA owners.  Also, it excludes disabled beneficiaries, beneficiaries who are less than 10 years younger than the IRA owner and minor beneficiaries for as long as they are minors.

In summary, I wish I had better news but, in my opinion, this change hurts taxpayers, or taxpayer heirs, more than it helps.  Effectively eliminating the Stretch IRA is very clearly an effort to expedite the liquidation of Traditional IRAs in order to yield tax dollars more quickly.  While IRAs remain an excellent tool for saving money for retirement, this change makes IRAs substantially less effective as a wealth transfer tool.  If the goal is to pass a substantial nest egg to children that can be used over many years, other estate-planning tools will need to be deployed.          

2019 4th Quarter Update

Top Headline for Q4: Fittingly, A Big Quarter to Close a Huge Decade

Equity markets surged sharply during the 4th quarter with the S&P 500 Index up 8.5% and the Nasdaq Composite Index up a whopping 12.2%. It’s difficult to tell what sparked the positive investor sentiment as earnings for the quarter were largely flat year-over-year and only marginal tangible improvement was realized on the trade front. “Phase 1” of the trade deal between the United States and China was officially announced on December 13th. The S&P 500 Index finished the year +2.0% after the announcement. Based on a similar surge in international equities, it appears that investors are forecasting more good news on the trade front with expected positive earnings impacts globally in 2020. It is fitting that the quarter finished strong given that it closes one of the best decades ever for the US stock market. Buoyed by low interest rates, government stimulus and the lack of a recession, the S&P 500 delivered over a 190% return during the decade. This return included 6 double digit-return years and only 2 negative years with the worst year (2018) being down only 6.24%. The decade was marked by the dominance of “MegaCap” stocks such as Apple and Microsoft – each finishing the decade with a market cap that exceeded $1 trillion.

General Market Update

US Equities: In a striking reversal of course from Q3, investors moved aggressively into higher risk sectors including technology which was the top performer for the quarter. Healthcare also saw a strong surge as investors appear to see less regulatory risk on that front. It is noteworthy that investors continue to greatly favor large market-cap stocks. While the Russell 2000 small-cap index was up nearly 10% for the quarter, it has greatly underperformed the S&P 500 over the last few years and, in fact, has still failed to recover its all-time high from 2018. The third quarter brought continued degradation in year-over-year earnings for the US market with full-year 2019 projections now showing no year-over-year growth. Trade news seems to be dominating the headlines relative to earnings which is driving market sentiment and, consequently, short-term performance. We would expect this trend to continue into 2020. It is noteworthy, however, that earnings for 2019 were not good and, without signs of improvement in 2020 and beyond, the expanded price/earnings multiples could sharply contract.

International and Emerging Market Equities: As noted above, the international markets seem to be sensing positive news ahead on the trade front with strong equity-market returns in many countries. The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 7.9% in Q4 and the Schwab Emerging Markets ETF was up 11.9%. Investor sentiment has risen regarding international markets despite no substantial improvement in global manufacturing data or GDP. International markets have been trading at lower multiples to the US which may imply a greater ability to expand on anticipated rather than actual earnings improvement.

Fixed Income and Credit: After a global bond price surge in Q3 that left us with $17 trillion in negative yielding bonds globally, the bond market finally slowed and reversed course a bit. Global markets were generally down slightly, the US corporate bond market posted flat returns and longer-dated US Treasuries were down in the mid-single-digit range. From an economic standpoint, one could argue that the global bond market has more room to run. Specifically, a majority of central banks are still in “easing” mode and most of the developed world is posting low and degrading GDP numbers. However, with so many central bank target rates already at, near, or below 0%, it’s reasonable to begin sensing a “top” in bond prices with asymmetric risk to the downside. In regard to the US markets, the “risk on” sentiment was seen in Q4 as corporate bonds outperformed treasuries especially on the long end of the yield curve.

A Look Ahead

Regarding the US stock market, the 4th quarter leaves one a bit perplexed. From an earnings standpoint, the data was not good and yet the market surged ahead. In fact, when looking at the full year, the price appreciation in 2019 can be attributed almost entirely to price-earnings-multiple expansion as year-over-year earnings are trending toward zero for the year. Given the lack of earnings, we’re now in well-above-average price-earnings-multiple territory. So, either the market is correct in forecasting good things to come or 2020 could prove to be a challenging year. Moreover, we continue to have “late cycle” economic signals in the US. The latest evidence is rising wages among low-wage earners which tends to threaten business margins. Still, despite all of the “late cycle” indicators, a recession does not appear imminent with few economists calling for one in 2020.

Overall, in 2020 we’re likely to see a somewhat volatile equity market driven by news headlines more than actual earnings. The market will be consumed with the upcoming US presidential election as the various candidates’ economic policies are as divergent as any time in modern history. 2020 will also be a big year for watching the Federal Reserve. The Federal Reserve’s actions relative to expectations will have a substantial impact – currently one rate drop is expected. Will we see further interest rate drops to potentially push the market higher or will we see a reversal of trend with an “allergic” market reaction like Q4 of 2018? Our guess is that the Fed will try to lay low ahead of the election. It’s tough to bet against the US equity market through November given the predicted absence of a recession, a probable drop in rates from the Federal Reserve and a likely heavy dose of positive tweets from the President leading up to the election.

In the longer-term, absent a recession, we remain bullish on the equity market. Large corporations have benefited tremendously by the near-zero interest-rate policy of the last decade and more recent corporate tax reduction. Many have used the opportunity to drop their cost-of-capital with large international companies seeing the greatest benefit. It’s also noteworthy that rates aren’t likely to climb in the short-term. Many economists think low rates in the developed world are a “new normal” related to demographic changes. If so, capital-intensive growth businesses will be one of the biggest beneficiaries. Moreover, large companies have seen substantial improvement in profit margins in recent years. The small cap market, however, is showing some danger signs. The perpetually low rates are masking the fact that there is a growing percentage of “zombie” companies in the sector (i.e., those with interest payments that exceed earnings) that will struggle to pay bills with a rise in interest rates or economic slow-down.

When looking at the bond market, it’s tough to get too excited. The last decade was characterized by an unprecedented global drop in interest rates culminating with all-time highs in certain markets in Q3 2019. In much of the developed world globally, it feels like the worst possible set-up for bonds (i.e., all-time low coupons and all-time high prices). The run could continue with further global economic weakness but the downside risk to bond prices is substantial. The bond market opportunity feels a bit more attractive in the US given that rates are higher and the fact that the Federal Reserve has a long way to get back to zero rates leaving upside to bond prices. Of course, economic conditions and central bank interest rate activity will drive the market. Stronger economic conditions are not likely to be favorable to bond prices whereas degrading conditions and rate drops could send the long US Treasury bonds substantially higher.

In summary, it’s shaping up to be a volatile year. As always, we will manage risk through diversification and strategic rebalancing to capitalize on any opportunities the market presents. We wish you great prosperity in 2020!

The “New Normal” – Lower Interest Rates, Lower Growth, Lower Inflation

Last month, Federal Reserve Chairman Jerome Powell publicly announced that we are in an economic environment characterized by lower interest rates, lower growth and lower inflation. To the surprise of many, he branded this environment a “new normal” suggesting that it may be permanent. What makes this announcement so striking is that, a little over a year ago, the Federal Reserve was aggressively raising rates – an action generally deployed to mitigate inflation in an overheating economy. So, what happened to cause the change in outlook and, more importantly, where are we headed from here?

Looking back, the Federal Reserve was likely interested in achieving two things by raising rates. For one, the economy was growing on the back of corporate tax-stimulus so keeping inflation in check was clearly a motivation. And, the Federal Reserve was interested in raising the benchmark rate above zero so that it would have some ability to stimulate the economy (i.e., lower rates) when needed. The Federal Reserve had taken a gradual approach with one increase in 2015 and 2016 before accelerating in 2017 with 3 increases followed by another 4 in 2018. Then, in early 2019, the rate-increasing actions abruptly stopped with Chairman Powell citing subdued inflation as a key driver.

Hindsight is 20/20 but, in retrospect, the Federal Reserve’s actions in raising rates aggressively in 2018 appear to have been a mistake. The Federal Reserve was raising rates at a time when the following was also true: (1) aggregate international GDP growth was slowing, (2) many international federal banks were lowering rates and (3) the Federal Reserve was also removing stimulus by reducing its balance sheet. The combination of these factors proved too onerous for the US equity market and the fourth quarter of 2018 saw a dramatic downward spike in equity prices. The investors were clearly unhappy with the actions of the Federal Reserve. Bear in mind, it’s not the Federal Reserve’s job to stabilize the stock market but Chairman Powell did reference “stock market volatility” as a consideration in his rationale for pausing in early 2019. As such, it’s clear that they would like to avoid being a cause of instability. It’s easy to assess why the stock market doesn’t like higher rates. For one, higher rates mean higher operating costs for businesses that borrow money (i.e., a higher cost-of-capital). Moreover, in a rising-rate environment highly-leveraged businesses face refinancing risks. In other words, some of these businesses could be pushed into bankruptcy when replacing lower cost debt at maturity with higher cost debt.

So, where do we go from here? At this point, we agree with the “new normal” thesis. Interest rates and inflation are generally just by-products of growth levels. When growth is high, inflation tends to also climb and, in response, federal banks increase rates. So, if you want to project interest rates, you first need to project growth. And, unfortunately, US GDP growth coming out of the Great Recession has been tepid. While the current “recovery” is the longest on record, the average annual GDP growth rate of around 2% is among the lowest. In fact, if you look at the long-term trend in US GDP growth, it’s clearly downward trending. On the bright side, the US is normal in this regard among its developed-market peers. In developed-markets, the GDP growth rates, along with inflation and interest rates, are unmistakably downward trending over a long period of time. Most economists tend to agree that the downward pressure stems from demographics (i.e., an aging population that spends less money) and economic changes (e.g., moving from a manufacturing to a service-based economy). Perhaps the best example of a “new normal” is Japan – a country which has struggled with low growth, low inflation and near-zero interest rates for several decades. The United States, along with other developed-nations like Germany, France and the UK, have demographic trends that lag Japan but tend to be very similar. So, perhaps Japan is a good leading indicator for where we are all headed. Lastly, it’s noteworthy that the stock market may not be able to handle higher rates. Corporate leverage is at all-time highs and raising rates may, quite simply, push many companies into financial insolvency.

The “new normal” environment will have significant investing implications. A perpetually low rate environment will be beneficial to many corporations – especially those in capital-intensive businesses like REITs. Many companies have been taking advantage of lower rates to both reduce their overall cost-of-capital and extend maturity on debt so that they can enjoy low rates for longer. Many of these businesses, in fact, enjoy the lowest financing costs in their history. So, low rates are generally good news for corporations. However, the low overall GDP growth projections will prove to be a headwind. Gains in stock market prices will likely come more slowly as many studies have shown a clear connection between overall GDP growth and equity market capitalization growth. The low-rate environment will likely be the most challenging to older investors who seek to reduce stock-market exposure in favor of more stable “fixed-income” investments. At present, we’re facing a paltry yield on these types of investments (e.g., long-term investment grade bonds are only paying 3-4% interest/year) and long-term US Treasury bonds are paying under 2.5%. These are frighteningly low figures if one believes they are not expected to rise anytime soon (if ever). Moreover, given that we seem to be in the later stages of the economic cycle, this would be considered a bad time to “reach for yield” (i.e., invest in riskier high-yield bonds or high-risk credit instruments).

Though we face challenging times ahead, Patina Wealth welcomes the challenge posed by this new environment. We will continue to focus on investing in a diversified pool of quality assets on behalf of our clients. We anticipate that diversification and periodic rebalancing will prove to be the best defense for whatever the future may bring us.

2019 3rd Quarter Update

Top Headline for Q3: $17 Trillion in “Negative-Yielding” Global Debt

The global bond markets have truly entered unprecedented territory with “negative yielding” debt peaking at over $17 trillion during the quarter. This means that people have purchased over $17 trillion in bonds that, net of inflation, are expected to lose them money. According to analysis performed by Bianco Research, LLC this is the highest level ever recorded. Bond yields move inversely with bond prices so the drop in yields corresponds with a rise in bond prices. Most notably, the 100-year Austrian government bond is up over 66% on the year which may be the best short-term performance in the history of the bond market. Along with the Austrian bonds, approximately 1/3 of all international government bonds are now negative yielding. It’s tough to say whether the low yields are a “new normal” or a temporary situation. The “new normal” argument centers around aging populations in developed nations as a key driver – citing Japan’s aging and declining population and 10+ years of low and stagnant rates. Others argue that it’s temporary and driven by a cyclical global economic slowdown. In any case, there are big implications for both the stock and bond market that we’ll discuss in a “look ahead.”

General Market Update

US Equities: US Equities generally moved sideways in Q3 but we’re seeing a noticeable shift toward lower risk sectors. The S&P 500 Index finished up 1.2% on the quarter and the Nasdaq Composite finished down 0.1% on the quarter. The Russell 2000 continued to exhibit underperformance relative to larger indices falling 2.8%. Despite the flat performance for the market, we’re seeing a clear shift toward lower risk sectors. For example, the winners have been large companies with low price volatility and we’ve seen abnormally strong performance from REITs, Consumer Staples and Utilities. The latter sectors are often popular in a falling interest rate environment as they are sometimes used as yield-generating “bond alternatives.” Moreover, Utilities and Consumer Staples are viewed as “defensive” ahead of slowing economic conditions. Second quarter earnings were, in aggregate, positive year-over-year but have been slowing and are expected to turn negative by year end. Short-term performance will undoubtedly be affected by the trade discussions. News on this front has moved markets and October may bring additional volatility with a planned China visit to the US next week. Any changes in actual tariffs will severely hurt a few industries but, more importantly, will sway overall market sentiment.

International and Emerging Market Equities: The international markets are beginning to feel some strain from slowing global industrial and manufacturing activity (most notably in China and Germany). The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 0.7% in Q3. Moreover, the more economically-sensitive Schwab Emerging Markets ETF was down 4.23%. South Korea, which is often used as a benchmark for international trade health, has seen a dramatic slowdown in exports suggesting that US/China trade tensions and a slowing global economy are having adverse supply-chain impacts outside of those countries.

US Bonds: The bond market continued its remarkable run in Q3 as global economic conditions worsened and more central banks throughout the world continued to drop rates. The market clearly sees more rate drops ahead and has added $480 billion to bond mutual funds and ETFs year-to-date despite the negative (net-of-inflation) yields. The year-to-date performance has been outstanding with intermediate-term corporate bond ETFs posting low double-digit returns and long-term corporate bond ETFs up around 20%. Treasuries also performed well though lagged corporate bonds as the market perceives that the risk of a near-term recession is still low. We’re starting to see some significant volatility in the long-bond category as the market struggles to interpret each wave of economic data.

A Look Ahead

Regarding the US and global stock market, it’s clear that we’re in a worsening economic and earnings environment especially when the effects of stimulus are removed. We’ve seen this coming for a long time but the market did not seem to care as it, perhaps, assumed any downturn would be minor or short-lived. In any case, one would likely expect some sideways stock market performance and a continued “flight to quality” (i.e., lower risk sectors) as the news disseminates to the masses that earnings are trending toward flat to down year-over-year. On the flip side, the historically low interest rates are exceptionally beneficial to many categories of stocks. For example, many “mega-cap” US stocks with international operations have taken the opportunity to raise funding through debt instruments overseas at very low interest rates. This low-cost funding should bode well for them in the long run. Moreover, some sectors, such as REITs, are very interest-rate sensitive and should thrive in a continued low rate environment absent a recession. It’s easy to be more bullish on the US than the global stock market in the short term. Despite the fact that the US is already priced much higher than many global markets, the US shows no imminent signs of recession and the Federal Reserve has a greater ability to stimulate the economy (i.e., benchmark interest rates in the US are the highest among developed countries). Lastly, one has to wonder what tools the White House may deploy ahead of the 2020 elections to avoid negative economic or market headlines.

When looking at the bond market, the key question is, “How much longer can this historic run continue?” Globally, it feels like the run is nearing an end given the sheer volume of negative yielding rates globally and the inability of global central banks to drop rates much further. However, a spreading global economic slowdown would push rates even lower in nations that have the capacity to do so. In the US, it feels like we’re trending toward an inevitable recession which should mean more interest rate drops and bond price appreciation. Of course, the signals have been growing for several years and it could be several more before any decline in GDP materializes. We still like the US bond market given a number of factors that should drive demand (e.g., the US has among the highest rates globally, the dollar is strong and the interest rate trend is downward).

In summary, our outlook hasn’t changed much since last quarter. For the US stock market, we continue to be cautiously optimistic in the short-term but a bit more bearish in the 1-3 year outlook as recession signals mount. International stock markets are priced cheaply and will be a great buy coming out of any slowdown. In this environment, we continue to like lower-risk segments of the market including higher market capitalizations and lower volatility stocks. We still like the bond market overall, though we see more potential in the US versus international.

Is It Time To Clean Up Your “Financial House”?

We all clean-up around the house from time to time. We understand the need to do it and we do it often or perhaps, for some of us, not often enough. With a little effort, a clean house leads to more efficiency (i.e., you can find the car keys) and less stress. The same can be said for cleaning your “Financial House” – i.e., your many banking and brokerage accounts. You probably have an extra bank, brokerage or credit card account that you rarely use or have lost track of. In fact, a new client recently admitted that she was “pretty sure she had an old 401(k) account somewhere but wasn’t exactly sure where it was.” She is not alone. I’ve heard a similar story from many clients and, I’m sure, many of you can relate. So, why are we so reluctant to clean our Financial House? It’s time to take action, do a little (financial) house cleaning and enjoy a little less stress in your life.

Let’s take a minute to review why your Financial House may be messy. When I entered the financial industry in the 1990’s, the landscape was quite different. It was very fragmented in the sense that there were many service providers competing for your business. Many of you may remember, for example, the near relentless credit card offers coming from banks all over the country. One of my former colleagues, who worked at Capital One, said that when he joined Capital One in 1994 the industry was highly fragmented with over 50 credit card issuers claiming at least 1 million customers. Moreover, many issuers were specialists that catered only to specific groups (e.g., travelers, business owners, etc.). Similar fragmentation and specialization existed in banking and in stock-brokerage – leading to quite a mess of accounts for many of us.

Fast forward to today. After 20 years of industry consolidation, the top 10 credit card issuers now control over 90% of the market. The same situation occurred in other banking services as fallout from the Great Recession led to a wave of consolidation. Similar trends existed in the brokerage industry where a small number of providers (e.g., Charles Schwab, Fidelity, Morgan Stanley and others) each now service a huge customer base. For example, my custodian, Charles Schwab, has grown to over 10 million customers and over $3 trillion in assets.

So, how does this affect us? The good news for all of us is that the lines have now been blurred among these behemoth financial institutions such that they all are attempting to be a “one-stop-shop” for your financial needs. Charles Schwab has added “Charles Schwab Bank” and can offer just about any banking product (e.g., credits cards, loans and lines-of-credit) and Capital One has grown from a credit card issuer into a full-service bank/brokerage. What this means for the consumer is that the opportunity to consolidate accounts is available like never before. For commodity products, like checking accounts, credits cards and debit cards, there is generally no need to maintain extra relationships. Moreover, as pricing continues to drop, even lines-of-credit, loans and trade-execution have become more commoditized. In other words, they’re all so similar in price that the value of shopping around is often not worth the hassle of maintaining extra relationships.

At this point, you might take a minute to think about what clutter may exist in your Financial House. Do you have an old 401(k) from a former employer that could be “rolled over” (i.e., transferred) to an IRA at your current brokerage? Do you have accounts or IRAs at multiple brokerages and, if so, why not consolidate them? Do you have a banking relationship simply to have a checking, debit card or credit card account? In general, I’ve found tremendous value in consolidating accounts for clients. On the investing side, there are cost savings to having accounts in one place and doing so could yield better overall investment results. Greater results are possible because larger providers generally have a better selection of investments and account consolidation leads to better oversite (e.g., integration with financial planning software). Also, in regard to basic banking services, clients at Charles Schwab, for example, can invest while still accessing the money via check, debit card or ACH transfer – all from one account. In my experience, the brokerages that now offer banking services tend to be a very attractive option for your cash balances. For example, Charles Schwab offers a high-yield savings option without locking up your capital so you can earn approximately 2% in the current rate environment rather than near-zero returns as is offered presently by many bank savings accounts.

Ten to twenty years ago we could only dream of a world where it was possible to exist with one financial relationship. Now it’s possible and yet many of us have failed to take advantage of it. It takes a little work, but it’s worth the effort. You’ll likely have less stress and, hopefully, a faster growing “nest egg.” Good luck!

2019 2nd Quarter Update

Top Headline for Q2: Largest Expansion Ever!

Since June 2009, the U.S. GDP has grown for a record 121 months without a recession. While this is the longest expansion in duration, the cumulative GDP growth thus far of around 25% is among the lowest on record. While it’s exciting to mark this milestone, it’s noteworthy that it was achieved with significant help. The U.S. Government created tail-winds through government stimulus including low interest rates, tax incentives and growth in the federal reserve balance sheet. At this point, everyone is wondering when the party will end. More to come on that front below in “A Look Ahead.”

General Market Update

U.S. Equities: U.S. Equities continued to march higher in Q2, albeit at a much slower pace than in Q1. Congratulations to the S&P 500 Index which, after rising 3.8% in the quarter, ended at a new all-time high. The Nasdaq Composite finished up 3.6% and the Russell 2000 Index was up 1.7% for the quarter. Many analysts continue to point out that we’re starting to see more price variance in the universe of U.S. stocks. For example, there is a bit of a shift toward safety and quality as REITs, Utilities and low-volatility stocks all saw large asset inflows year-to-date in 2019 and well above-average performance. Meanwhile, the higher-risk Russell 2000 (small cap) companies have not come close to regaining their peak levels from 2018. It’s noteworthy that the U.S. stock market is expanding in price in the face of shrinking earnings. Factset is reporting that earnings estimates for Q2 and Q3 are expected to be negative on a year-over-year basis. Moreover, it’s likely that the full year will also be negative. So, price increases are coming mainly from the rather tenuous price/earnings-multiple expansion rather than reported or projected earnings expansion.

International and Emerging Market Equities: Like the U.S. market, the international markets enjoyed gains in the 2nd quarter. For example, the Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 3.3% in Q2. The uncertainties surrounding the U.S. – China trade war has kept central bankers across Europe ready to respond to any continued economic slowdown with additional stimulus. Moreover, the Schwab Emerging Markets ETF was up 1.5% in Q2. The emerging market ETF grew despite a slight pullback in China’s equity market during the period. China has continued to inject large amounts of liquidity into their financial system and has guided short-term interest rates lower in an effort to stimulate their economy.

U.S. Bonds: The bond market continued its march higher in Q2 as bond buyers began to predict, with increasing confidence, a drop in interest rates in 2019. The year-to-date performance has been outstanding with intermediate-term bond ETFs posting high single digit returns and long-term bond ETFs generally into double-digit returns. Corporate bonds outperformed Treasuries indicating that the market’s appetite for risk is high. Demand for intermediate and long-term Treasuries has driven long-term effective interest rates down in a short period of time (e.g., the 10-year rate sits at around 2% after peaking at over 3.2% in Q4 of 2018). The market is so convinced of a rate drop in 2019 that any non-action by the Federal Reserve will likely adversely impact both stocks and bonds.

A Look Ahead

As we’ve commented previously, it’s hard to get too comfortable with the current U.S. stock market. Most signals suggest that it’s time to cut back on equity positions. For example, there are many signals that suggest that we’re in the final phases of the current GDP expansion and corporate earnings are decelerating such that they may be negative overall for 2019. However, the market continues to grind higher. So, where do we go from here? This market brings to mind the following two famous investing quotes: (1) “the trend is your friend” and (2) “don’t fight the Fed.” The first quote is a by-product of human behavior. An upward trending market attracts more buyers which drives markets even higher. The second quote is an acknowledgement of the power the Federal Reserve has over the markets. It seems that both factors are at play. The U.S. stock and bond markets have strong momentum and the market participants assume, with high confidence, that any Federal Reserve actions will be beneficial in the near-term. Moreover, with a 2020 election on the horizon, it’s reasonable to assume that there will be substantial and continued pressure on the Federal Reserve from the Executive Branch to be generous with stimulus.

Given these factors, it’s tough to bet against the U.S. stock market but we do see a few things that could rock the boat. For one, any inaction by the Federal Reserve at this point (beginning with the late July meeting) could have a very negative impact. Moreover, as earnings are reported throughout Q3, we’re likely to hear more negative surprises than normal. In fact, Factset reports that negative earnings guidance for Q2 (i.e., downward revisions in estimates) is the 2nd highest number that they’ve recorded since they started recording data in 2006. And, the heavily-followed Technology sector is leading all other sectors in expected negative news.

In summary, for the U.S. stock market, we continue to be cautiously optimistic in the short-term but a bit more bearish in the 1-3 year outlook. In this environment, we continue to like lower-risk segments of the market including higher market capitalizations and lower volatility ETFs. On the bond side, we continue to favor short to medium duration segments of the yield curve given the current potential for volatility in the longer-dated bonds and relatively low risk-premium.

Impact Investing (Socially Responsible Investing)

During my twenty years in the investment management industry, I’ve seen a number of trends. One of the more exciting trends to emerge recently is a movement toward “impact investing.” In short, impact investing involves directing your investment dollars in ways that drive social change and thereby positively impact the world. But, what exactly does that mean and how does one pull it off? In this article, we’re going to look at a few of the more popular ways in which investors execute their impact investing goals and, hopefully, gain a few more impact investors along the way.

Let’s first take a brief look at the evolution of impact investing. Impact investing first emerged as an idea among certain large institutional investors (e.g., large non-profits and public pensions). These organizations began to look for ways to manage their endowments in ways that were consistent with their missions by considering environmental, social and governance (“ESG”) factors when choosing investments. For example, an environmental organization may seek to limit its exposure to companies that have a history of adverse environmental impacts. Or, certain religious-affiliated organizations may want to steer clear of certain “sin” stocks. A small industry emerged in an effort to help these investors make better choices. For example, consultants and data providers began to create ESG “scores” to help companies screen stocks and proxy-voting companies created “ESG” voting policies to facilitate more mission-driven proxy voting.

Unfortunately, in the early days, impact investing was not particularly popular as most people in the investing world simply wanted to maximize returns and believed that ESG factors were counter to that objective. However, as time went on it became more clear to industry participants that companies scoring well on ESG factors also tended to be companies that saw better operating results. In 2012, a study was published titled “The Impact of Sustainability on Organization Processes and Performance” (by Eccles, Ioannou & Serafeim) which looked at the performance of companies based on sustainability factors (e.g., how they treat employees, their consideration of broader societal impacts and resource efficiency). In summary, the report stated, “we provide evidence that High Sustainability companies significantly outperform their counterparts over the long-term both in terms of stock-market and accounting performance”. This study and others helped to transform a boutique industry into a worldwide movement.

These days, investors of all shapes and sizes are looking to both make money AND have an impact with their investments. Perhaps the easiest way for individual investors to participate in this movement is to hire an investment adviser that provides an impact investing solution. An adviser can sit down with you as an investor and learn about what type of impact you are interested in achieving. By understanding your motivations and passions, the advisory firm can better customize a portfolio to ensure that your investments align with your values. The following is a sample of a few of the types of investment funds that are available:

• Emphasis on companies that have a lower carbon output relative to industry norms

• Emphasis on companies that demonstrate greater gender diversity within senior leadership

• Focus on investments in companies developing renewable energy solutions

If you’re not looking to go the advisor route, there are many tools for the individual investor to assist in aligning investments with values. The Global Reporting Initiative (globalreporting.org) is an excellent source for public company ESG information. The Forum for Sustainable and Responsible Investing (ussif.org) is a good source for content and provides a list of potential ESG-focused mutual funds. Moreover, ETF.com which contains extensive information on exchange-traded-funds (“ETFs”) currently lists 82 ETFs in this category with over $10B in assets. Good luck on your journey into impact investing. And remember, it’s a win-win – good for your portfolio and good for the world.

Happy 529 (Plan) Day!

As a parent of young children, I know the anxiety that comes with projecting, and planning for, college expenses. Reports are widespread about the escalating costs of education and, I’m sure, many of you are already feeling the pinch. Higher education costs have, in fact, been rising faster than nearly everything else that we spend money on (and faster than most of our wages for that matter!).

Over the last 20 years, “College Tuition & Fees” have seen more price inflation than all categories except “Hospital Services”, including “Child Care”, “Average Hourly Earnings”, “Housing”, and “Food & Beverage.” It’s tempting to pick on the education system at this point but the higher education system in the United States is regarded as among the best in the world. Moreover, research indicates that costs are rising, not because of greedy college administrators but, rather, primarily because education is a very “people-heavy” industry. We, thankfully, haven’t yet found a way for robots to teach classes so the efficiency gains seen in other industries haven’t appeared in education.

We can’t predict when, or if, the robots will visit us in the classroom but we can use a valuable planning tool to help us set aside some money for future expenses (i.e., the 529 Plan). 529 Plans are tax-advantaged educational savings plans that are authorized by, you guessed it, Section 529 of the IRS tax code. They were created, from a policy stand-point, to encourage more people to seek higher-education. There are two types of 529 Plans. One is called “pre-paid tuition” in which individuals can essentially purchase future college credits at a pre-determined price today. Many 529 Plans have stopped offering this option given the challenge of projecting future tuition costs. The other category is called “educational savings plans.” In educational savings plans, savers get to set aside a certain amount of after-tax money each year which then grows tax-free until it is used. Moreover, there are no taxes when the money is extracted from the plan provided the money is used for “qualified educational costs” (e.g., tuition, room and board, books, etc.). A recent change to the tax law in 2016 further expanded the definition of qualified costs to include K-12 tuition costs at independent schools.

If you’ve researched 529 Plans, you may have noticed that plans can be obtained through brokers/advisers or directly from a State or Commonwealth. The latter is what we recommend at Patina Wealth (i.e., in Virginia this would be the plan called “inVest529”). The logic behind that choice is that the costs will be lower without sacrificing investment performance. In other words, by signing up directly, you avoid the “advisory fee” that is paid to Patina Wealth or others. In our opinion, it’s not worth paying this fee given that you won’t likely need to change the investment allocation very often. At Patina Wealth, we do not charge fees for assisting clients with setting up 529 Plans or in making re-allocation decisions. Rather, we are happy to provide assistance with these plans as a client benefit. So, if Patina Wealth is already assisting you with your investments, there is no additional fee from us for your child’s 529 Plan. If college is in your family’s future, don’t let this valuable tool go unused. We’re here to help when/if you need it.

2019 First Quarter Update

Top Headline for Q1: The Big Bounce

After a brutal fourth quarter that culminated in double digit losses for the major indices, the U.S. equity markets have generally been on a steady upward trajectory. Although the indices have not regained their 2018 “highs” they have recovered much of the loss from the fourth quarter decline. For the quarter, the S&P 500 Index finished up 13.1%, the Nasdaq Composite grew 16.5% and the Russell 2000 Index was up 14.2%.

General Market Update

US Equities: As mentioned above, the indices “bounced” off their December lows en route to an excellent quarter. However, not all segments of the market performed equally well. There appears to be an underlying shift toward segments of the market with stronger balance sheets and more stable earnings. For example, Utilities, Real-Estate (including Real-Estate stocks and REITs) and Consumer Staples all had particularly good quarters. Moreover, it’s noteworthy that the Russell 2000 Index, comprised of smaller companies with less stable earnings and higher average debt levels, did not see the same amount of recovery during Q1. As of March 31, the Russell 2000 Index remains 11.2% off its 2018 peak versus the S&P 500 Index which closed the gap to 3.3%.

International and Emerging Market Equities: Like the U.S. market, the international markets enjoyed a strong first quarter. For example, the Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 10.4% in Q1. Moreover, the Schwab Emerging Markets ETF was up 10.5% in Q1. The emerging market performance was driven primarily by China which experienced double-digit equity market appreciation during the period.

US Bonds: The bond market, including Corporate bonds and Treasuries, saw a sharp rise in prices during the first quarter and a corresponding drop in yields. All maturities appreciated with the greatest growth being seen in the longer-dated segments and, in particular, the corporate bond segments. The bond market price action was interesting as it seemed to anticipate the outcome of the March meeting of the Federal Reserve. The Federal Reserve had been expected to increase rates two additional times in 2019 but took a much more “dovish” stance in words and action – revising it’s forecast to zero rate-changes for 2019. The announcement added more fuel to the existing upward trend in bond prices.

A Look Ahead

As we look to the future, we see conflicting signals. That is, economic fundamentals continue to deteriorate and yet equity markets are climbing with expanding price-earnings multiples. In the equity markets, there appears to be a tug-of-war between the short-sighted stock-market “bulls” and the underlying economic trends. Our expectation for equity markets is that the road ahead includes greater volatility and downside risk. In general, it’s hard to justify any expansion of price-earnings multiples in the current economic environment.

Regarding the current economic conditions, the International Monetary Fund reports a downward trajectory for GDP in Europe, Asia and North America (i.e., most of the world). Moreover, the Federal Reserve and surveys of leading economists also forecast positive, but declining, GDP in 2019. As one would expect, this macro-trend is reflected in corporate earnings as U.S. companies continue to slow down from 2018 peak levels. As of the last update, Factset reports that analysts are only expecting U.S. corporate earnings to see mid-single-digit growth in 2019. Another ominous sign reported by Factset is that the number of downward adjustments in earnings projections by analysts during the quarter was the second largest in the last eight years.

By now, you’ve also heard the buzz regarding the “inverted yield curve.” An inverted yield curve, where shorter-dated bonds have higher yields than longer-dated bonds, has proven a reliable predictor of recessions. During the quarter we saw 1-year Treasury bonds exceed the yield of 10-year Treasury bonds for the first time in more than a decade. The yield curve action seems consistent with other “late-cycle” indicators including high corporate debt levels, low unemployment and some early signs of wage inflation. What is surprising to us is that no one seems to be concerned with, or is planning for, the possible “rainy days” ahead. For example, consumer and business sentiment are at 10-year highs, consumer spending remains relatively strong (including a recent up-tick in real-estate activity) and corporate debt continues to climb.

On the bond side, Federal Reserve actions – real or predicted – will drive the markets in the short-term. The Federal Reserve’s willingness to abruptly shift trajectory on rates makes their forecasts less reliable and will likely lead to more volatility in 2019. The market, in fact, no longer seems to believe the Federal Reserve forecasts as the “futures” market is predicting two rate decreases in 2019 as compared to the flat “dot-plot” projections offered by the Fed. Lastly, we can’t ignore the potential impact of the upcoming 2020 elections. As evidenced by Larry Kudlow’s call for a 50 basis point reduction, it’s clear that the current presidential administration is putting pressure on the Federal Reserve to lower rates in 2019. The Federal Reserve is supposed to ignore such pressures but some suggest that the abrupt change of course in Q1 was impacted by political influence.

In summary, underlying economic trends call for greater caution in the equity markets. We will continue to monitor exposure and shift toward lower-risk segments of the market including higher market capitalizations and lower volatility ETFs. One the bond side, we continue to weight the short and medium duration segments of the yield curve more heavily. While the longer-date bonds enjoyed a nice increase during the quarter, the futures markets indicate that bond buyers may have already “priced in” a rate decrease. As such, any sideways or upward movement in rates by the Federal Reserve may cause a reversal in bond price trends with the longer-dated segment being the most adversely affected.

401(k) Plans – Best Practices for Business Owners

As a fellow business owner, I recognize the importance of recruiting and retaining great employees. Employees, especially younger ones, routinely rank “benefits” as a key factor when hunting for jobs and in determining whether to retain an existing job. I believe that one of the most important benefits that can be offered to an employee is an employer-sponsored retirement plan. Today we’ll evaluate the benefits of a 401(k) plan and some “best practices” for implementation.

As an investment adviser, one question that I often receive is, “Which retirement plan is right for my business?” The answer depends on certain facts such as the number of employee participants, the income level of the participants and the desired flexibility of the plan. Some plans, such as Simplified Employee Pensions (“SEPs”) and “defined-benefit” pension plans, are often a great option for closely-held businesses where the compensation levels are high. Other plans, like SIMPLE plans, tend to be better suited for businesses that are looking to provide a more typical retirement benefit for up to 100 employees. See my prior blog for more information. Traditional 401(k) plans tend to be the “gold standard” of retirement plans given that they can be offered to an unlimited number of employees and offer the greatest level of flexibility to the company in the implementation.

In the past, the downside of using a 401(k) was that the plan administration was complicated and expensive. Moreover, these plans had the potential to create liability for the company pursuant to certain federal regulations. The good news for the business owner is that, while the plans are still more expensive, there are numerous service providers that make for hassle-free implementation. Moreover, Investment Advisors can be utilized to further benefit employees and minimize potential liability.

Here is an example of how the process can work today assuming a business desires to set up a 401(k) plan from scratch. Please note that existing plans may also be transferred from the current custodian to receive all of the same benefits. The best first step in setting up a plan is to select an investment advisory firm, like Patina Wealth, that services 401(k)s. In this case, Patina Wealth, would be hired as both the “Investment Adviser” to the plan and a “3(38) Fiduciary.” Patina Wealth will then perform the following services:

• Serve as a liaison with a firm that will perform all record-keeping (e.g., Professional Capital Services, Inc.)

• Provide a recommended list of investment funds to be included in the plan (e.g., low cost ETFs or mutual funds)

• Provide a selection of “investment allocation models” that can be used by plan participants to make investment decisions

• Provide ongoing updates to the models

• Serve as a resource for any employees that have a retirement-related question

In recent years, implementation fees have fallen to a degree that it makes sense for businesses to fully outsource all of the required functions. For example, Charles Schwab charges only 3 basis points for custody of the Plan and Professional Capital Services, Inc. charges 15 basis points, along with some fixed fees, for a comprehensive record-keeping solution. Moreover, Patina Wealth’s fee is negotiable but is generally around 50 basis points for Investment Advisory and 3(38) Fiduciary services.

So far, we’ve talked about what good implementation looks like but let’s now take a moment to focus on what to avoid. Here are the five biggest mistakes that I see business owners making in setting up 401(k) plans.

1. Failure to Delegate 3(38) Duties – As mentioned previously, 401(k)s can result in liability to the business. However, this liability can be mitigated by hiring an Investment Adviser that is willing to take on this responsibility. And, it’s important to make sure this duty is described in the agreement.

2. Hiring an Inexperienced Record-Keeper – There are many service providers out there and it’s tempting to try to a save a few dollars on the record-keeping side. It’s not worth it. By having a very experienced record-keeper with a turn-key solution, you can stay focused on your business and your employees.

3. Not receiving objective advice – It’s important that your Investment Adviser and record-keeper are independent (i.e., they do not also manage/own the investment funds in the plan). Some plans are established by fund managers whose primary objective is to fill the 401(k) with high-priced investment funds that they own.

4. Set it and Forget It – Many companies set up 401(k)s but fail to provide ongoing resources to employees. In my experience, employees welcome the ability to speak with an independent investment adviser on an ad hoc basis and appreciate the ongoing discretionary model adjustments.

5. Low participation – In order for a 401(k) to benefit employees and lower employer attrition, it’s important for employees to use it. The most heavily utilized 401(k) plans typically include a generous employer contribution “match” to encourage consistent participation.

6. So, in summary, 401(k)s are a wonderful retirement plan option that no longer needs to be feared. A robust stable of service providers have made them accessible to a broad range of businesses and at reasonable prices. Moreover, incorporating an Investment Adviser can lead to happier participants with less liability to the company. As always, if I can help you sort out any questions, please let me know.

Sam Harris

When should I start taking my social security checks?

As an investment adviser, I hear this question often. My clients are always hoping for a clear and simple answer but, like so many financial decisions, the answer is “it depends.” More on that later but let’s take a step back and review what this program is all about.

Franklin D. Roosevelt signed the Social Security Act in 1935 creating the federal agency behind the benefits. Two years later, in 1937, the first social security taxes were collected and regular ongoing monthly benefits began in 1940. The intent of the program initially was to provide payments to US workers upon reaching retirement as a form of supplemental income. It was not intended to replace income but, rather, provide financial support in addition to company pension plans, and other forms of personal savings. The program has been modified through the years to provide benefits to disabled workers, spouses and children of beneficiaries. Today, over 62 million people receive social security benefits making it one of our most popular social-benefit programs.

As most people know, a worker accrues benefits through a lifetime of working and paying taxes into the program. Then, in retirement a worker gets a fixed monthly payment for life subject to an annual cost-of-living adjustment. Workers need 40 “work credits” in order to be eligible for the program which amounts to approximately 10 years of work. However, benefits can vary widely based on compensation levels and the number of years paying taxes into the program. In order to achieve maximum benefits, a worker would generally need around 35 years of work at very high compensation levels. In 2019, the maximum benefit equated to a payment of $3,770/month though the Social Security Administration (SSA) indicates that the vast majority of payments fall in the $800-$2,400 range.

In order for a worker to get 100% of the benefit that he or she is entitled to receive, the worker must wait to claim benefits until reaching “full retirement age” as designated by the SSA. Full retirement age can range from 65-67 depending on the worker’s year of birth. However, the decision becomes more challenging given that the SSA allows workers to claim benefits as early as age 62 or as late as age 70. If a worker claims benefits early, the benefit is reduced and, if claimed late, it is increased. So, this brings us back to our original question. Is it more advantageous, to claim benefits at 62 and begin receiving the smaller payments or hold out until 70 to get the larger payments?

One of the key factors for consideration is whether someone needs the money. If so, then delaying benefits may not be an option. Let’s assume that delaying is an option and one is motivated to maximize lifetime benefits. In this situation, the answer depends primarily on how long the worker lives and whether the worker is married. If a non-married worker has a low life expectancy, then it makes more sense to take the money early versus waiting whereas, if the worker is going to live many years into retirement, delaying would be better. Of course, we can’t answer that question but it is possible to makes some assumptions and compute a “break even age” to help with the decision. In other words, if the worker is projected to live beyond the break-even age, then waiting is the better option. Each situation is different but most people will find a break-even age in the late 70’s. It’s also noteworthy that social security benefits can be taxable so, if one is still working up until age 70, it increases the chances that it will be beneficial to wait on claiming them. Lastly, the above break-even strategy is for an unmarried worker. If married, then the spouse’s life-expectancy also needs to be factored in. When two potential beneficiaries are considered, it often makes sense to wait given the likelihood of at least one person surviving well into their 80’s or beyond. Benefits may also be available to ex-spouses of a worker so check the SSA website for rules and eligibility.

It is worth commenting here on the fact that the social security trust is funded by current workers whereas benefits are paid to retired workers. As such, demographic shifts (i.e., a shrinking working population in favor of a growing retirement population along with higher life expectancies) are stressing the system. More specifically, 2018 marked the first year since the 1980’s where the program paid out more than it took in in tax revenue. Moreover, this situation is projected to get substantially worse in the coming years such that some economists have forecasted the $2.9 trillion in trust assets to be fully depleted within 15-20 years. It’s unclear who will pick up the tab at that point but structural changes appear to be unavoidable. For those in or nearing retirement, enjoy those payments while they last. And, if possible, try to leave a little for the rest of us.