Nearly everyone has decided that markets and economics will not be the same as they were from 2003-2008 going forward. The primary question is whether we enter a 1930's variation or a 1970's variation, deflation or inflation? As always, most people are convinced they know which it will be. Until this past summer I expected a "vacation from inflation" for six to eighteen months and then a continuation of inflation for another ten to fifteen years.
Two fairly well-known internet writers are currently battling it out on opposite sides of the question, Adam Hamilton tilted toward inflation and Mike Shedlock toward deflation . Read both. They write logically and clearly and will not waste your time.
Hamilton believes that inflation is entirely an excess money result. If the Central Bank inflates the money supply, it is like puffing air into a balloon. The balloon expands and prices rise. This is sometimesd described as too much money wishing to buy relatively too few goods to spend it all on.
Hamilton's main chart in recent publications shows MZM money , which basically short term bank deposits and money market funds which is freely available to the owner, declining on an annual change basis from mid 2003 to mid 2005. Then with the rise of Bernanke the annual change rate increased from almost zero in mid 2005 to 16.4% in the first quarter of 2008. (To be fair, the rate of increase in MZM was about 3.5% when Bernanke actually took the reins.) The annual rate of increase dropped to "only" 9% by September 2008 but was back to about year over year 12.5% increase by the end of the year, per Hamilton's chart. His argument is that it was only irrational fear and panic which has driven prices down temporarily and that commodities, especially gold, are incredible bargains given the inflation that is coming due to the money suppy.
When Hamilton looked at M0 money , cash in circulation and in banks plus mandatory reserves that banks must keep on deposit with the FED, he is shocked that the 1960-2008 average annual increase of 6% went to +99% annualized by December 2008! He finds this shocking and ipso facto evidence that inflation will roar. Deflation case dismissed.
Mike Shedlock's argument is just as certain for deflation, which he says has been in effect for a year already and will continue. Shedlock admits that cash is clearly important but that credit, shorter term loans that facilitate all kinds of commercial activity and which dwarfs cash, has collapsed. He turns Hamilton's argument on its head that bank reserves at the FED are inflationary by showing that they account for most of the gigantic increase in M0 in 2008. How and why? Because banks have plenty of cash but are not lending it. They are hoarding it at the FED which now pays interest on it!
Furthermore Shedlock is certain he can demolish Hamilton's argument that the M0 rocket launch is inflationary by carrying the M0 chart which Hamilton started in 1960 back to 1919. It shows that M0 rocketed rocketed up from the early 1930's until mid to late 1940's, and thus was NOT inflationary at all! That's a devastating blow to Hamilton's main argument.
Shedlock also drew a table table of various events and whether they occur in each of six conditions, the sixth of which is "now". Almost all the events occuring now are deflationary.
Both Hamilton and Shedlock make good arguments, but what if it's a bit more complicated than just money or credit? What if it's both? We know that banks didn't lend much in the 1930's and that the government borrowed a lot of the cash. Industrial development slowed to a crawl, and unemployment was horrible. But at the same time many or most commodity prices rose, dramatically in some cases. As just one example for whch I have long term data, wheat, certainly a staple of life on the plates of most Americans and many others in the world, rose from a low of 31 cents ($0.30) a bushel in 1932 to $1.45 a bushel in 1937, a 368% rise while incomes were falling! Unemployment was rising, wages were falling, and prices for essentials like wheat were rising. That's brutal. Housing prices were falling in the 1930's, by all verbal reports I have heard, just as they are now, and the 1930's are considered the prime model for deflation.
Like many I have leaned toward the easy idea that we have some deflation now but will surely have inflation later. The "surprise-a-mental", as Ed Seykota called economic fundamentals overlooked by most and picked up by only a few early on, could be we that we will have both deflation and inflation concurrently as in the 1930's. Oddly enough, my Hillary/Obama portfolio of short term municipals and gold would work reasonably well in such conditions.
There is no way an ordinary mortal can know what is really happening now. The best we can know is from watching all markets carefully and thoughtfully. World markets are inundated by continuing massive private liquidations and by government interventions around the globe. Think about it. Governments are on the prowl for banks and other assets to keep everything running in some semblance of normalcy (normality). It's just a normal recession they say. But governments from Japan, China and Russia to Europe, Britain and the US are nationalizing the banks and other "strategic" assets. There are a variety of politically correct terms to describe the takeovers: re-financing or rescue or whatever.
Gold flew up to $900 this week while the dollar gained as well on its trading partners (assuming we all still trade) except for Japan. That means Europe and Britain got rocked after having projected "what me worry" status so long via ECB chief Trichet. It's been apparent for quite some time that this was not just a New York deal. In an inflationary time, all economies are synchronized, unlike what we lived through from the late 1970's to the late 1990's. Measured by the US ETF RSX, the Russian equity markets are down over 80% since May 2008 net of persistent devaluations of the ruble to the dollar. Russia is still far better off, so far, than after the 1998 bankruptcy blowout that helped bring down LTCM.
Is this all just another decennial wipeout after which we resume upward progress? Or is this too much this time? I think the former not because I am a perma-bull or lazy historian, but because inflation should continue in this decade. I caution that this does not mean equities or bonds have to go bullish, only that some aspects of economies and crude goods prices can or should go back up. In other words this should be more like the late 1960's to 1980 for a while yet. Bonds should go down as some recovery takes hold. How could they stay up on Everest after 28 years of gains? With stocks it should be very,very selective. I don't even want to go into it, but government-favored sectors (you know them) and materials should revive somewhat.
But perhaps one should just own the commodities as Jimmy Rogers used to say and Dennis Gartman says recently. Why bet on how well a corporation may do with it all when you can buy gold or copper or agricultural ETF's and coal and uranium ETF's? It's a commodity era not a bond or equity era, and this collapse proves it to this economic Long Wave fan. Forget standard stocks and standard bonds. Look for dividend-paying substitutes for bonds and for capital gains in commodities. Buy some on signficant pullbacks and sell some on significants gains, just like good commodity traders do. (Learn about and thoroughly study US closed end funds, and look at US and Canadian oil and gas royalty trust income stocks.) If you can make 10% per year trading and 6-8% on interest or dividends, welcome to the new market. Unfortunately even if you are retired, you may not be able to sit and hold a "diversified portfolio". On the other hand, would you rather sit in front of a market trading screen or be a greeter at WalMart? Not literally, I hope, but "in concept". Capital preservation and modest goals and risks may require some new skills.
Occasionally I see one of George Friedman's reports from Stratfor in San Antonio, Texas. George has made the point several times that the always large Russian Embassy staff in Mexico City is reactivating or beefing up covert activities within Mexico. This not so much to harm Mexico as a priority but to create background difficulties for the U.S. which they see us doing to them in the former Baltic and Slavic soviet states. The cozier Russian relations with Venezuela and Cuba, which may actually have toned down a bit now again due to the crude oil collapse, are also for the same reason, and both Mexican and Venezuelan/Cuban plans are likely tied together in ways I won't go into at this time.
As you all may know, there is a steady and fairly heavy exodus of middle and upper class Mexicans into south Texas and elsewhere in the US due to the Kidnapping War in Mexico. South Texas is favored by middle class Mexican commercial people because of nearness to home and low real estate prices. A lot of both residential and commercial property has been bought up by these refugees, and they are putting down roots. The refugees are heartily welcomed by Texas.
I remember in earlier domestic crises that wealthier Mexicans flocked to San Diego and bought up huge swaths of high rise condos in Coronado and elsewhere. I'm not sure where they are going now. But a very high profile refugee may be making his own exit plans. Carlos Slim, said to be the second wealthiest man in the world, has been buying New York Times stock in the past year and is reportedly negotiating a very big deal for preferred stock and warrants (or convertibles) which could on eventual conversion give him up to one- third ownership of the Times which is in financial distress. The Ochs and Sulzberger families own the Times through various special voting rights shares, but would probably not mind having Slim on board as they share some common interests and he has the money.
I bring this up because it is very reminiscent of Rupert Murdoch's pre-exodus planning when he was leaving Australia to re-locate in the US. Murdoch bought and/or put together what is now the Fox Network and other media outlets. It's a brilliant strategy to buy some influential media for several reasons. Self-promoting public relations, of course, is a major reason to own media no matter who or where you are. But it also gives the wealthy and powerful immigrant some leverage in his new environment for all sorts of endeavors. Slim already has other assets here including Southern Copper which is headquartered in Arizona, and he would like to get back Asarco which he lost in bankruptcy court in El Paso, Texas after putatively having run it into the ground, keeping its best assets for Grupo Mexico, another Slim treasure. This might be another reason to have good friends at the New York Times.
In any event, if Slim is coming to America, and I am only guessing at this point that he is, this is not a good sign for Mexico. It would mean that the game is up, and that the Mexican Kidnapping War is growing ever more dangerous and possibly reaching end stage. If the world's second richest man is wary, we'd all better be wary of Mexico's on-going war. It might put a crimp in NAFTA, and the famous Ross Perot "sucking sound" might be reversed from southbound to northbound.
Also the persistent sinking of the Mexican peso versus the US dollar even during the prime tourist season suggest that something is not quite normal south of the border.
(The Russian attempts to discredit Ukraine and intimidate Western Europe over gas supplies may have failed this week, but they do not normally go away quietly or gently.)
The silver lining of the Obama Pork Barrel Saga Revival arrived today when that great champion of the poor, Rep Charles Rangel (Dem) of Harlem, NY, currently under investigation for corruption, introduced the bill I recently alluded to which will remove the Alternative Minimum Taxable status of municipal "private-activity" bonds which wealthy municipal bond buyers hate. Here is the Bond Buyer's story:
Private activity bonds are what well-placed people use to fund private projects at tax-subsidized rates via municipal bonds at the local level. A lot of if not all specialized for-profit hospitals and your every-fifteen-years-new-needed-or-not local professional sports arena for your favorite team, largely owned by wealthy democrats, are built this way. But also most school construction and local water and sewer and road construction is financed through regular, non AMT, municipal bonds. The construction and everything is ALL conveniently unionized, of course, and there are lush kickbacks and "finders fees" at every stage of financing, permitting, and construction in municipal projects.
But suddenly the now archaic alternative minimum taxation of the private-activity bonds, which was used to punish mostly very wealthy republican little old ladies with billions in muni bonds, has turned out to be punishing wealthy democrats, and must therefore be squashed under the cover of "infra-structure" building to create jobs in this really lousy economy: official corruption at every phase financed by the taxpayer is suddenly "public policy".
But realistically that's the way things get done in America, especially in infrastructure. Local town and city and township and county and state government in the US is where we live and where things get done. The Federal Government is where army and navy and air force and national standards orgnizations and regulatory agencies live and get funded by everyone. The Federal level hasn't a clue what's going on or needs to go on at the local level. They respond to the prodding and courting by local officials lobbying in Washington D.C., and their elected representatives of course. And the unions.
The relaxation of the tax on the private-activity bonds means that every sports stadium including Fenway Park will now very likely be torn down and replaced with a new, earthquake-proofed and solar-powered home for every professional sports team in America. Not to mention that scads of the new questionable surgical sub-sub-sub specialty invasive procedure hospitals will be built to relieve us all of our colon polyps and pocketbooks, none of which procedures are deemed medically-necessary or payable by MediCare or other insurance carriers. Infra-structure heaven! Pork at its best.
But at the same time a lot of reasonable on-the-shelf local projects which have been planned for and for which property and/or easements have been acquired are at stake. It has been impossible for a year to fund any such projects. These are for real basics in education, roads, parks, utilities, and all manner of local facilities, including new and upgrades and retro-fits.
The interesting and defensible "emergency" aspect of this muni bond move is that many of these projects can be intiallized quickly if they were pre-planned, as many were. In a rapid growth period up to 2007 many local governments needed new facilities and planned for them but got stranded by the muni bond freeze up in 2008.
I'm going to get in on this one myself. I'll bet the muni bond fund makers at Nuveen and elsewhere are salivating today as they rush to issue new open and closed end funds to buy these higher yield beautiful new bonds to come on a state by state basis. Until the dollar re-starts its terminal decline when the current reflation effort eventually starts to work "too well", the place to be will be in state-specific AMT-free private-activity muni bonds. Then we go much more heavily to gold.
This certainly puts a positive spin on the great Pork Barrel Rush of 2009. It may work. For a while.
As you know I regarded as extremely important the breaking in November of the 2003 high in UST Bond futures above 123, and the breakdown below about 3.9% in the cash T bond interest rate. This destroyed the orthodox Long Wave notion that the disinflationary move down from 1980 had finally ended between 1999-2003, and that we would have inflationary growth until the late 2020‘s. The interest rate breakdown in November 2008 meant either that the long move down from 1980 (or earlier) had extended five or more years, or that the whole cycle concept was defective.
Traders yawned, but long term planners/investors were paralyzed. Was it all simply a very short term massive liquidity squeeze and giant margin call throughout the world that destroyed all asset classes? If so won't we spring right back into the inflationary growth path? Or was the rupture of the commodity bubble of 2008 the end of an era and the start of a long depression?
The bankers and the politicians disagree for personal and professional reasons. Treasury and Federal Reserve were convinced it was a short term liquidity issue of trust and confidence from bank to bank. If Bank A wasn’t sure if Bank B was going to be solvent, it wouldn’t want to be a counter party with B on anything. This was true for banks A through Z and beyond in September and October. So the Treasury tried to reassure the banking community by buying preferred shares in the banks to replace the blighted capital preferred shares in Fannie Mae and Freddie Mac which most banks had held as required Basel Tier 1 capital and which was now history. I doubt that one congressperson in a hundred understands bank capitalization requirements and how they influence interbank transactions legally and financially. Do read up on preferred stock at Wikipedia and elsewhere. It's very important right now.
Congresspersons DO understand pork barreling, which is seeking national taxpayer funds for their own district or state's pet projects which are dictated or directed by the locals who elected them to Congress or might help elect them the next time. So if the Treasury, with FED help, was "giving" to the banks, let’s get them to give to the politicians too. And so here we are today with a new and untested President about to take office with the drooling pork barrel barons of Congress egging him on to ever greater and obscene handouts for which there is no tax money in the Treasury. I wish Mark Twain were here to put this in proper perspective. The Treasury funds to the banks are repayable with interest. The pork barrel projects are repayable to Congress in votes and various other legal and semi-legal payoffs.
I've been reading a lot of market commentators, and they are as confused as anyone else. They definitely are not up to Basel Tier 1 capital snuff. Harry Dent thinks inflation is always good as it implies progress, but he thinks all the current reinflation attempts are doomed to failure as we are headed for a long term depression on demographic and multiple cycle grounds. A lot of other people think inflation is evil, and we are headed for the deep depression as a result thereof. (See Dent's new book, "The Great Depression Ahead" which I have been reading this weekend for further detail. I imagine Yogi Berra saying, "Dent writes so bad he's illiterate", but he gets his messages across clearly enough.)
Many people who think they know seem to feel that the deflation is temporary and that rampant inflation will be back soon, made far worse than ever by Congress and the new President. The markets seem to agree with this opinion which I have generally shared so far. Bonds are way up and interest rates are way down, but gold is holding up even with all other commodities in the abyss, and the dollar is not screaming higher. It's a standoff so far.
When ignorance and greed abound, as currently in Congress and Wall Street, it’s best to be safely hedged. I still think that short term (but not money market) government note funds are prudent, laced with a gold and/or energy exposure. Either gold or US T Bonds have to change direction dramatically in order to move me from my stance.
My first of the year rebalancing/repositioning is done. I haven't really made a lot of changes, but have consolidated and/or eliminated some smallish positions to keep it simpler. Bear in mind that my main goal these days is relative safety and fairly steady income with inflation protection for the future. I have both tax-deferred accounts and taxable accounts
In tax-deferred accounts my goal is to generate income within them sufficient to fund IRS "Required Minimum Distributions" (RMD) which are based upon life expectancy. The IRS guarantees (to themselves) that everything in them **will be taxed**. Since taxes are quite likely to rise, I have little desire to increase the total value per se of such funds at this stage. All gains are taxed the same as income, and the IRS is a full partner. So income with some inflation protection is key.
Half of all such funds are now in Vanguard's GNMA fund VFIJX with an average duration of 2.8 years (far shorter than normal but for a good reason), with a very low cost (0.11% per year), and paying 4.80% currently.
Another 12.5% of these funds are in HSTRX which is Hussman's managed Total Return income fund. Hussman has an eye toward inflation-hedged safety and typically has had a fairly high percentage in short duration TIPS. He also keeps 5-20% in gold stocks or gold ETF's or forex and small amounts in dividend paying utilities. HSTRX pays a regular cash dividend of only about 1.5% , about the same as a money market fund, and that's the way to think of it, *except* that it has the flexibility to do a lot more under the right conditions, and it almost always pays a sizeable year end capital gains dividend which I plan to reinvest to preserve the funds's inflation value. (The TIPS ETF's and mutuals I know of are all too long in duration for my purposes compared to HSTRX.)
The remaining 37.5% is largely in the oil and gas trusts that I have discussed so much and in a fund (TYG )containing a lot of pipeline LP's which is structured so as to be suitable for a tax-deferred account. Also included with the trusts is a small position, which could be raised if they get cheaper again, in two bombed-out high dividend closed end funds in real estate and resource stocks, DRP and ETO. The oil and gas trusts and TYG are paying about 9% annually on average. The trusts are of course wasting assets and their estimated reserves lives, ~13 years average at the moment, are very close to their effective stock durations ( see "For the Duration") as measured by the price to dividend ratio. Since the tax deferred funds and their beneficiary are also "wasting assets" ;) this should work out well and keep taxes down in the long run.
The dividend return of this mixture is about 5.3% which is pretty generous at the moment, but except for the trusts the risk is quite low. I plan to continue to trade the trusts once or twice a year on a value basis, selling some when they get too high and buying some when they get too low.
The nice guys at the IRS and in Congress have agreed that we don't have to take out our RMD's from tax-deferred accounts in 2009 since the assumption is that most people had huge losses in them in 2008. I didn't have losses, but I welcome the opportunity to reduce taxes in 2009, the better to fly under Obama radar. Also it allows for some modest compounding by reinvesting the dividends.
The approach this year for taxable accounts is also to minimize taxable income and provide inflation/dollar insurance. All fixed income funds have been shifted into the Vanguard Short Term Tax-free Municipal Fund VWSUX with a duration of 1.1 years, an annual cost of only 0.08%, and paying 3.03% on a distribution yield basis, equivalent to what ~4.15% would be after tax. Approximately 55% of all taxable account funds are now in VWSUX.
Another 11% of funds are in a fund owning my state's longer term AAA municipal bonds and paying 5.8% tax-free which is equivalent to over 8% for a taxable fund.
The rest, ~34%, is in gold and silver, a few metals royalty companies (ROY, SLW, RGLD) I have previously mentioned and the Rydex Managed Futures Fund RYMFX which I refer to as the "Trader Vic Fund" as it operates under Victor Sperandeo's investment principles. The concept here is to hold these hedges "forever" unless they run way up in price. In a sense I hope they don't. I think of them as inflation and dollar debasement insurance for the tax-free income funds. This 34% pays very little or no cash dividend.
The first chart shows the total returns (annualized) of these funds since the inception of HSTRX in 2002:
CEF is used as a proxy for all precious metals in the holdings.
The second chart shows the longer term record since 1988 for the junior funds of VFIJX, and VWSUX and used PRPFX as a proxy for HSTRX as they have largely similar goals. VFIIX/VFIJX and VWSTX/VWSUX have consistent long term records. Even though the whole period was largely a bull market for bonds, these two funds are short enough in duration and high enough in quality that they should perform well as (if) interest rates rise.
Also clearly Central Fund of Canada (CEF), which is a closed end trust holding gold and silver bullion, does very well during inflation and not so well during disinflation while PRPFX and HSTRX are more adaptive to conditions. The same should be true of RYMFX which has only been operating since March 2007 but whose futures trading record under Sperandeo is well documented. CEF is only a part of my metals holdings and I hold it because it is easy to adjust position size with it.
There is very little in the way of "generic" or index equity anywhere. That is both because of the Hussman-inspired portfolio duration idea at my age, and also because with S&P earnings forecasts dropping rapidly, stocks may not be as good values as some of the value people think they are. Plan A is to do very little trading this year, but watch things very closely.
I must have heard that question a thousand times today from CONgrASS people, journalists, and ordinary people. What economic galaxy are they from?
Banks use capital (money) to make loans and investments in order to make more money to pay expenses and have enough left over to grow. If they run out of capital they can't borrow or lend, and they are history. Lehman was the famous example in 2008. What's unclear about that?
Many banks were running out of capital this year for all the reasons we now know, so no one wanted to lend them new money or continue to re-lend them old money. Suppliers didn't even want to sell anything to them to run their business with. They might not have got paid.
Some overseas investors did lend some new money, and Mr Buffet lent some, but few others did. So for many of the banks, and some of the non-banks, the Treasury bought preferred stocks from them which increased their capital so that they could continue to function. Presumably the Treasury thought they were decent enough banks who actually could make some dollars doing what they do and would keep the doors open, and that they, the Treasury, would probably get their money back too and with a profit. Capitalism as it were.
When corporations (banks in this case) sell stock the new money they take in goes for "general corporate purposes", which in the case of banks is for "banking" in their best judgment. This is not "project financing" money as in pork barrel congressional financing. If you don't know what general business the banks are in you don't invest in them. If you invest in them, as the Treasury did, you don't know or need to know all the tiny details of where your every dollar went: that you get from quarterly corporate reports and the success or failure of the bank. If you want itsy-bitsy details you'd better buy the whole damned company as the Treasury did with Fannie Mae and Freddie Mac. Then you put in your own management to sit in the front office and every other office and watch their every move, presumably also to make a profit and stay in business. You don't buy the bank's business with $20 billion or more in preferred stock each. You give them a breather from looming creditor shutdown and hopefully others will also be encouraged to invest in the bank since you did.
I certainly believe in the limitless capacity of human beings to be completely stupid. I watch the TV news every day and read newspapers and internut sites. But I must think a lot of this junk reporting and posing about "what are they doing with the money?" is just politics and not the incredible idiocy it appears to be.
I strongly recommend reading this piece by Bennet Sedacca via John Mauldin on how to tiptoe around the bull trap being set for us in fixed income vehicles. Sedacca is pretty clearly, I think, (without his actually saying so directly) in GNMA notes of modest duration. GNMAs have **always** been Treasury-guaranteed, conservative mortgage-backed securities backed largely by Veterans Administration home loans to very qualified home buyers. Vanguard's GNMA fund VFIIX/VFIJX, as well as Sedacca (I suspect), favor issues that are in solid zip codes which have little need or reason to refinance, or to default!
They are currently paying ~4.7% in a 2.8 year duration fund, so they are great for tax-deferrred retirement funds or if you are in a low tax bracket. Shorter term and money market funds are tending towards 1%. GNMAs are not state taxable in some states, being Treasury-guaranteed issues.
Sedacca's other points are also well-taken. The FED and Treasury are trying with all their power to force us out into the riskier markets with their starvation short rates of zero to 1%. I personally think I have to resist that threat and the squeeze attempt. But be your own judge. These are tricky times. Be careful. I have watched the junk bonds, emerging market bonds, and preferred stocks roaring up in the past few weeks, but they are riskier now.
Sedacca understands this market while PIMCO seemingly wants the FED to bail them and everyone else out. This is just my private and personal opinion of course. PIMCO has a lot of very good funds, some of which I have used.
"Buy and Hold" is what we imagine if "for the duration" applies to investing. TV ads for brokerages and brain dead media writers are now advising people not to panic just because their accounts are down 50% from December 31, 2007. It "Bogles" the mind. "Stay the course", they say. But the course was unreliable and devastating in 2008. Buying and holding the indexes no matter what is a proven disaster course for most adult investors. For the past ten years through today, the total return of the low cost Vanguard S&P 500 Index Fund VFINX with all dividends reinvested and no taxes deducted was -1.47% per year annualized or -13.72% total. For the same ten years and same conditions, the Vanguard Prime Money Market Fund VMMXX was up 3.48% annualized or 40.66% total. It's not hard to understand why some people always stay in money market funds.
Over the same ten years and conditions the Vanguard Ginnie Mae fund VFIIX was up 5.87% annualized and 76.66% total. One of my favorites of 2007 and until July 2008, Loomis Sayles Bond Fund LSBDX, was up only 6.18% annualized and 81.92% total after a huge fall this autumn.
If you had been planning in January 1999 to retire in ten years, in which of those funds would you have likely invested? For the then preceding ten years from January 6, 1989 to January 6, 1999 VFINX (SP500) was up 19.26% annualized or 484.98% total. The money market fund was up only 5.62% annualized or 72.95% total for those past ten years. Let me guess which fund you or I might well have chosen.
Things change, markets change, and we need to change too. John Hussman's January 5 weekly comment shows a way to adapt to change which is based upon an investor's age and when that investor will need to begin drawdowns for family events ranging from college expenses to retirement. As I have written many times, the worst thing that can happen to someone expecting to retire in a year or two (or five or more) is to lose 40-50% of saved assets in a bear market year. That happened in 2002, and it happened to some folks in 2008, and it will happen again some other year.
Hussman shows how an annual re-balancing of investments can incorporate the concept of asset class "duration" as a way to limit over-exposure to volatile stocks which can lead to 40-50% losses. As discussed here often in evaluating bond funds, duration refers to price sensitivity to changes in interest rates. Duration for most bonds or funds is the time to when you get your total bond payment stream on a present value basis. (Read Hussman's 2004 discussion for the math.)
A money market fund theoretically has no price risk. It is pegged at $1 and never goes up or down, so its duration is zero. The Vanguard Short Term Municipal fund (VWSTX/VWSUX) has an average maturity of 1.2 years and an average duration of 1.1 years. One effect of this is that the bond fund will go up about 1.1% if general interest rates fall 1% or down about 1.1% if interest rates rise 1%. Compare that to the Vanguard Long Term Treasury Bond Fund (VUSTX/VUSUX) with an average maturity of 17.1 years and average duration of 11.2 years. In this case a 1% rise in general rates sends the fund down 11.2%! This is why we saw long Treasury bonds move up so far and fast in the past few months and fall so fast and far in the past week. They are ten times more volatile than the short term municipals fund. We all are more or less aware of this fact. You generally get paid a lot more to take on the ten-fold risk of a long term bond. But not this year.
As Hussman shows, stocks also have a duration factor. It's easier to do the math on the stock duration as it is price divided by dividend rate. A very simple way to approximate the S&P 500 duration is to use this helpful calculator. For these purposes enter a beginning date of January and ending date of December and take the ending dividend rate. Divide that into 1 (1/.0323 for 2008), round it, and you get 31 as the duration for the S&P at year's end. This is a rough estimate but gives you some idea for how much riskier stocks are than a one year duration short term municipal fund, namely 31 times riskier. At the end of June 2007 with a dividend rate of 1.73% the duration was 58 years, so it's only one-half as risky now to own stocks as it was then. At the end of 1999 with the S&P 500 dividend rate at 1.15% the duration was 87 years! At the end of 1974 the S&P 500 duration was 18.6 years.
OK, so what do you do with these numbers? Let's say you will be retiring in ten years. According to Hussman you'll want to match your total portfolio to your time to retirement, namely ten years. So if the stock duration is 31 you'd divide 10 years by that duration and get 32% as the maximum allocation of your 100% portfolio for stocks. That means you'd want to have 68% in money market funds with zero duration. Or, say, 25% in stocks and 75% in a bond fund or funds with a duration of 7 years.
If you had rebalanced your portfolio at the end of June 2007 last year for a ten year retirement duration, you would have reduced your stock allocation to a maximum of 17% of your portfolio with 83% in money market funds, or perhaps 10% stocks and 90% in a 7 year duration bond fund. If the latter you would have lost 28% of your 10% in VFINX (S&P 500), or 2.8% overall. And you would have made 8.33% on the 90% of your 7 year duration Vanguard Intermediate Term Bond Index Fund VBIIX, or 7.5% overall. Netted out 7.5%-2.8% = +4.7% annualized over the 18 month period. That sure beats losing 28% annualized by being 100% in VFINX for that period. Not spectacular but not a retirement buster.
I chose an ideal starting date, and these are only rough calculations, but they show what you can do without even trying to predict what the markets will do. With a simple spreadsheet, you could do this once a year as you get a year closer to when you will need your money. Check it out and do read the Hussman articles.
Despite all my efforts last year, and thanks to the end of December rallies in oil and gold and bonds, I came out up 0.19% for 2008 in my retirement accounts! Not nearly as well as I would have done just being in a Hussman-like duration match portfolio or even in a money market fund. Hmmmmmmm. :)