Glassman Wealth Services LLC

The Yield Drought – Retirees’ Greatest Challenge 

The US government continues to bail out banks, homeowners and the economy at the expense of retirees and conservative investors. As a result, we are suffering from a serious yield drought. Glassman Wealth Services’ white paper explains the reasons for our current low-yield environment and the strategies we use to bring relief to retirees and those who rely on income producing assets.  Click Here to receive your free white paper.

The global media is enamored with the Chinese growth story, but in reality this should not be an enormous surprise.

For much of the past 2000 years, India and China were the dominant economies on the global landscape. Economic superpower status changed abruptly during the industrial revolution, but as The Economist pointed out, “Why they fell so far behind may be more of a mystery than why they are currently flourishing.”

Over the past several months, bond and equity markets have been on starkly divergent paths.  Investors are growing increasingly concerned that perhaps the bond market knows something that the stock market is overlooking.  In reality, the answer may be simpler than we realize.

As of the middle of last week, Citi research discovered that global equities are up roughly 6% while global government bonds yields are down 25 basis points.  In the U.S., the situation is even more dramatic with yields down nearly 1.5% since the peak in late April.

There are seemingly two explanations for the recent turn of events.  The first is corporations.  Corporate cash at nonfinancial companies is up 26% through March to $1.8trln, the largest such increase since at least 1952. 

Emerging from one of the most severe recessions in the last century, companies are more than willing to hoard cash and favor a  ‘wait and see’ approach before resuming expansion.   Cash levels at S&P 1500 companies are well in excess of $1trln now, but, where does that extra cash wind up?

According to a recent survey from CFO.com, 74% of short-term cash is placed in bank deposits, money market funds or U.S. Treasury securities. 

 The second reason bond yields are falling is that individual investors continue to sell equities in favor of fixed income securities.  Through July, investors took $33bln out of domestic equity funds, with much of that finding a home in the perceived safety of taxable bonds. 

This is hardly the first time such an occurrence has happened.  In fact, Citi found a number of occasions since 2000 where global bond yields fell as global equities rallied.  In a majority of those instances, the equity markets were right.  Equities continued to rally and bond yields eventually rose.

There is reason to believe that equities offer the more compelling opportunity going forward.  Forgetting the impact of price appreciation, the average dividend yield on the DJIA was 2.94% as on August 13^th, compared to a current yield of 2.62% on the 10-year Treasury. 

The last time the DJIA had a higher yield than the 10-year Treasury was in late 2008/early 2009.  It is relatively uncommon for the DJIA to exhibit a higher yield, although, in the early part of last century it was a common occurrence. 

The Treasury market has been susceptible to a number of technical factors in recent months, from the recent announcement by the Federal Reserve to purchase treasuries to huge individual investor inflows.  Yields could certainly fall further if the economy enters a second recession, but the likelihood of that is marginal at the moment.

In our Monthly Economic report, we take an in-depth look at the changes in our markets and the effects of economic policy nationally and globally. This broader perspective provides greater clarity in understanding the forces that affect investment performance and future expectations. Click Here for our July report.

An interesting development has come to the forefront in the past several weeks.  Democrats who were previously in favor of allowing the Bush-era tax cuts to expire at the end of this year are suddenly swimming in the opposite direction, with several favoring extensions to the tax credit given the poor economic backdrop.  It is easy to find supportive arguments for both camps, but the simple reality is that economically restrictive policies will create a drag on growth at a time when the economy can ill afford them. 

The preceding graph details what taxpayers can expect in the upcoming year, barring any extension of the Bush-era tax cuts.  President Obama has already detailed a willingness to extend the relief for those making below $250k. 

While individuals making more than $137k only represent a small portion of taxpayers in this country, they account for roughly 30% of all consumer spending.  Considering our excessive use of debt in every imaginable form, it should come as no surprise then that consumption accounts for 71% of GDP.  

The combination of higher taxes and a weak economy is translating into lackluster spending figures for those higher income individuals.  Even accounting for a 33% surge in daily spending during the month of May, spending among individuals making more than $90k a year is still almost 30% below its May 2008 peak.  The increase in May was likely a result of “thrift fatigue,” whereby consumers finally reach a point at which they no longer feel like saving.  This proves to be a very temporary phenomenon.

The administration argues that allowing the tax cuts to expire would generate $800 billion of additional revenue over the next 10 years.  This is a tidy sum at a time when the federal debt is skyrocketing, but if we learned anything in recent decades, it is that a government with access to more money will spend rather than save the incremental dollars of savings.  Until the government learns how to cut back and spend more efficiently, a seemingly impossible task, the new revenue will go the waste.

What these numbers also fail to account for is what happens if the upper income brackets decide to become permanently more frugal and a double-dip recession ensues?  The additional dollars of revenue generation would no long matter if we are pushed into 20 years of deflation, similar to what Japan has endured.  

It should also be pointed out that the US is already home to one of the top marginal tax rates in the entire world.  Even the oft-ridiculed Europeans are nipping on the heels of the US, after rates in the European Union fell from an average of 41% in 2003 to 36% by 2009. 

Democrats understand not only the need to aid the economy, but also realize the difficult battle they face in the upcoming mid-term elections in November.  According to the website RealClearPolitics.com, Senate Democrats are dangerously close to losing their majority and right now, Democrats are expected to retain 49 seats, with 43 going to the Republicans.  That leaves exactly 8 seats to determine who controls the Senate. 

The situation in the House is even more tenuous, with 202 seats in favor of the Democrats, 201 to the Republicans and 32 viewed as tossups.  

This is not simply a case of higher taxes or the viability of the Democratic majority.  Uncertainty around whether or not the tax break will be extended or allowed to expire simply adds to the layers of investor unease.

According to Barclays, assuming the tax cuts roll off at the end of the year, Price/Earnings multiples could contract by one point, from 12x consensus earnings to 11x.  Only one point you argue, but with consensus earnings at $96 for 2011, that represents a roughly 100 point differential in the S&P 500. 

Democrats understand not only the need to aid the economy, but also realize the difficult battle they face in the upcoming mid-term elections in November.  According to the website RealClearPolitics.com, Senate Democrats are dangerously close to losing their majority and right now, Democrats are expected to retain 49 seats, with 43 going to the Republicans.  That leaves exactly 8 seats to determine who controls the Senate. 

The situation in the House is even more tenuous, with 202 seats in favor of the Democrats, 201 to the Republicans and 32 viewed as tossups.  

This is not simply a case of higher taxes or the viability of the Democratic majority.  Uncertainty around whether or not the tax break will be extended or allowed to expire simply adds to the layers of investor unease.

According to Barclays, assuming the tax cuts roll off at the end of the year, Price/Earnings multiples could contract by one point, from 12x consensus earnings to 11x.  Only one point you argue, but with consensus earnings at $96 for 2011, that represents a roughly 100 point differential in the S&P 500.

With consumers at the upper end of the tax bracket finding themselves dis-incentivized to spend money and the economy in a dangerously perilous position, now is not the appropriate time to rollback prior tax cuts.  The 2.4% growth rate in GDP during the second quarter only served to confirm that the economy is gasping for breath and additional restrictive policies will only compound the situation.

Barry Glassman has emphasized and practiced collaborative financial planning between his clients’ accountants, attorneys and other advisors long before this became the industry’s latest buzzword. Click Here to read more about our Wealth Advisor Summit and how collaboration helps families to more effectively plan and realize their financial goals.

While many are focused on the unemployment numbers, currently at 9.5%, more emblematic of the problem is the low employment to population ratio, which stands at roughly 58%, levels last experienced in the early 1980s, when the population was approximately 80mln less than it is today.

The most interesting development during this recession has been the divergence in employment by age group.  After a devastating loss of wealth in 2008, the baby boomer demographic elected to postpone retirement, resulting in this group being the only one to experience net employment growth during this period.

We have been telling clients that the increase in overall debt in the US and countries around the world will continue to have a dragging affect on domestic and global economic recovery. The June 24, 2010 edition of The Economist includes an impressive interactive map detailing the overall debt levels for a wide range of countries, based on data supplied by the McKinsey Global Institute. Click Here to access the report.

Glassman Wealth Services is proud to be a sponsor of the 2011 American Odyssey Relay, a twenty-four hour, a two hundred mile relay race from Gettysburg to Washington, DC. Celebrating its third year, American Odyssey Relay anticipates over 2,000 runners comprised of teams of 12 who will start at Gettysburg and weave their way through Civil War landmarks in Antietam/Sharpsburg, Harpers Ferry and Riley’s Lock before arriving in Washington, DC on April 30.

A portion of the proceeds from the American Odyssey Relay and 100% of the GWS sponsorship dollars goes to support two very worthwhile charities: The Wellness Community – DC and Hope for the Warriors. For more information, go to Glassman Wealth Services Giving Back.

The resurgence in risk appetite continued apace this past week, allowing the S&P 500 index and the Dow Jones Industrial Average to return to positive territory on the year.  By the end of the week, the S&P was up 2.4% and the DJIA finished up 2.3%. 

Yields on US Treasury bonds ended moderately tighter on the week despite the strong performance in risk assets.  At the beginning of the year, numerous prognosticators were calling for a surge in Treasury yields, but to the contrary, yields fell from 3.8% at the start of the year to 3.2% this past Friday.  The explanation for this move may be simpler than we all realize. 

Based on data from the Federal Reserve’s Flow of Funds report, US households are severely underinvested in Treasury and Municipal securities. With more than 50% of household assets tied up in equities and real estate, the recession of 2008/09 seems to have left a mark on many individuals, especially those in the baby boomer generation who are inching ever closer to retirement.  This is fueling a reallocation away from equities in favor of bonds and income producing securities.

This is certainly not a panacea for low interest rates forever, especially considering the uncertainty around China’s future appetite for Treasuries, but it does provide a sorely needed source of financing for the Treasury Department in coming years. 

Housing: with the government gradually removing its chokehold on the housing industry, economists are growing concerned that housing is set to experience a slowdown in the second half of the year.

As expected, the initial reports surrounding May housing data are weak with housing starts falling 10% due to a 17% drop in single family starts.  The weakness in residential investment represented a major drag on GDP from 2006 through the first quarter of 2009, before finally contributing to positive growth in the second half of 2009.  Those gains were rather fleeting and housing once again became a net detractor to growth in the most recent quarter. 

Perhaps more problematic was the news that Fannie Mae and Freddie Mac, the beleaguered US mortgage financing companies, have requested $145bln from government coffers, with one ratings agency suggesting that a $1trln financing package for those two firms is not out of the question. 

According to the New York Times, foreclosures forced the two firms to take over ownership of a new home every 90 seconds during the first quarter of this year.  By the end of March, the firms owned a combined 163k homes.

This is actually not as detrimental as it appears on the surface because Fannie and Freddie represented a dwindling slice of the market during the years between 2005 and 2007 and were fortunate to avoid a good portion of the poorly originated loans.  However, as we are all acutely aware, the firms are the de facto lender of last resort and by some estimates, account for as much as 97% of the mortgage market. 

Long term, Fannie and Freddie will face years of losses related to sour mortgages, all at the expense of the US taxpayer. 

Taxpayers are also on the hook for the current home modification program, which is looking like an unmitigated disaster at this point.  The Home Affordable Modification Program (HAMP) was originally designed to provide payment relief for homeowners who were struggling under the burden of debt.  Sounds simple enough, but what the government forgot to account for was all the other debts (credit cards, auto loans, student loans, etc) those individuals are carrying. 

For the average person, HAMP provides $500 a month in mortgage payment relief.  Even accounting for that deduction, 64% of pretax income is spent on debt payments.  That is an unserviceable burden and Fitch Ratings estimates that 65% to 75% who enter the HAMP modification process will re-default within 12 months.