It seems hard to believe that we are only a
few months away from the fifth anniversary of the market collapse that marked
the beginning of the economic malaise we still find ourselves in today. The stock market as measured by the Dow Jones
Industrial Average reached its peak of 14,165 back in early October 2007. The following year and a half saw that
average fall more than half and bottom out just above 6,500. Since then, stocks have thankfully recovered
much of those losses but are still roughly down 11% from the 2007 levels.
It’s anyone’s guess when the stock market will
have fully recovered, but we think that will likely happen sometime next
year. That implies that stock investors
will have seen zero price appreciation in over five years. That’s a long time. It’s especially a long time if you’re retired
and depending on some amount of appreciation to supplement your income. In addition, this will have been the second
time in less than a decade that stocks have experienced a 50% decline.
When the tech bubble burst in 2000, stocks
sold off for the following three years and then fully recovered (except the
NASDAQ index) over the next two. This
means that any of the cumulative gains over the past dozen years have occurred
in barely two years. This has been a
real problem for savers and has discouraged many people from investing in
stocks at all. This is understandable
because if you spread those couple of years’ gains over twelve years, the
per-year return doesn’t look so good. In
fact, it’s pretty lousy.
Modern portfolio theory has constantly
preached that the best real returns are to be had in the stock market over the
long term. The problem is that there
isn’t a definition as to how long the long-term is. Here lies the problem for anyone making
regular withdrawals from their savings.
As many of you have heard me say, the only
time you care about what something is worth is the day you bought it and the
day you sold it. From this perspective,
cash flow planning is where investment management and financial planning come
together. Successfully done, a good
retirement plan will: 1. Provide a relatively steady income stream independent
of the market 2. Allow you to adjust your income for inflation (maintain your
purchasing power) 3. Do this for a lifetime.
These goals can only be achieved through a total return perspective -
i.e. a combination of cash income and share price appreciation.
In today’s interest rate environment, this is
becoming increasingly difficult to achieve because of the Federal Reserve’s
monetary policy. The Federal Reserve has
pushed down short-term rates to all-time lows in response to the financial
crisis and ensuing recession. Even
before the crisis, the Fed had set rates extremely low. Many believe (us included) that the years of
easy money policy have been a big contributor to the debt meltdown in the
housing market and on Wall Street. Now,
in addition to holding down short-term rates, the Fed has embarked on
“Operation Twist” which is a program to manipulate the long end for the
interest rate curve too. These policy
goals are achieved through the Fed’s open market activities. This is where the Fed actively buys and sells
its own bonds and a select few other issues to influence the process in the
secondary market. Price changes in turn
affect the yield.
In the Fed’s defense, their actions are
largely driven by the federal government’s atrocious fiscal policies and global
economic condition. The huge annual
deficits and a lack of any long term tax policy has put the Federal Reserve in
a difficult predicament of having to print money via quantitative easing and
eroding the value of the dollar. All the
while they are risking the inflationary impact which undermines their price
stability mandate. Inflation has thus
far been tame but only because of the crisis in Europe. It’s only a matter of time before expanding
the money supply will lead to higher prices.
Investors have now been put into a position
where their traditional reinvestment opportunities are yielding less and
less. Every time a bond matures or a
security gets called, investors are faced with lower and lower income
prospects. These policies have created a
perverse situation where the most financially responsible individuals in the
economy (savers) are being punished to benefit (bailout) the least financially
responsible (debtors). It’s a bad deal
all the way around, but one we’re going to be faced with for a while.
As investment managers, we’re often asked by
our clients what can be done about this.
It’s challenging to say the least.
The lack of stock market returns and increased volatility has led us to
focus on current income over the last few years. We’ve had a lot of success as evidenced by
that fact that most of our client accounts have moved past their 2007
values. We have accomplished this by
focusing on mortgage related investments and bank preferred stocks. However, as the mortgages continue to payoff
and the preferred stocks are getting called, we have had to expand our universe
of what we consider fixed income investments.
For now, that means taking on more risk in the
effort to replace this income. We
accomplish this is by looking to use a greater amount of alternative
investments such as master limited partnerships (MLP), real estate investment
trusts, bank loan funds, high yield bonds, corporate bonds, and dividend
stocks. While each of these have their
own set of nuances and challenges, they share the ability to potentially
generate better levels of cash flow than can be produced by more mainstream
bond-like investments. Here’s an example
of two of these:
Master Limited Partnerships (MLPs) - An
example would be the ALPS Alerian MLP.
This exchange traded fund is the largest MLP ETF in the market with assets
of $3.2 billion. MLPs
are a type of publicly traded limited partnership. As a limited partner, a person provides
capital, and in return, receives a periodic pay out from the company’s
revenue. These MLP ETFs typically track the
performance of natural gas and crude oil pipeline operators. We have chosen to begin adding this asset
class because while the yield is excellent (currently 6.25%), it also offers us
diversification in properties that tend to move independently of other asset
classes such as stocks, bonds and commodities.
Bank Loan funds - An example of one we own is
PPR (ING prime rate trust). This
exchange traded fund invests in senior loans that are typically issued by lower
investment grade companies. We typically
own this asset class because it pays a healthy dividend (currently paying + 7%)
and offers a floating interest rate.
This helps us two ways: we make
income now and have the potential to make more once interest rise in the
future.
The only downside to these alternative investments
is that they come with more short-term share price volatility than the
traditional bond portfolio. But we’re
comfortable with this as long as we’re afforded the time to ride out those
price fluctuations. This is a similar
strategy that we’ve used with several of the equity positions that we
hold. The international sector, for
example, has been quite volatile in the past twelve months. It would have been
nice to have avoided those price swings, but doing so would have meant guessing
on timing those trades and giving up on an almost 4% income stream.
We believe a total return perspective pays
off. A portfolio’s total return is the
combination of both income and capital appreciation. The two work together but in very different
ways and over very different time horizons.
Don’t focus on one or the other but instead look at the cash flows over
the short-term and the capital appreciation over the long-term.
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