UPDATE: The Future of Bonds

by Matt Malick and Ben Atwater

For the last thirty years, bond yields have fallen fairly consistently.  Consequently, bond prices have risen over this period of time.  It is often said that “what goes up must come down,” and this is probably the case with bond prices.  In an environment where the Federal Reserve has lowered short-term interest rates to zero and engaged in active bond buying (quantitative easing) to push down long-term rates, is the party over for bond holders?  Are we about to enter a new super-cycle of rising interest rates that will leave bond investors licking their wounds?

It is interesting to note how stocks and bonds performed during prior super-cycles of rising and falling interest rates.



From 1982, after interest rates peaked, through 2012, the Barclays Capital Aggregate Bond Index returned an average of 8.82% per year.  Stocks also did well during this period, with the S&P 500 returning 11.14% per year, but with far more drama, especially from 2000 until now.  Therefore, purely from a “sleep at night” perspective, owning bonds for the last thirty years served investors well, even though stocks actually did better.

According to Craig L. Israelsen, an associate professor at Brigham Young University, the federal discount rate (which the Federal Reserve sets) was 1.34% in 1948, similar to today. Over the next thirty-three years, this rate climbed somewhat steadily to 13.42% in 1981- reflective of a prolonged and dramatic increase in interest rates.  During this time, the Barclays Capital Aggregate Bond Index provided an average annual return of only 3.83%.  Meanwhile, the S&P 500 returned 11% annually during this period of rising rates.

In other words, stocks did well during a prolonged period of rising rates (1948 – 1981) and falling rates (1982 – 2012).  Bonds, however, delivered significantly lower returns when interest rates were on the rise.

Using a slightly different time period when interest rates increased dramatically, 1941 to 2009, Fidelity Investments calculated a 3.3% per year return for Treasury bonds.  However, after backing out an average annual inflation rate of 4.6% over the period, the real return for Treasury bonds was -1.3% per year.

This does not mean, however, that bonds should be irrelevant to investors.  The chart below shows that even in a rising rate environment (1941 to 1981), bonds lowered overall portfolio volatility (standard deviation).  A 100% stock portfolio from 1941 to 1981 returned 11% with a standard deviation of 14%.  Adding just 20% to bonds reduced overall return by about 9%, but volatility dropped by more than 20%.



Given the present depressed level of interest rates, we can infer three things from the last 70 years of history:  1) Bonds should experience below average returns and probably will not outpace inflation over the next several decades, 2) Bonds still have a place in the portfolios of risk-averse investors as a hedge against volatility and 3) Stocks will likely dramatically outperform bonds over the long-term.

Wealth Inequality - Most Americans Have No Clue

Although I've read about the Ariely and Norton study and talked about the results in my classes, I've only recently stumbled across the YouTube video that  takes the data from the study (and a couple other stats on wealth and income inequality) and cleverly attempts to explain the results from a graphical perspective.

For those unfamiliar with the research, a study by Dan Ariely (Duke) and Michael Norton (Harvard) in 2011 attempts to measure the difference between what average Americans believe is the level of wealth distribution in the US and what it actually is.  They also ask average Americans to reveal what they believe is the "ideal" wealth distribution for a country and compare that to what citizens estimated wealth distribution to be and the actual levels.  The results are fascinating.

http://www.youtube.com/watch?v=QPKKQnijnsM&feature=youtube_gdata_player

I've included, below, a link to their paper published in Perspectives on Psychological Science that includes a comparison of the results for democrats, republicans, men, women, wealthy, and poor.

Quote from their paper, "Most important from a policy perspective, we observed a surprising level of consensus: All demographic groups—even those not usually associated with wealth redistribution such as Republicans and the wealthy—desired a more equal distribution of wealth than the status quo."


http://www.people.hbs.edu/mnorton/norton%20ariely.pdf

Red Ink

National debt as increased over 300% during Congressman Joe Pitts's tenure in Washington.

Is the title of this post startling, hard to believe, make you angry, fearful, defensive...?  Isn't that the way we do this now?

Congressman Pitts, in his January 6, 2013 Letter to the Editor (Lancaster Sunday News, link below), mentioned the upcoming battle over the debt limit and shared some observations regarding the causes of our fiscal crisis and the current clash of ideology in Washington.   As I read his article, I was hoping to find some acknowledgement of Washington’s collective lack of fiscal responsibility over the last two decades.  Instead, sadly, I read the same “blame” language that is currently crippling our democracy.  I even read a statement that appears to be an excuse for his record.  It reads as if he’s throwing his hands up in the air and saying, “what do you want me to do, I’ve only been a Congressman since 1997 and ‘Congress does not annually vote on many programs.  They are funded automatically’, so... not my fault.”

With all due respect Congressman Pitts, please, you are a smart and politically experienced man, a Washington insider for over 15 years.  You know what’s going on and you know how we got here.  You have as much red ink on your hands as anyone, so instead of partaking in this partisan temper tantrum, rise above it and acknowledge that both parties are to blame and work together.  Having you and your single-minded conservative colleagues hold the country and economy hostage over a debt ceiling debate that you had no problem supporting, maybe 7 times, during the Bush Administration is, for lack of a better word, childish.   

In addition, how is it that our current administration is to blame for our level of national debt?  When you took office, the national debt was $5.307 trillion and it is now $16.432 trillion.  While you have been a congressman, the national debt has grown over 300% and given the large number of congressmen and senators who have served as long as or longer than you, how is it that you and your colleagues aren’t to blame?  Certainly during the 15+ years you’ve been in office, there has been ample time to vote on programs Congress doesn’t vote on annually, as you noted in your column.  And I do realize that there are democrats who are just as hypocritical and superficial as you, for example, former Senator Barak Obama voted against increasing the debt limit in 2006 as a statement against the debt increasing policies of the Bush administration.  I’m guessing you didn't have a problem with the debt ceiling in 2006 and voted in favor of increasing the debt limit?

Yes, of course, the national debt is a problem.  We need fiscal discipline, but this is no way for grown men and women to go about it.

Examine the Real Fiscal Cliff  by Joe Pitts, January 6, 2013

Update: Facebook Vs. Apple

 by Matt Malick and Ben Atwater

For investors like us, the picture above is an amazing sight.  It is a three month chart of Apple (blue line) and Facebook (green line).  Investing without a disciplined strategy is a gamble.  Throughout much of last year, Apple seemed to be infallible while Facebook’s “failed” initial public offering was the talk of Wall Street.  In late October, however, their fortunes reversed without warning – a trend nobody could have predicted.
 

On May 18, 2012 Facebook had its initial public offering at $38 per share.  The stock promptly plunged over the next four months to fall below $18 per share.  After experiencing some fits and starts, about three months ago Facebook found its footing and has since soared to over $31.

Meanwhile, Apple surged from $400 per share in January 2012 to $700 per share by the fall of 2012.  The stock, which at $475 billion is the largest market capitalization company in the Standard & Poor’s 500 (Exxon is second at $415 billion), was a major contributor to the market’s stellar performance until the 4^th quarter of 2012.  Since then, the stock has fallen to around $500 per share – nearly a 30% drop.

The stock market’s strength over the last three months has come despite Apple’s weakness, which in and of itself is fascinating.

This is as good an illustration as any that attempts to make short-term, speculative stock picks can be treacherous.  Successful long-term investing is about limiting your mistakes, not hitting home runs.

Thank you for your support.  We truly appreciate doing business with you and we hope you will continue to recommend us to your friends, family and business associates.
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The Taxman Cometh

By Matt Malick and Ben Atwater

Bob Dylan wrote, “You don’t need a weatherman; to know which way the wind blows.” With an annual federal deficit of over $1 trillion, total national debt north of $16 trillion, the reelection of President Barack Obama, and the heated debate over the “fiscal cliff,” it is clear that taxes will rise in 2013 and beyond.

The pressing questions now: how much and in what manner?  Another question, more pertinent to us, is what effect will an increase in tax rates have on the stock market?

Let’s begin by looking at the two most important tax rates for stock investors – qualified dividends and long-term capital gains.  Current law has the tax on qualified dividends rising from 15% to 39.6% - a tremendous increase that would dramatically damage what investors earn on a net basis.

However, the good news is that even President Obama’s proposed budget only taxes qualified dividends at 20%, so it is highly unlikely that the tax on qualified dividends will be more than 20% for an extended period.  If the President and Congress don’t reach a deal on the fiscal cliff, rates will technically rise to 39.6% for a short time.  But, as 2013 progresses and politicians reach a compromise, we do not believe that anyone will pay more than 20% on qualified dividends when they file their 2013 tax returns.

As for long-term capital gains taxes, current law has this rate increasing to 20% from 15%.

One caveat to all of this is a new tax that will take effect in 2013 to fund the Patient Protection and Affordable Care Act (Obamacare), a Health Insurance High Income tax / surcharge.  With the reelection of President Obama, we must assume that Congress cannot repeal this legislation.  Therefore, beginning in 2013 the federal government will assess an additional 3.8% tax / surcharge on net investment income – dividends, interest and capital gains.  This tax applies to filers with joint adjusted gross income of $250,000 or more and individuals with $200,000 or more.

While a 3.8% additional tax on high income investors is not entirely trivial, we do not believe an investor would ignore otherwise profitable investments just to avoid this tax.  For example, a $10,000 investment in a stock yielding 4% would go from generating $340 (15% dividend tax) in after-tax income to $304.80 (20% dividend tax + 3.8% “Obamacare” tax).  In a world of near-zero interest rates, this is still an attractive yield.  And a comparison of after-tax capital gains would produce similar results.

So, the question that investors should focus on is not necessarily how much taxes will be, but what kind of value do the underlying investments offer.  As you well know, we have been arguing for several years that stocks offer a compelling long-term value.  If you can make solid profits on your underlying investment, should you really lose that much sleep over a 15% versus a 20% or 23.8% capital gains tax?  In our opinion, the current uncertainty about taxes is causing much more angst than the actual tax increases that are likely to take effect.

It is also vital to remember that many mass affluent investors own most of their marketable securities in tax-deferred accounts like IRA Rollovers, 401(k) plans, Roth IRAs, etc.  Capital gains and dividends that investors earn within these vehicles are not taxed at the time they occur, rendering the increase in dividend and capital gains taxes a moot point.

Tax-deferred accounts are a good transition to marginal tax rates, which are set to increase with the fiscal cliff and will likely rise for high income earners even as part of a compromise that allows most of the Bush-era tax cuts to remain in place.  When retirees pull money from tax-deferred accounts, they pay ordinary income tax rates.

Presently, the highest marginal tax rate is 35% and it is set to increase, under current law, to 39.6%.  If you are married and filing jointly, you need to earn $388,350 before you pay a dollar of taxes at the 35% rate.  If you are single, you need to earn $178,650.

Not only do rates rise under current law, but high income earners also face an additional 0.9% Medicare tax / surcharge on wages above $200,000.  This is another provision of the Patient Protection and Affordable Care Act.

So, what is someone to do between now and year-end?  The vast majority of people should probably do nothing.  However, some folks may want to chat with their accountant, attorney and investment advisor.

First, if you own a stock with very significant unrealized long-term capital gains, and you are content with the appreciation you have achieved, then it might make sense to liquidate the stock now.  But, before you do that, consider what you are going to do with the proceeds because the opportunity cost of selling a long-term holding simply to pay 5% less in capital gains tax might ultimately bite more than the tax ever would.

Second, if you are a high income earner with lots of vested stock options, then you might seek to exercise your options in 2012 because next year you will pay a higher marginal income tax rate and many of the options you exercise are likely to be taxed at your marginal rate.

And finally, although we haven’t talked about the estate tax, it is also set for major changes, though uncertainty around the estate tax will probably persist throughout 2013.  If you have a total net worth greater than $5 million and you haven’t reviewed your planning in a few years, we would recommend that you run to your estate planning attorney – preferably today.