|
July 15, 2009 Dear Client: Q2 2009 Market Update
Index Returns for Period Ending June 30, 2009
Most investors' anxieties have abated over the past few months, as financial markets have sharply recovered from the lows reached in early March. We spoke with most of our clients during the most stomach-churning weeks in February and March. We explained that markets were riskier than normal, and that investors could expect to achieve higher than normal investment returns during such periods. Indeed, from March 9th through June 30th the U.S. stock market gained 37%, small-cap stocks gained 49%, foreign stocks gained 46% and bonds gained 3%. Many clients found it difficult in February and March to avoid the urge to go to cash, though most were able to maintain their equity allocations. After such a strong recovery, some are considering whether this is a good time to eliminate or reduce equity holdings, and create a "safe" portfolio. Safe Portfolios A client sent an email last week asking if California municipal bonds are safe - whether she can count on getting all of her principal back at maturity. While there is no such thing as a 100% guarantee of principal, U.S. Treasury bills, notes and bonds are considered to be the worldwide standard of a safe investment. But most investors should be concerned about more than the safety of their principal. While investing always carries the risk of loss of principal, the greater risk to most investors is their ability to accumulate enough funds to provide for a comfortable and worry-free retirement. Let's look at the retirement prospects of a person who holds only Treasury bills. The yield of Treasury bills has historically equaled the inflation rate. To save for retirement with Treasury bills alone, you would need to save every dollar you are going to spend in the future. I love a plan based on saving a lot of money and investing it conservatively. The challenge from a planning perspective is that no one I work with is willing to adopt the requisite lifestyle. Plan to spend $60,000 in today's dollars per year in retirement, for example, from age 60 to 90[1]? With an all Treasury-bill portfolio, you would need to save $60,000 each year in today's dollars, from age 30 to 60[2]. Want to buy a house? Since mortgage rates are typically 3% higher than inflation, it wouldn't make sense to use a mortgage to buy your house. Start saving more cash. Want to save for your kids' college? Even harder, because education costs have exceeded inflation for decades. For a college that costs $120,000 for four years now, assuming 5% college cost inflation, 3% yield on your savings, 10 years away, you'll need to save $145,000 now. Putting Your Cash to Work The difference in expected return between Treasury bills and other types of assets is called the "risk premium." Investors demand compensation for taking risk, and the amount of compensation expected is a direct function of the riskiness of an investment.
Annualized Returns of Different Asset Classes
While the risk premium of equities (stocks) is enormous (over 7% annually for small-cap stocks), even a small increase in compensated risk has a huge positive effect on your retirement plan. If you shifted about one half of the cash to bonds, you'd expect to beat inflation by 1% annually, reducing the annual savings requirement to $45,000 in our example, from $60,000. Earning 2% above inflation would reduce the annual savings burden to $34,000 per year. As an example of the power of equities, let's assume a 30-year old investor has a 100% equity portfolio that earns a risk premium of 7% above Treasury bills, and plans to maintain this portfolio until she retires at age 60. At age 60, the investor plans to shift to 100% long-term corporate bonds (Treasury bills + 2%). The annual savings requirement would shrink to $20,000, from $60,000, for an all cash portfolio. Since the probability is that equities will earn their historical risk premium over long investment horizons, we think the best investment portfolio is one that includes a higher percentage of equities than bonds or cash until retirement. Even after retirement, we recommend a substantial equity allocation for most of our clients. The Most Amazing Investment Opportunity Ever... In Hindsight About ten years ago, I met with Ms. Smith[3], a woman in her fifties. She wanted my opinion on her sole investment, valued at the time at about $500,000. Her father had purchased this investment for her 18 years earlier. I looked at her paperwork. My advice was to... do nothing. That's right - the Queen of Diversification said to hold that precious single asset for another 12 years. Ms. Smith's amazing asset was a 30-year zero coupon Treasury bond issued in 1981. Zero coupon bonds do not pay any interest; instead, the purchase price is deeply discounted, based on an assumed interest rate. At the time of purchase, the interest rate paid by 30-year Treasury bonds was 14%. Her father would have paid $17,260 to buy bonds that would mature to $1,000,000 in 2011. Ms. Smith's good fortune created a crisis of confidence for me. Why didn't I see these investments in more portfolios? How could investing be so easy? If an investor could earn a virtually risk-free 14% annualized return for 30 years, wouldn't it be the mythical "ideal" investment: a no-risk, high-return investment you can keep for thirty years? Was it ideal? Let's look back to 1980. Inflation had increased quickly in the late 1970s. Paul Volker and the Federal Reserve Bank increased the Federal Funds rate sharply, to 20% at the end of 1980. In just seven weeks, from early January to mid-February 1980, the yield on 30-year bonds increased from 10.3% to 12.6%, a 23% increase. The value of a 30-year Treasury zero coupon bond declined 48% in that seven-week period as a result of the increase in interest rates. (Remember, the value of a bond decreases when interest rates increase. The longer the maturity of the bond, the greater the decline, and the smaller the coupon, the larger the decline.)
Treasury Bond Yields and Mortgage Rates
It would have been hard to convince someone who purchased the 30-year zero bond at a 10.3% yield and saw its value decline 48% in seven weeks that it had been a good investment. Even an investor who correctly understood that the market value of bonds could fluctuate without reducing his final return would have been disappointed to learn that seven weeks after his bond purchase, the same investment would have locked in 12.6% annually for 30 years. After reaching 12.6% in February 1980, Treasury bond rates then declined to 9.5% by June 1980. From that point rates marched up to 14.1% in August 1981. Mortgage rates topped 18%. People were panicked; the stock market had spent seven years "underwater", below the level attained in 1973. Americans were demoralized by events in Iran and Afghanistan. (Sound familiar?) Economic conditions were dire: inflation doubled between 1978 and 1980, to a 13% annual rate. Most investors expected inflation rates to increase and persist at very high rates for decades. Investors feared that a 14% annual yield would trail the inflation rate, and they would be better off holding short-term Treasury bills, whose yields would continue to increase to keep pace with inflation. I'm sure that many investors thought there would be signs of inflation peaking, at which time they would jump in and purchase 30-year Treasuries at the peak yield, maybe 15% or 16% or even 20%. But by the time inflation was under control, yields had already decreased sharply. The opportunity to lock in 14% for 30 years was gone. Ms. Smith's father may have expected inflation to revert to normal levels within a few years; he may have stepped up during a very risky period to take advantage of a long-term investment. He may have made some offsetting bad investments at the time. There is no way to know. But what we do know is that this purchase was not without risk for Ms. Smith's father at the time he made the investment. I expect that he knew that all investments include risks, whether the risks are inflation, deflation, recession, credit contraction, government intervention, government spending, etc. It is only in hindsight that this single investment appears to have been ideal. Perhaps ten years from now, we'll look back and say "how could anyone have thought the deep recession of 2008 and 2009 would continue indefinitely? How could someone have thought equity prices would decline below their lows of March 9th, or even the values of June 30th?" Please do not hesitate to contact us with any questions.
Regards,
[1] $60,000 in today's dollars would actually be $145,000 in 30 years, with 3% annual inflation |
||||||||||||||||||||||||||||||||||||||||||||||||
