“On a total return basis, the Bloomberg U.S. Aggregate Bond Index did not keep pace with the increase in the CPI rate over the 15-year period ended in December 2022.”
– Bob Carey, “Losing Money Safely,” February 7, 2023
In last month’s article, we commented on the recent insolvency of Silicon Valley Bank and its impact on the broader financial markets. This month, we discuss the real risk that investors should be paying attention to.
Uncertain Times
Last month I celebrated the 30-year anniversary of the day I passed my securities license exam and officially entered the profession of advising clients on their investing decisions. As I look back on all those years, the one constant that has been present each and every day of my career has been uncertainty in both the global economy and the investment markets. I have come to believe that uncertainty is the only certainty: as much as we may crave the feeling of certainty, it is an illusion that will never be achieved in the investment world.
As we consider the investing landscape today, it seems that uncertainty is in a bull market.
In many ways, the situation that investors face today seems unprecedented and impossible to analyze. In response to the Covid shutdowns, the world’s monetary authorities executed an unprecedented program of growing the money supply by a record amount in order to prevent a total economic collapse. This, in turn, led to a historic increase in the inflation rate, which presents a significant risk to the normal functioning of the global economy. And now, the monetary authorities are trying to “undo” the massive growth in the money supply and inflation rate by raising interest rates and contracting the money supply.
As this process unfolds, it seems inevitable that higher interest rates and tighter monetary conditions will eventually bring on a recession, to go along with a struggling stock market that has already declined by over 20% over the last year. The only thing that is impossible to know is how high interest rates must go, for how long, and how devastating that process will be for economic growth and stock market prices before inflation is finally brought under control.
Investors are understandably confused and looking for answers, and it appears very difficult to estimate how long it is going to take for this situation to resolve. It is not surprising that I’ve noticed a significant rise in the number of client conversations that are focused on a discussion of our economic and market “outlook” and how we see the next year or two playing out. It is always that way when economic uncertainty is at a peak, as it is today.
As comforting as it may be to formulate a logical “outlook” to answer these questions and soothe our uncertain minds, the reality is that these questions are unanswerable because there are no facts about the future. This search for certainty also creates a total distraction by focusing our attention on the wrong problem: it places far too much focus on the risk that our investment capital might decline in value over the next year or two and totally ignores the real long-term risks we should be paying attention to.
The fact is the real risks we face as investors have nothing to do with the value of our brokerage statement over the next year or 18 months.
Longevity Risk
The primary truth that American investors must address is the fact that we need to plan for a much longer and much more expensive retirement period than any large population has ever had.
We have written in the past about the reality that average life expectancies have risen dramatically in the last 100 years in America. Although most people still use their parents’ lives as a rough measuring stick when thinking about how long they might live, the fact is that life expectancy has risen in an exponential – not linear – way in the last generation. For a healthy couple reaching age 65, there is roughly a 50% chance that one spouse will live to be 95 years old.
However, if you are reading this article, you are part of the “Investor Class” in America, and so you are not subject to average statistics about longevity and mortality. The life expectancies and lifestyles of the investor class are breaking out of the pack and achieving gains even larger than the population at large.
The investor class is crowded over to the right on the bell curve of life expectancy because their lifestyle differs significantly from the average American. They are less likely to smoke. More likely to go to the gym, eat better, and have better medical care than average. Most importantly, they have a much higher level of educational attainment, and there is a significant correlation between education and longevity.
If all of this describes you, the reality is that you (and/or your spouse) are going to live a nice long life, and possibly much longer than you have planned for. From a financial viewpoint, the implication of this is that the primary risk presented in your wealth plan is the need to ensure that your money never runs out, despite how long you may live.
Purchasing Power Risk
Inflation has been somewhat of a joke over the last two decades. In fact, the world spent most of that time trying to cope with one of the largest deflationary events in history, the Great Recession of 2008.
However, in the last 18 months, inflation is back with a vengeance and is demonstrating to the American consumer the pernicious impact that it can have on their monthly budgets. Consumer prices rose by 4.7% in 2021 and by 8% in 2022, and many essential goods and services experienced significant double-digit increases in price. These increases in the cost of living have caused a great deal of stress on the household budget of most Americans over the last two years, especially since we have all become accustomed to low or no inflation in our regular expenses.
As investors facing an exceptionally long life expectancy, this jump in inflation brings into sharper focus the second real risk that we must consider, which is the fact that our cost of living will not simply drift upward in a gentle, linear fashion over many years. It will compound. And that compounding will have a dramatic effect on our expenses during our later years.
A couple retiring at age 65 today would do well to plan for a 30-year retirement, given the significant chances that one of them will live to be 95. Let’s assume that they hope to sustain a lifestyle that costs them $100,000 per year in today’s dollars. If inflation is effectively reduced to the long-term average rate of about 3%, that same lifestyle will cost them $242,000 30 years from now. If inflation remains stubbornly high at today’s rate of just about 6.4%, that lifestyle will cost them $643,000 per year.
The Risk of “Safe” Investments
Our culture has told us to always remember that the stock market is “risky” and that storing our capital in fixed investments like bonds and money market funds is much “safer” – especially as we get older. This misperception is regularly reinforced by the media, which is constantly reminding us of the inherent instability of equity investments.
The financial media is in the business of selling advertising, and it sells more advertising by attracting more eyeballs to its “news.” And the media learned long ago the rule that “if it bleeds, it reads” – people are much more attracted to pessimism, negativity, and alarmism than they are to positive news. So, this is what financial journalism gives us – a steady dose of oversimplified negativity.
The latest example of this that has come to our attention was the following headline which appeared on the Home Page of Yahoo! Finance on Friday, February 10th:
Stocks wobble as S&P 500 on track for worst week of the year
Of course, the absurdity of this headline lies in the fact that February 10th was the last day of the sixth week of 2023. And we are expected to be petrified that it might be the “worst week of the year.” As an alternative to the “wobbly” stock market, our culture tells us that fixed income, bonds, and money market funds are a much less risky way to invest because they do not fluctuate in value nearly as much as the stock market. The last year has reinforced this belief: not only have equities declined in value by more than 20%, but bond market yields have also risen to levels that many consider attractive. In today’s market, an investor can be paid over 5% for owning a one-year, government-guaranteed Treasury Bill.
However, the narrative that bonds are less risky than stocks depends entirely upon the way we are defining “risk.” If we accept that the first two risks discussed above are our real concern, then we must conclude that the real risk to our financial well-being is the loss of purchasing power our money will experience due to inflation, over the span of a long life expectancy. And on that score, bonds have done a fairly poor job historically of providing safety.
Even in today’s high-interest rate environment, investors don’t stand much of a chance of keeping up with inflation using fixed-income investments. At a 6.5% annual inflation rate and in a 30% tax bracket, the real yield on a one-year T-bill at a 5% yield is still minus 3%. Someone who would seriously consider doing that really does not understand the real long-term risk of the loss of purchasing power.
Worse yet, this is not just a problem in today’s high inflation environment; it has been a persistent problem throughout history. Fixed-income investments have historically done a terrible job of keeping up with the erosion of wealth represented by inflation. As noted by analyst Bob Carey in his recent article “Losing Money Safely”:
On a total return basis, the Bloomberg U.S. Aggregate Bond Index did not keep pace with the increase in the CPI rate over the 15-year period that ended in December 2022. While surging inflation in 2021 and 2022 accounts for some of the bond market’s lagging performance, it is our opinion that loose monetary policy at the Federal Reserve is the real culprit. At just 0.84%, the federal fund’s target rate (upper bound) was 226 bps below the CPI rate for the 15-year period…That trend has not reversed completely. As of February 6, 2023, the federal fund’s target rate stood at 175 bps below the CPI rate. With that in mind, it is our opinion that investors still run the risk of losing money safely in the bond market.
And by the way, that was before an investor paid her income taxes on the returns that she did achieve from bond market investments.
The Risk of Missing the Truth
Amidst all of the headlines in 2022 about the bear market that caused equities to decline by 20% and the “wobbly” performance of stocks in February of this year, here is another headline you may have missed:
The cash dividend of the S&P 500 soared nearly 11% to a new record high in 2022.
You probably missed that headline, not because it isn’t true, but because it didn’t appear in any mainstream financial media outlet. It is much too good news for that.
It may be valuable for just a moment to set aside concerns about the principal value of your investments. Yes, it is true that values declined by double digits in 2022 and may decline even further over the next year or two. However, it is also true that the value of the S&P 500 has increased by just about 53x over the last 60 years. For just a moment, let us leave all of that aside.
The truth is, we don’t finance our lives on the principal value of our investments. We finance our lives with a monthly income. As author Nick Murray has pointed out, “You don’t take your brokerage statement to the supermarket with you every week.”
Although most people typically identify fixed-income investments with the ability to produce such a living income (hence the name!), we often forget that equities produce an income stream as well, in the form of dividends. However, equities do something that bonds can never do – they produce a growing stream of income over time, while fixed-income produces a fixed stream of income over time (hence the name). And so, it can be simultaneously true that in 2022, equity values declined by over 20%, but equity dividends rose by 11%. In fact, over the last 60 years equity dividends have risen by over 30x. This is something that bonds will never, and can never, do.
Going into a 30-year retirement, with a relentless rise in living expenses, owning an asset class that has notoriously trailed inflation, and is incapable of growing it’s income stream is a recipe for disaster. Regardless of our 12 or 18-month “market outlook,” or ability to handicap if the recession will last for a year, or two years or more — these risks are not going away.
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions and always stick to their plans, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.