Many investors recognize that the bond market provides an opportunity for asset class diversification, but what may go unappreciated are the insights that bonds can provide for investments in the stock market. There are three data points in particular that can be useful for investors building portfolios in stocks.
Inflation crossover rate
The actual rate of inflation that an investor experiences over their investing timeline has enormous consequences for their economics; at a minimum, investors hope and plan for a return on their money that matches inflation to maintain their purchasing power. When making return projections for a given investment goal, like retirement savings, it generally makes sense to apply an assumption for the rate of inflation over that period. Investors can use historical inflation data, or the most recent measure, or can make a guess about what is likely to happen in the future.
When making a guess about the future, the bond market may provide a helpful insight. The “breakeven rate”, which measures the difference in yield between a point on the yield curve between traditional treasury bonds and inflation indexed treasury bonds, captures in one number the bond market’s anticipated inflation for that period. This image shows the breakeven rate at the 10 year spot on the curve:
Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate [T10YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10YIE, September 5, 2018
The most recent value of 2.08% suggests the bond market currently believes that to be the likely annual inflation rate over the next ten years.
Risk free rate
Approaches to valuation for stocks like the Capital Asset Pricing Model and mathematics to analyze options like the Black-Scholes model require an input for the “risk free” rate. Investor preference can dictate what rate they choose for this purpose; the 3 month T Bill rate is often useful due to the regular supply via Treasury auctions, the minimal duration risk, the high liquidity, and the full backing of the United States government credit quality.
Board of Governors of the Federal Reserve System (US), 3-Month Treasury Constant Maturity Rate [DGS3MO], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS3MO, September 5, 2018.
Viewing the change and volatility in the chosen rate over time can also help inform expectations for the stability of the model. For example, in the CAPM calculations, a 3 month T Bill rate at 1% implies a very different value for a subject stock than the same rate at 2%.
Shape of the curve
The “yield curve” is made up of treasury bills, notes, and bonds with maturities ranging from a few days to as much as thirty years. The historically normal shape of this curve slopes upward, with the shortest bonds showing yields that are relatively lower than bonds with longer maturities. There are different theories for why the curve is normally shaped in this way, with implications for investor preference and opinions about risk, but for decades the typical relationship between spots on the curve is that longer maturity bonds yield more than shorter, with the amount of difference rising and falling over time.
When the curve deviates from the historical norm, and either “flattens” to where there is little difference between the yields at different spots on the curve, or “inverts” to where shorter rates yield more than longer rates, there may be serious implications for the economy and for the stock market.
The image below shows the 10 year treasury rate minus the 2 year treasury rate for the last ten years. Over that period, the spread between the two has bounced around a considerable amount, and in the last few months has shrunk to about 0.25%
Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2Y, September 4, 2018.
Market participants may read many portents into a flattening or inverted yield curve. Some common concerns are that a curve that deviates from the norm in this way suggests that a recession is likely in the near future. A more concrete view is to consider how the actions of the Federal Reserve propagate out through the bond market. In the recent case, the Fed has raised their funds target several times, which led to the short end of the market rising too (see the 3 month Bill rate above). The points on the curve further out, such as at the ten year and thirty year spots, have not yet priced in the likelihood of higher inflation or the Fed funds target to sustain in the current range. So the short end yields are up, but the longer yields have risen less on a relative basis; this leads to a flatter curve.
Notes and disclaimers
The Federal Reserve Bank of St. Louis provides an excellent resource for economic data; the charts and figures for this article are all sourced from FRED.
This article is intended for educational purposes only, and is not a solicitation to buy or sell any security or investment. Investors should consult with a qualified professional, and carefully consider the risks and potential rewards of any investment strategy prior to making an investment.
Why did the market "go down" in late January, 2018? There are many possible reasons, and most of the time a substantial move in the market is really about a combination of things (if there is any real reason at all).
My current vote for the "biggest" reason for this particular fall in the price of stocks is what was happening in the bond market, which was itself reacting to what was happening with the Federal Reserve policy, which was itself...complicated.
Inflation always matters...sometimes, it matters more
In brief, the Federal Reserve in the United States has a few main purposes, which are often reduced to the "dual mandate" of promoting employment and moderating interest rates. The entire financial system relates more or less directly to the cost of money over time (aka interest rates), and inflation is a major consideration in how the markets set appropriate interest rates for a given investment or transaction.
Again, speaking in simple terms here, for an investment to yield an economic gain to the investor, the realized return must be greater than the rate of inflation for the same period. If not, the investor is actually losing "purchasing power". For example, if I have $1 today and a can of soda costs $0.50, I can buy two cans. If I wait a few days, and the price of the soda rises to $0.55 but my $1 is still just $1, I can no longer buy two cans...the purchasing power of my dollar has eroded due to inflation.
In January of this year, two things seemed to come together to jolt the market: (1) the major US stock indices were setting records for the longest period without a "correction"; and (2) the Chairwoman of the Fed was stepping down and aside for her successor. My view is that these two factors were causing the market to process what might happen with inflation, both from pressure of a "hot" stock market, and from the relative uncertainty as to how the new Chairman would respond to that pressure.
The US has enjoyed a very long period of relatively tame inflation, and the prospect of a quicker increase in consumer prices can be unsettling.
Investment options in an inflationary period?
For investors (which includes normal folks looking to properly manage their retirement savings), the task of how to best position themselves in a period of rising inflation can be challenging. Here are a few points to consider:
Time to review with a pro?
Let's get two things out of the way early: (1) there is a lot of noise in the news right now about Bitcoin and its crypto-cousins (and too little information, in my humble opinion), (2) this post is a contribution to the noise, but hopefully contains a little information relevant to my client base and readers.
the briefest of summaries
There are plenty of articles going around about what crypto currencies are supposed to be, and how blockchain technology is meant to work, so I will keep my comments on this aspect super brief. The blockchain is sometimes referred to as a "distributed ledger" for financial transactions, which can in many ways bypass the existing infrastructure of banks and payment processors and clearance / settlement facilities currently involved in exchanges of value between parties. And while this ledger is maintained and processed in a relatively "public" way by market participants, individual participants are able to act in a relatively anonymous way.
Bitcoin is a medium of exchange on one version of blockchain, and it follows a very specific protocol or set of rules about how new Bitcoins can be introduced to the market and how transactions in Bitcoin between parties can be processed (this activity is collectively referred to as "mining").
Bitcoin itself has "forked" into some new variants that have expanded or refined protocols that attempt to address some perceived challenges with actually using a crypto currency, and there are also different approaches to the blockchain that support other coins, like Ether on the Ethereum network.
so, should you own some?
Chances are decent that you are more aware of Bitcoin and its brethren because the prices of crypto currencies have risen so dramatically in the last year; it is a basic function of a "bubble" or hot market that big gains in value attract attention, which inspires a desire to participate, which pushes prices higher, which causes the cycle to repeat...for a time.
So are crypto currencies in a bubble? Sure. Is that "bad"? It depends on your perspective. The primary aim of this post is to offer a framework for considering an individual investment in Bitcoin or one of the other coins, so I will pivot to that:
too long, didn't read? (tl;dr)
Everyone's talking about Bitcoin and the other so-called "crypto currencies". Much of the present attention seems to be driven by a fairly typical "fear of missing out" bubble. Investments in crypto coins have both idiosyncratic and traditional considerations for investors. Proceed with caution!
Current and prospective clients of DRW Financial should feel free to email or call David with questions on how or if it is appropriate to incorporate an investment of this sort within their overall plan.
Many of the posts I write are as much for me as for anyone out there looking for new insights on their financial condition. Today's is one such post.
I have written elsewhere about how our money choices reflect on our values, and that when there is conflict between what we say we value and how we live our values, there is an opportunity for self-reflection and a choice to align the two.
you probably don't need that...
But where does ego fit into this discussion of values and money? One example within my own budget and experience involves technology, specifically smartphones and computers.
I use an Android based phone and a Chromebook for my work and personal computing needs. These choices were originally at least a bit driven by economics: iPhones are expensive and in the early days just having an iPhone required a specialized phone plan that cost more than average; similarly, a decent Chromebook costs around $200, while a similarly featured Windows machine might cost twice as much (or more), and a Mac might cost 3x - 4x just to get started.
But even though I may have started out with fiscal discipline in mind, what happened over time is that at each opportunity to replace or upgrade my equipment I would inevitably spend some time looking at the "nicer" options available. A $200 Chromebook has proven to be sufficient, but the $600 one may be prettier and have some snappier specs... The $150 - $200 "mid range" Android smartphone does 95%+ or more of what the current "top end" phone may offer, but there is always that voice in the background saying "wow, that fancy phone is cool!"
Examine, don't justify
This is where the budgeting rubber meets the road. When faced with an option to spend more or less for essentially the same experience, it is crucial to be honest. When explaining (to yourself or others) why you want the more expensive option, choose to have enough perspective to examine those reasons objectively. It is so easy to justify a choice that we want to take, but it can be hard to be honest about the quality of those justifications.
Shopping while under the influence of vanity or with a heightened sense of your needs can lead to some financially unsound decisions.
Some folks don't have any investments. Others are in a situation where their circumstances dictate a very "keep it simple" approach. But for much of the rest the population, there may be value in working alongside a professional investment manager in pursuit of an "optimal" investing approach for their specific needs.
we follow a fee-only, "fiduciary" approach
DRW Financial offers investment management solely on a fee-only basis and as a Registered Financial Adviser. This means our only compensation comes from providing advice, not by commissions on transactions. We believe this allows us to offer that advice with fewer conflicts of interest and to act as a fiduciary for our clients.
do you have...?
These are a few examples of issues and areas where we have helped others improve their understanding and their approach to investing. DRW Financial works with artists and engineers, physicians and educators, "millenials" and retirees.
are we a fit?
For a quick and "no cost" consultation to evaluate our "fit" for working with you on investment management, email David@DRWFinancial.com
"I don't have any finances to plan"
I hear this pretty regularly. And I get the humor. The reality is that there are valuable opportunities for most people (or families) in going through the process of financial planning. And it is a process; done well, this process can lead to some very positive outcomes:
DRW Financial offers financial planning services on a flat fee basis. This means that there is an agreement upfront to address a given scope and scale of planning, and a stated fee that covers a full calendar year of work and revisions to that plan.
For many people, paying income taxes is something that happens "automatically" with every paycheck, via the mechanism of payroll deductions. Line items like Social Security, Medicare, and an approximate amount of income taxes owed come out of each paycheck, and the process of completing and filing a tax return in April of the next year results in a reconciliation of that process: did the taxpayer pay "too much" or "too little" over the course of the year, and do they get a refund or a bill for taxes due?
for the self-employed, and...
But for folks who earn income "on the side" or are self-employed, payroll deductions are far less common. For many people in this scenario, the typical approach is to pay "quarterly estimated taxes" via the IRS form 1040 ES.
The general idea here is that the taxpayer will figure out what they are likely to owe for the full year, and make four equal payments by the quarterly deadlines. In reality, for many self-employed people their income does not come in conveniently steady streams, and accurately forecasting their full year income can be difficult. For people in that situation, it may be necessary to make adjustments along the way to get the cumulative tax payments close to the right amount.
"gig economy", "side hustles", investments...
Even for people who get most of their regular income from a salary or W2 paycheck, there may be a need to consider making 1040 ES payments. Drive Uber for extra cash? Rent out a room on AirBnB? Realize some significant investment gains? All of these could potentially raise the tax liability for the year; if the amount paid in along the way is too low, there could be a penalty in addition to the eventual tax owed.
the next due date: april 18, 2017
If any of the above applies to your situation, get ready for the first 2017 quarterly due date in mid April. If this date seems familiar, it's because that's the 2016 personal return filing deadline too!
If you belong to the portion of the population aged 60 or older, you have probably given a good bit of thought to Social Security; if you are much younger than that, the concept is probably not high on your current list of priorities.
But as a financial planner and investment adviser, I routinely find that the various benefits available via the Social Security Administration are an important and often misunderstood part of folk's financial picture.
it's your money, coming back
One thing to understand upfront is that almost everyone earning income in the United States pays a tax into the Social Security fund throughout their earning years. Although Social Security benefits are sometimes described as "entitlements" in a way that suggests otherwise, the money that retirees get back comes primarily from their own contributions and those of their peers and the generations preceding / following them.
spouses and kids can benefit, too
Some of the benefits available via Social Security are available to spouses and children of the income earner who paid into the system. For instance, in a two parent household if one worked outside the home for a wage and the other spent their working years raising kids and caring for the home, the one without an income history may also qualify for a retirement benefit based on the contributions of the working spouse.
check your benefits early and often
The Social Security Administration offers a couple of tools that are really very valuable for gaining a basic understanding of where a given person stands in relation to their potential benefits.
We now live huge chunks of our lives online, and do ever more of our financial transactions and interactions via email, applications on our phones, and through websites.
As a provider of financial planning and investment advice, I am perhaps a little more sensitive than most to what can go wrong in terms of online security and privacy. The recommendations below are not intended to be comprehensive or "fail safe", but could form a foundation for improving online safety.
lock your phone
This one should be obvious, but it seems that a number of us out there in the world are still resisting the step to add a PIN, fingerprint, or password to our smartphone. These devices typically have unrestricted access to email, social media, and maybe even financial accounts via apps. Accidentally leaving an unlocked phone on the bus, coffee shop table, or a park bench can provide one-stop access to a stranger.
At a minimum, a 4 digit PIN or "pattern lock" can provide a measure of protection, especially against the mildly curious.
BONUS: take a minute to review the "remote lock" function for your phone model, operating system, or carrier.
iPhone Remote Lock Instructions
Android / Google Remote Lock Instructions
go two factor
An increasing number of accounts (email, Facebook, Twitter, etc) offer what is called "two factor" or "two step" authentication or log-in. What this means in brief is that to initially access your account on a new device (phone, laptop, tablet) you must have both the password AND a code sent to a trusted device. So you may be logging into Gmail on a new computer and Google will send a text message to your phone, adding a layer of security to that log-in.
Generally, you can choose to have your account "remember" that device, so you do not have to go through the two step process every time. HOWEVER, if you are using your phone as a part of this two step process, it becomes even more important to password protect or otherwise lock your phone.
passwords are crucial
The first line of defense against another person accessing private accounts may just be having a decent password. Gone are the days of being able to pick a pet's name or a clever but simple combination of initials and birth date. And it is not reasonable to use the same password for multiple services.
Current best practice in strong passwords require length and randomness.
One approach could be a string of 8+ random numbers, letters (both lower and upper case), and symbols. A challenge with this option is that the password can be overly difficult to remember even one account, much less a similar string for dozens of accounts.
A second option can be a "phrase" or combination of random words: "bananaumbrellafloristdog" is an example that may work in some scenarios...throwing in a number or symbol would make it better.
Using a "password manager" may be helpful for some people, or having a readily accessible (but secure!) reference with various passwords could be supportive.
Some browsers (the software you use to access the internet) now default to a "secure" mode when possible. You can check whether your access is in this secure mode or not by looking at the address bar. The actual language or graphic varies by browser, although most will show some version of a "lock" and include the letters "HTTPS"; an example from Chrome is in the image below. To be clear, being in "HTTPS" vs "HTTP" does not guarantee against invasions of privacy or remove any personal responsibility for security, but is better on a relative basis.
I think it is pretty common for people to fear "running out" of money. We've all heard stories of people "dying broke" or reduced to poverty late in life, and those stories are both sad and scary. So it makes a great deal of sense to avoid that fate. Financial planning and prudent investment management play a crucial role in an overall approach to help ensure there are sufficient assets and income in place as we age, and they can also help prevent having too much left over as well!
how can there be too much money?
If we all agree to the premise that it is generally not comfortable to run out of money during our lifetimes, it may then seem counter-intuitive to discuss the opposite challenge of dying with too much income or assets. But prudent personal financial management also involves making a plan for the eventual distribution or transfer of an estate, as well as the care of the people and causes that have mattered to the person during their life. A well crafted financial plan will seek to find an appropriate balance between having too little and having too much.
quick look at "too much"
What happens when you die with "too much" in terms of assets?
what's the plan?
The points above are meant to highlight that, while having assets and income is probably a better state of affairs for most people than having none, it is also the case that having significant assets and income involved demands careful planning as well.
A robust financial plan with a qualified financial planner, such as a CFP®, should seek to address both ends of this question, from dying with too little to dying with too much, as well as a number of other important financial considerations.
Ready for more information?
Click the "let's talk" button to send me an email. I am a fee-only, registered investment advisor offering highly transparent financial planning and investment management advice in a fiduciary context.
David R Wattenbarger, president of DRW Financial
FCL LLC (“DRW Financial”) is a registered investment advisor offering advisory services in the State(s) of TN, GA, IL, OK and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by DRW Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant to an applicable state exemption.
All written content on this site is for information purposes only. Opinions expressed herein are solely those of DRW Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.