[Excerpted from Barry Barker's monthly newsletter]
Investor Hypersensitivity Dominates the Market
Investor hypersensitivity brought on by the worst global recession in a century continues to dominate market behavior and explains much of the volatility we see in our own investment and retirement portfolios. This is unlikely to change until we mitigate the structural problems undermining the economies of the developed world which, in a nutshell, were caused by so many of us living beyond our means.
The current glut of existing homes for sale, including the shadow market of unsold homes with underwater mortgages must be sold or demolished, and the developed world’s massive government entitlement programs must be pared back so that they become sustainable. It will take years to unwind the housing fiasco and change entitlement programs enough to put them on a sustainable path, so that America’s economic engine can be revved up sufficiently to drive down unemployment and fill government coffers.
Until that happens, near term returns on equity and fixed income will remain underwhelming and the returns on savings accounts and money market funds will be non-existent. Although taking greater and greater risk to improve returns is not advisable in this investment climate, there is a reasonable investment strategy that should be considered and will be discussed in this article.
We have entered the third quarter and the Dow Jones is essentially flat. The third quarter started strong, however, and we can expect the DJI to end the year between 2% to 4% higher. Not head turning numbers for sure, but with inflation climbing over 2%, we may see a real return of up to 1.5% before taxes. The market faces some major headwinds with unemployment back over 9%, a moribund housing market, and as of yet unrestrained deficit spending. The most likely economic scenario is that Congress will agree to reduce deficit spending by $1.2T over the next 10 years, agree on a policy to create more jobs, think infrastructure bank, and investors will pay cash to buy insanely cheap foreclosed homes and short sales thus slowly unwinding the massive housing and mortgage debacle.
Forecast: Dow 11,800 at year end.
Are Dividends the Answer to Low Fixed Income Yields?
With three months to go before 2012, now is not the time to take on more portfolio risk. Fear and greed continue to rule the market and most of us are not immune to these two competing and powerful, emotions when we invest our hard earned money. Unfortunately, the risk reward curve is seriously out of whack and the Fed’s operation twist is driving fixed income yields ever lower encouraging investors to take on more risk in the bond markets or to move more money into dividend stocks to meet their income demands.
Investors who do not need income are parking so much cash in savings and brokerage accounts that some banks are charging them to hold it. Is there a safer solution than taking on more risk in the markets? The better question is - are you being rewarded for the risk that you are taking? Given the yields on money market funds, CDs, treasury bonds, and investment grade corporate bonds, the answer is emphatically no.
Yields on these issues today are incredibly low so you are not being paid enough even though the risks are low. If you move your money into high yield bonds and bond funds, you are taking on substantially higher risk for narrowing spreads between treasuries and high yield bonds.
Finally, if you put your money into equities, you take on even more risk and, with the equity markets going sideways; earn little or no return on your money. If you have enormous wealth, the easy solution is to just to park most of your money in a saving account until things get better. If you are saving for retirement or need an income from your investments in retirement, the solutions are not so obvious. It may be years before fixed income interest rates and capital gains in the equity markets recapture their historic average annual returns, so if you need income or a decent return as you save for retirement, your choices are limited. If you are saving for retirement and have many years to go, making systematic contributions to your company retirement plans is an ironclad method to invest in today’s volatile market.
By making monthly contributions to your retirement plans and as much as you can afford, you are income averaging, that is buying at both the highs and the lows and, by balancing every 6 months, this method of investing will yield a handsome nest egg when you retire.
You can do something similar by investing in an IRA. When you need income in retirement is when the solution becomes more difficult. If you can cut back on spending until the market returns to normal, you can keep more money in cash, thus reducing your risk. But what do you do if the market goes sideways for years to come and you have cut down as much as you can.
You still need to properly allocate your portfolio, but only take on as much risk as you need. After you determine your cash needs, build a risk ladder by filling each rung with low risk annuities and bonds to higher risk dividend equities until you reach your income target, adjust for risk and income, and balance as needed. If your risk is still too high, you will half to cut back more, find another income source, or accept the risk that comes with the income you must generate if you can still sleep at night.
Guggenheim BulletShares vs. iShares LQD
Guggenheim Bulletshares like BSCD and BSJD offer a compelling method of investing in corporate and high yield bonds in an ETF without entering the frustrating and arcane theater of individual bond trading. Each ETF is filled with bonds from 30 to over 100 companies with the holdings weighted by credit rating. The idea is that if you hold them to maturity you will get your interest back along with your principal so they tend to be less volatile than iShares LQD which has an average duration, but no fixed maturity or liquidation date.
Both funds have relatively low expenses, but LQD has a higher turnover rate which can weigh on performance. On the other hand, LQD holds a larger number of bonds than the Bulletshares so a default should have a lower impact on LQD than on the Bulletshares. The Bulletshares are especially nice if you want to fill a rung in an individual bond ladder or build a bond ladder with lower overall risk than a ladder built with individual bonds.
Disclosure: I have no positions in Guggenheim BulletShares or iShares LQD, but may purchase shares in both for my own portfolio or my clients sometime in the next year.