Financial Literacy

A neighbor asked me about $11,000 in a single stock that he just inherited from an aunt. He doesn’t know much about investing but he wanted to hold the stock since his aunt was successful at stock investing. However, his wife wanted him to sell it to put that money into a different stock that she thought had far more growth potential. I had the impression that he was looking to get some argument pointers from me to win this debate with his wife.

I asked a few questions, “Do you know exactly why your aunt bought the stock?”

He replied, “No idea.”

I asked, “So she may have bought this stock as a loser to create a tax loss against other gains?”

He replied, “Possibly, but I don’t even know what that means.”

I asked, “Do you have any idea what her criteria were for selling this particular stock?”

He replied, “I have no idea.”

I asked, “What exactly are your criteria for selling this particular stock going forward?”

He replied, “I really don’t have any.”

I then said, “Ok, it is clear to me now. What your aunt bequeathed to you was the $11,000 of value; not the particular stock that it randomly happened to be in the moment she passed away. Each investment vehicle needs to be managed and you just told me that you do not know how to manage this one. Don’t be like a lottery winner that loses all their winnings from poor money management. It is my recommendation that you sell the stock immediately and place the money into something that you are knowledgeable about and capable of managing in order to conserve and benefit from your aunt’s generous gift.”

When you want to protect and conserve your investment money, then you place it in secure vehicles like FDIC insured accounts and AAA credit rating instruments like bonds. The return on your money will be low on these investments but its purpose is not high growth but protecting what you have. These are also easy investments to find and totally passive to manage, there is nothing for you to do and they require no financial education.

However, to acquire and buildup any meaningful amount of money it cannot occur in places like those. Compound interest at safe but low rates cannot add up to much on small amounts of money. It is physically impossible unless you have many, many decades. In order to earn a sizeable amount of money you must earn a 20% return on your money, or more. Money that earns 20% or more will compound into a very meaningful amount of money each year that you allow the gains to continue to grow.

The problem is that there are no easy, off-the-shelf investments that will hand you a return this high. It will take more education, time, and effort to find, acquire, manage, and exit investments with this level of return. Here are some investing examples that I have done to reach this target return: rental real estate, raising livestock, stock trading, and selling home-made items.  I’m sure everyone will have a different list of investing candidates of what may be appropriate for their talent and capability. I met someone that earns well over 20% on weekends by buying and selling used motorcycle parts; any interest you may have will likely have some avenue for you to earn a meaningful return.

When you are in the “accumulation phase” of your investing life, you must find 20% returns to build your portfolio into a meaningful amount of money. Once you are retired and are in the “distribution phase” of your investing life, then you want to have more of your money in locations where it is conserved and protected; but unfortunately earnings will be significantly lower. But that’s OK because what is most important during the distribution phase is to actually have some money to withdraw and spend when you are least able to earn more.

The U.S. federal government’s fiscal year-end is September 30^th plus the federal debt limit is expected to be reached around the last week in October or the first week in November.

The White House has been in talks for weeks with a few moderate republicans in the senate to find a compromise on these fiscal issues. President Obama is looking for a replacement spending deal for his sequester cuts that took effect earlier this year.

Yesterday, Senator Bob Corker of Tennessee said, “It is very evident that there isn’t any common ground and we’ve all agreed there is no reason for these talks to continue.”

Congress returns to work on September 9th and will have to quickly figure out how to fund the government beyond September 30th. Meanwhile, Tea Party groups and dozens of House republicans are urging Speaker Boehner to block any spending deal that doesn’t eliminate funding for Obamacare.

No matter what your political opinion may be about these issues, the financially literate always adjust and align their finances with reality.

Remember that each time there was a debt ceiling showdown in Washington that interest rates went up temporarily and the stock market declined. So you may want to adjust your balance sheet accordingly:

• Avoid or scale out of long-term bonds and medium-term bonds
• Lock-in low-rate mortgages
• If you like CD’s, have cash ready for any up-tick in CD rates
• Postpone additional stock market purchases until the decline

However Washington’s debt showdown may play out, like every financial event, be sure that you are aligned to both defend your assets and hopefully profit from their decisions and market gyrations.

Newly minted financial advisers eagerly talk about earning 10-12% or more on your money. Many of these claims are made using stock market bottoms and tops to skew the results. For example, these unusually high returns they reference will be either start around 1932 (after the crash) or 1984 (just before the stock market soared).

If you want some realistic numbers, look at the bar chart. Sure, the stock market has earned 8% over the last 20 years, however, during this same period the average investor earned only a measly 1-4%. There has been much research over why actual individual investors earn so little (emotional buying and selling, trying to time the market cycles, paying high fees to mutual funds and 401(k) plans, high tax rates, etc.), but for whatever reason, this is the reality. So you cannot rely on 8% returns unless you are capable enough to actually earn 8% returns. Do you track how well you are earning each quarter or year? Many of your investment goals are depending on this number, like buying a home, funding a degree, or retiring early. Make sure your plans are based on reality and not rainbows & unicorns sold by financial advisers.

Amateur investors jump into the stock market at the price peak; and they jump in with leverage (debt).

This chart shows that stock margin debt reaches a peak just before the stock market falls +20%.

So what is some of the “Smart Money” doing? Billionaire investor George Soros just spent $1.25 billion in put options on the S&P 500 index (which profits from a decline in price). George Soros made over a billion betting against the British pound, another billion betting against the Australian dollar, and more recently, another billion betting against the Japanese yen. He is now betting that the U.S. stock market is going to fall while the small average investor is borrowing money to jump into the market. On which side is your money?

The price of gold has fallen 30% in the last two years; this is after rising 600% over ten years.

Where will gold go from here? One market phenomenon is that the demand for paper gold (ETF’s, futures, options, certificates, and other derivatives) has plummeted while the demand for physical gold (coins and bullion) has been skyrocketing.

In countries where their currency has been wiped out (Asia, S. Europe, Latin America, etc.) there are long lines to enter shops selling a dwindling supply of physical gold. In countries with no experience with a sudden currency devaluation (U.S., Canada, Britain, France, etc.), for the average person, physical gold is simply old jewelry that you pawn for money.

This week, something new has happened, the price of gold futures has changed from upward sloping to downward sloping. Meaning the price of gold today is worth more than the futures price of gold a few months from now. (In economic terms, the price of gold has changed from contango to backwardation.) This is not supposed to happen for gold and is normally arbitraged away. For this to be maintained for gold means that there is insufficient supplies of gold so investors, banks, speculators, gold producers and users, are willing to pay more for gold today than take the risk that they won’t be able to access some in a few months.

This downward slope of futures prices for gold has only occurred 4 times in the last 14 years and each time it signaled a medium-term low in the price of gold. So, today may be a good price to buy gold before its next upward move.

Over the weekend, markets have been digesting several news events that are turning the tide in investor sentiment. For most of the year, stocks have been up, bonds have been up, and the U.S. dollar has been steady.

But then recent events include: Federal Reserve Chairman saying that he will begin tapering off the quantitative easing program of buying bonds to keep interest rates low, China is going through jitters over banking liquidity, the Bank of Japan may be losing control of the country’s interest rates, gold has fallen 34% from a year ago, and finally, long-term interest rates have risen faster than any time since 1962 along the entire yield curve (maturity dates for bonds 30 year, 20 year, 10 year, 5 year, etc.).

The combination of these events have prompted investors to re-adjust their outlook to a new investing landscape. A future with rising interest rates and all that may flow from it: downward pressure on the stock market, downward pressure on the bond market, a slowing housing market, and a rising U.S. dollar. Suddenly, over the weekend these scenarios are being talked about and priced into assets. What are all of the scenarios that your portfolio prepared for?

The Dow Jones Industrial Average and S&P 500 have both made new price highs. Hurray, we’re saved! The “wealth effect” will increase consumer confidence, people will start spending money and the economy will improve.

But if you look at a price chart that has been adjusted for inflation, courtesy of AdvisorPerspectives.com, you’ll notice that all of the 3 major stock indexes are still below their price high of 2000 and 2007. Now this isn’t actual inflation but the government issued CPI, true inflation is of course higher.

What does this mean? It means that the strength of the U.S. stock market is fake. It is a mirage created by U.S. Federal Reserve’s actions to make the U.S. dollar worth less through inflation or money printing. Since inflation is eroding the value of the currency, the prices of assets and investments are getting more expensive. The price of a share of stock, a barrel of oil, a home, or anything else is becoming more expensive when priced in a currency that is losing value, the U.S. dollar.

For you to financially tread water, your income and assets must first overcome inflation. For example, if inflation is 3% per year and your salary raise was only 2% then you’ve lost 1% in purchasing power. So even though you received a 2% raise in nominal terms, you are 1% poorer in inflation-adjusted terms. Understanding the compounding effect of inflation is an important element in your financial literacy.

First, a relevant quote from Thomas Sowell,

“When I used to teach, I would ask the class to imagine a government agency with only two tasks:
1) Build statues of Benedict Arnold.
2) Provide medications to children.

If this agency’s budget were cut, what would it do? Of course, cut the children’s medications because that is far more likely to prompt the public to get the budgets restored. If they cut back on Benedict Arnold statues, people might actually ask why they were building them in the first place.”

Example #1:
This week, the Michigan governor was told he had zero chance of increasing the gasoline tax by 17 cents to pay for road repairs and construction. He then asked the Michigan legislature to come up with a solution and they did: “Strip away all the money collected from the current gas tax that goes to education and use it on roads, then we will have a voter referendum in the fall to raise the state sales tax by 1% and we’ll say it is for education so people will vote for it.”

Example 2:
To create public alarm over the sequester budget cuts…

• The Dept. of Homeland Security prematurely released +300 convicted illegal aliens from prison
• The FAA claimed it would cut back controllers and increase flight delays
• White House tours were cancelled (saving $74,000) but million-dollar monthly vacations by the first family and vice-presidential family will continue; along with oil paint-portraits of White House administrators totaling hundreds of thousands.

In order to allow the president to make careful budget cuts where he wanted, the house of representatives offered a bill to give him that flexibility. But the president said he would veto that bill because then he would be to blame for cuts.

Sequester Perspective:
The sequester cuts are only a tiny reduction in the growth in government spending, a total of $44 billion this year. To put this in perspective, the ratings agency, Fitch said that the U.S. would have to cut $1.6 trillion to avoid further credit downgrades and another $3 trillion if the U.S. were going to start reducing the debt. Basically, the sequester is less than 1% of what is necessary to get on stable footing. If you include the $123 trillion in unfunded U.S. liabilities, the sequester is only 0.04% of a cut.

To equate this to a family’s finances, if your income were $80,000 and you had an unsustainable amount of $350,000 in credit card debt, the sequester that politicians are crying about would be like letting your credit card balances increase further in 10 years to only $405,000 instead of only $410,000. Only a politician could call that a “cut” in spending and be baffled over why their credit rating is falling!

The U.S. Federal Reserve bought junk debts from banks to bail them out and then to print money.

Bernanke says we shouldn’t worry about inflation because he can turn around the money printing in 15 minutes by selling all of the bonds he has to stop any increasing inflation.

Interesting fantasy – who is going to buy trillions of junk bonds?

The true price discovery of these impaired bonds may be near zero and so no money would be going back to the Federal Reserve so there would be no brakes on increasing inflation.

But the bonds that were bought are NOT the same bonds that would be sold – interest rates change and the expiration date is closer. Plus, the bonds that have ALREADY expired must be re-created to keep the debt level of the Federal Reserve at the same place.

As Max Kaiser says so eloquently about the Fed’s fantasy about of exiting all the debt in 15 minutes, “Just because you can eat a porcupine whole does not mean you can pull it out – the quills are now facing the wrong way.”