Financial Literacy

The U.S. stock market frequently falls by 10%. While this drop is not a big problem for a long-term investor, the stock market also periodically falls by 25-50% or more, which is a huge problem. When the U.S. stock market drops by a large amount, the stock markets in other countries can fall even further like Britain, France, Russia, and Brazil. Instead of riding these stock market declines to the bottom, side-stepping these large drops over +15% will substantially boost the value of your investment accounts over time. Riding down a severe stock market drop of 25-50% can make the difference between being able or unable to retire as planned.

Below are a couple ways to protect your portfolio:

1. Most 401(k)s have no hedging options and so selling your stock funds to avoid larger losses is the only tactic to protect your investments. When a broad stock market index like the S&P 500 falls from a price high by 14%, you could, for example, sell half of your stocks or stock funds. When the index continues to fall and is down by 20%, sell your remaining stocks or stock funds so that you do not suffer a 25-50% loss or more in a protracted stock market decline. Then, slowly buying back into stocks at much lower prices.

2. Instead of selling your stocks or stock funds, maintain some cash on standby to purchase an inverse ETF to hedge your stocks or stock funds. ETFs are funds that trade like stocks and there are dozens that move in the opposite direction of the general stock market. For example, if you are concerned about a market drop, you can purchase an UltraShort S&P 500 with ticker symbol “SDS” to hedge your stocks and stocks funds. When the S&P 500 moves down by 1%, the SDS will move up by twice that amount or 2%. So if you have $10,000 in stocks you only need to purchase $5,000 of this hedge to neutralize a large down move in the stock market.

3. Using stock option strategies is another method to hedge your portfolio as well. This is beyond the scope of a short blog post but they are not difficult to discover and learn before the next stock market decline. Just be aware that it is routine for portfolio managers to purchase put options to hedge their portfolio for potentially negative news events or price drops and pay for these puts by selling call options (a hedging strategy called an option collar).

What I have mentioned are ideas that you need to fully understand before you consider using them. You need to understand how they trade, how much you need, and exactly why & when to enter them and exit them – a full plan before you actually employ them.

The stock market is at all-time highs from Federal Reserve money printing but this money printing is scheduled to stop before the end of 2014. This fundamental shift in the financial markets may trigger the beginning of a stock market decline. Everyone that owns stocks or stock funds needs to have some kind of plan to sidestep large losses to their portfolio at all times. I highly recommend you that you have some kind of plan, or you’ll be left riding the stock market all the way down on its next +25% drop that will certainly happen sooner or later. Losing this much of your hard-earned money will impair your net worth and dramatically lengthen the time-horizon for your investments to meet your financial goals.

I have reviewed many retirement accounts for others and I normally see a hodge-podge of default selections, long-forgotten transfers, and unopened statements. This is partly because most people have no interest in investing and fewer still have the motivation to pay much attention to their accounts. While this is understandable, your investing success will have a dramatic impact on your lifestyle in any potential retirement future. The financially literate have some way to manage their accounts. New online services make it easier and cheaper than ever before.

Traditional money managers are expensive in two ways. First, in the fees and commissions that they charge you, and second, corralling your investments into their firm’s poor-performing funds with high expenses. Online services typically charge less than half of the fees and have no vested interest in which funds that they select for you.

There are several online money management services that you could consider, but I just came across a new one that you can use for free – plus it has 401(k) plan recommendations. This company, FutureAdvisor.com has a fee-based option where they manage your money for you but they also have a free version for anyone who is willing to make the transaction changes for themselves.

For those of you who not interested in becoming investing experts, you must hire some kind of money manager to make the most of your hard-earned money. There are many low-cost options that are online today and now you even have a free one to consider.

While the U.S. Federal Reserve continues to print money, the U.S. stock market continues to advance higher. Although the Federal Reserve is in now well into ‘taper mode”, reducing the amount of money printing each month, it is still at $45 billion per month. This money is buying U.S. Treasury bonds and gives another injection to the stock market.

Remember that since 2008 each time the Federal Reserve stops a money printing (quantitative easing programs #1, 2, and 3), then the stock market falls. The Federal Reserve is at $45 billion per month and is reducing that amount by $10 billion per month. So in November when the current money printing program ends, that may be a prudent time to sell some of your stocks and lock-in some of your stock market gains. Just be aware that market participants know this and may act well ahead of time!

If the last program end is any guide, then the stock market will fall, the Federal Reserve will panic and then start a new round of money printing to goose the stock market again. However, since labor participation is falling the unemployment rate falsely appears to be improving. This unemployment rate being a low number today at 6.1%, the Federal Reserve may not be so quick to print so much money again. However, the Federal Reserve Chairman did say today that they will not be raising interest rates anytime soon.

Central governments fear deflation, a condition of a general drop prices or economic contraction, because this normally corresponds with high unemployment and politicians quickly lose their job. So any hint of inflation being too low and headed for deflation and governments respond with stimulus spending, dropping interest rates, or other market manipulating schemes. These tactics to prevent an economic downturn may delay it, but unfortunately, will ultimately exacerbate the regular business cycles of boom & bust.

This week, the European Central Bank (ECB) is in such a panic over low inflation and low growth that they cut their interbank interest rate from zero to a negative rate of -0.10%. Charging banks money to keep their excess reserves at the ECB is an incentive for banks to do anything else with this money, like a hot potato, the ECB hopes banks will loan more of it out to consumers and businesses to spur the economy to grow. However, what is more likely is that banks will pass this charge (or more accurately, this ECB tax) onto depositors in the form of fees or negative-interest rates. This will likely further reduce bank capital as depositors will withdraw the money and hold it themselves for free. Negative interest rates is also a lowering of interest rates which makes the Euro less attractive as a currency. So the Euro declined to a 4 month low on this news, which is part of the ECB plan to help European exporters grow with a cheaper currency.

Meanwhile, in the U.S. there are several troubling charts of ongoing economic weakness that has not turned around since 2008:

• U.S. homeownership rate continues to fall
• 29% of all U.S. homes still have negative equity (mortgage is higher than the value of the home)
• Employment participation has steadily dropped to a 36-year low
• The velocity of money (M2) has declined to its lowest level, ever recorded, signaling a very stagnant economy

How to position yourself among all of these deflationary signals? First, you have to remember that the U.S. Federal Reserve has spurred asset bubbles with artificially low interest rates: 5-year price bubbles in both the stock and real estate markets. Now Europe is actively trying to create their own asset bubbles to kick start its economy. To invest alongside the U.S. and European government’s policies, the place for some of your money is still large-cap U.S. & European stocks, along with investment-grade U.S. and European real estate.

A Roth IRA is the greatest location for your investment dollars compared to any other location:

•  Investments grow tax-free
• After a contribution has been made, after 5 years it can be withdrawn tax-free
• After age 59 ½, gains can be withdrawn tax-free
• Unlike a regular IRA, there is no mandatory withdrawal out of the account
• Heirs can make tax-free withdrawals, as long as they wait 5-years after the owner’s death
• Most importantly, when Congress talks about taxing retirement accounts, they do not include Roth IRAs because they have already been taxed once.

The primary use of this account is for retirement savings so it is best to begin contributing as soon as possible. Since the requirement is that contributions are limited to earned income, how can children get earned income? I know a Realtor who uses their toddler kids in advertisements so she pays them a modeling fee that is put into their Roth IRAs. All that is needed for earned income is a legitimate, arms-length transaction. If you don’t do this for them then they can begin to contribute when they earn money from a paper-route, baby-sitting, lawn-cutting, or other 10-14 year old activities to start their Roth IRA.

There are two limits for Roth IRAs: a contribution limit (today it is $5,500) and an income-limit (today it is $127,000.) However, there is a back-door to putting money into a Roth IRA to get around both of these limitations. Since 2010, you can contribute to a regular IRA and then convert that IRA to a Roth IRA. You can do this each year that you have earned income.

What has been mentioned are the basic rules for a Roth IRA but there are many specific rules that you’ll need to follow from either the IRS website or your tax advisor. Be aware that that taxes are your biggest drag on both your income and net worth and the Roth IRA is the best location for you to avoid these over your lifetime.

President Nixon started the U.S. petro-dollar in August 1971 when the U.S. defaulted on gold-backed currency and closed the federal gold window. The petro-dollar agreement was that the U.S. would be Saudi Arabia’s military protector and buy Saudi Arabian oil, in exchange, Saudi Arabia would trade all oil in U.S. dollars. This agreement props up the demand for U.S. dollars and defends Saudi Arabia from its enemies.

But the world has changed since 1971:

• President Obama has abandoned defending Saudi Arabia
• China has replaced the U.S. as Saudi Arabia’s largest oil buyer and investor
• Russia is the world’s largest oil exporter and they no longer price oil in U.S. dollars
• Russia now handles Iran’s oil trade, no longer in U.S. dollars
• U.S. oil fracking has reduced U.S. oil imports so there is less foreign trade in U.S. dollars
• Increasing Asian trade is being done directly between currencies, not through the U.S. dollar

Each of these elements is chipping away at the need, demand, and value of the U.S. dollar in world trade. The U.S. is still the world’s largest economy but it used to be that +95% of all world trade went through the U.S. dollar as the world’s reserve currency. Today, the U.S. dollar still dominates world trade and derivatives at 90%, but this ratio has been in a downtrend over the last couple years reaching all-time-lows. China’s economy has already surpassed the European Union’s economy and is predicted to become the world’s largest economy in 3-8 years by surpassing the U.S. So sooner or later, the U.S. dollar will be dropped as the world’s reserve currency for either the Chinese yuan or SDR’s (Special Depository Receipts by the World Bank; a basket of currencies). As this transition occurs, all the money printing, reckless spending, and the insolvent U.S. Federal Reserve balance sheet will no longer be ignored by investors and traders. If you have any cash, assets, or investments, do you have a plan on how to migrate these into stronger currencies if the U.S. dollar begins a notable decline?

As the U.S. Federal Reserve has kept interest rates low for over 6 years now, investors and retirees have searched far and wide to get a yield on their investments. One investment that many people get excited about are tax-free municipal bonds.

These are bonds issued by state, county, or city governments. There are a few types of municipal bonds: revenue bonds that are paid back from projects being financed, general obligation bonds backed by property taxes, housing bonds backed by mortgages, zero-coupon bonds that only pay at maturity, insured bonds in case the municipality defaults, variable or fixed-rate bonds, and others.

What many investors look for in municipal bonds is for them to be double or triple-tax free. Triple-tax free refers to the interest being untaxed on your city, state, and federal tax returns. (Double tax-free refers to those that do not pay city income tax.) Be aware that some municipal bonds are taxable, for example sports stadiums are not free from federal taxes. When you find a bond that is tax-free for you, the next step is to determine its taxable equivalent yield. This refers to calculating how much it would yield if it were taxed – so you can compare it to other taxable bonds to determine if it is a good investment choice for you. For example, if you find a municipal bond paying 4% how do you compare that to a corporate bond paying 4%? By using this formula to calculate the tax-equivalent yield:

Tax Equivalent Yield = Tax Free Yield / (1 – (Your Tax Bracket))

So, if you were in the 30% tax bracket, then your tax-equivalent yield is: .04 / (1 – .30) or .0571 which is (5.71%). So now you can compare taxable bond yields with municipal tax-free bond yields. If you are considering taxable bonds but they are yielding less than 5.71%, then this municipal bond is offering you a better yield, on an after-tax basis.

Please do not purchase a municipal bond or fund without doing some further homework:

1. Is this bond double or triple tax-free for you? Municipal bonds are state specific.
2. Review if the bond may be called from you before you want it to mature. This may also be called a Sinking Fund where a portion of the debt must be periodically paid off.
3. Find the credit rating of the bond issuing entity to find if their credit rating is adequate or has a negative future outlook.
4. Determine if the bond is exempt from alternative minimum tax (AMT). Some bonds, such as sports stadiums, will be taxed by AMT even though you do not pay state income tax on the income.
5. If the bond is insured, then you must also check the credit rating and future outlook for that insurer to make certain the insurance isn’t worthless.
6. Finally, the maturity date of the bond must correspond to when you need to spend the money, otherwise, you are taking on interest-rate risk for which you are not being compensated.

A co-worker read an article Monday about 3D printing and bought shares of one of the industry leaders. Then he called me to ask what I thought about that stock. I replied, “I’d sell it immediately. It is trading at 2-times what it is worth and trending down, I’m afraid the big run-up was 2 years ago.”

It is fine with me if he wants to speculate with a small and affordable amount of risk capital. But having traded for a long time, I see the phases that new stock traders go through over and over. I went through these myself and most traders do as well.

Beginner Stage: buy a stock in the news that you hope might go up but instead you ride it a long-way down for a loss. Financial results are overall losses in spite of a couple lucky winners.

Novice Stage: buy stocks but continually get scared out of your trades so you never ride them up, leaving you with many tiny losses and tiny gains. Financial results are just treading water after a lot of work.

Intermediate Stage: your computer screen has two dozen conflicting indicators and chart patterns, but your stock trades have a price target and a stop-loss exit. Financial results are slightly profitable overall but very erratic.

Advanced Stage: you use very few indicators, scale out of positions, thoughtful position sizing, diversify your types of trades, and have a positive expectancy. Financial results are profitable and relatively consistent.

If some of these vocabulary terms are new to you, then you may want to get acquainted with them before you make more stock trades.

Many people discover that they really don’t enjoy the process of stock trading. At this point they either become a dividend investor, buy-and-hold index investor, or outsource the work to investment newsletters or financial advisors.  Outsourcing to others can be fine but first you must get an audited track record. Whether it is a newsletter or advisor, most of them lose money for clients. Therefore, you must locate and perform some type of due diligence before you put a single penny of your hard-won money to risk on their ideas.

One measure for evaluating stock investing is to determine whether the stock market is relatively high or relatively low. Are stocks getting cheap or expensive? With reference points like this you can more accurately make decisions about purchasing, selling, or rebalancing.

In late 1997, I wrote that the stock market was horrifically over-priced and you should be very careful with your stock portfolio. The stock market bubble then continued to inflate for 2 more years until its peak in 2000. During those run-up years, internet companies with minimal sales and no hope of earnings were going public and then skyrocketing in price. At the market peak back in 2000, the Russell 2000 Index, a stock index for smaller-capitalized companies, was trading at 39-times earnings. (Let me explain what this means: if you purchased this stock index you are paying $39 for $1 of earnings. Just to break-even on your purchase it would take 39 years – does that sound cheap or expensive to you?)

Over the last 25 years, the average price-earnings ratio for the Russell 2000 is under 30. For a comparison, the large companies of the S&P 500 Index have an average price-earnings ratio of around 18 times earnings. Some investors would never consider buying a stock with a price-earnings ratio over 12.

Today, the S&P 500 Index is still trading at a reasonable 17.2 times earnings, however, the Russell 2000 Index is trading at a lofty 49-times earnings. This is far higher than it was during the dot-com bubble in 2000 before it crashed. Sure, the Russell 2000 Index could still move up another 2 years, but it indicates that you should be very careful with buying or holding small-cap stocks at this high level. The risk or downside is very large and the potential gain or upside keeps getting smaller.

In 2008, the U.S. Federal Reserve lowered interest rates to zero to prevent the financial system from locking-up and causing an economic depression. This was a helpful temporary measure for a few months. But then the Federal Reserve continued their zero-interest policy for over 5 years. This chronic price distortion to the economy has had several predictable effects:

• Savers were punished as they earn little to nothing on their money. This transfers wealth from people like retirees that should not be taking risks with their money.
• Businesses and banks were rewarded with cheap money to take on all kinds of low-paying investments, even lending money back to the government for a guaranteed profit.
• Governments were rewarded with cheap money to borrow – keeping deficits artificially low.
• The stock market boomed as profits increased, not from operations, but from lower interest rates for their loans.

Keeping interest rates at zero for so long creates a transfer of wealth from these distortions. This was confirmed recently in the Wall Street Journal, the surge in stock prices and home values has boosted affluent household wealth to a record in 2013. Although keeping interest rates low was supposed to stimulate economic activity, overall consumer spending is still down because of huge swaths of unemployed, rising healthcare costs, and consumer debts are still being paid off from pre-2008.

Keeping interest rates artificially low will end in one of two scenarios. First, interest rates will rise on their own (investors fearing inflation or lack of confidence in U.S. debt repayment), or the U.S. Federal Reserve will begin raising them on their own. Either way, the low-interest party will end and you need to be prepared when the next wealth transfer will begin.

A few suggestions for you to consider include: refinance loans now while rates are still low, be ready to sell some of your stock funds as the stock market begins to decline, avoid bonds because they will be falling in value as interest rates rise, look for floating rate investments to take advantage of rising interest rates, and put some money in investments indexed to inflation.