Second Quarter 2007
Here's the Economic Weather Report for the Second Quarter of 2007. This is a look back, not a look ahead. Economic forecasters, just like weather forecasters, can make informed guesses about the next few weeks or months, but never the next few years. For investors the skies were sunny in the financial markets this spring. Buyers were optimistically buying, driving up the prices of stocks here and in most foreign markets. Mild economic temperatures in the form of relatively low interest rates and a modest inflation rate produced a good growing season for company profits. The Standard and Poor's 500 Index began the quarter at 1424.55 and on the last trading day of June closed at 1503.35, a gain of 78.8 points or about 5%. Not bad for three months. The Wall Street saying "Sell in May and Go Away" was not operative this spring. Employment statistics continue to reflect what economists refer to as full or nearly full employment. Of course not everyone is employed at any given moment. Some are changing jobs by choice or otherwise. However, our national unemployment rate according to the U.S. Department of Labor is still very healthy 4.5%.
The residential real estate market has slowed considerably. Speculators are no longer able to build and quickly sell new homes. Many houses are waiting for a new owner. Some home owners with marginal incomes bought too much house. A number have been foreclosed. Real estate investment companies that sell and service mortgages have been under attack by the short sellers and hedge funds, traders who borrow stock from their brokers in a margin account then sell their borrowed shares and wait, hoping to buy them back at a lower price later on. The stock market allows this nutty behavior because it helps create a "liquid" market. This loosely translates into "more buying and selling."
A recent report from the Federal Reserve stated that the net worth of American households has increased to $27.5 TRILLION during the Third Quarter of 2006, the most recent period with dependable data. This report counts first mortgages on our primary residences but does not report the net value of our homes' equity or IRAs and 401(k) accounts. This number is greater than the net worth of all of the rest of the world's households combined. American household liquid assets (stocks, bonds, mutual funds, money market funds and bank deposits) were $20 TRILLION of the total amount. If this amount of net worth were to be divided equally among all 300 million Americans, we'd each have about $92,000. All the fans of wealth redistribution would like to see this happen. However, in my opinion, wealth can not be redistributed it can only be created or confiscated. In the hands of the unprepared, wealth will likely be squandered and dissipated.
Now to my quarterly sermon to the choir on the negative spin promulgated by the news industry: Remember, whenever you read a newspaper, watch TV news or listen to radio news you are consuming a product called THE BAD NEWS. Good news doesn't sell. "Bad news is good copy" is the newsroom editors' mantra. My advice is to try to find an antidote against the poison of depressing stories and editorial bias in the 24-7 news business. Read a good book. Read my newsletter twice. Go to a concert. Yes, it is true. Bad things happen all the time and often to really good people. But what goes unreported is how much good also happens every day. We live in a world with a standard of living never before enjoyed by so many at any time in history. Brilliant women and men are creating solutions to our problems every day. Consider this: Today in America any two people, a man and woman selected at random, both age 62, both non-smokers, have a combined life expectancy of well over 20 years. If you're forty today, imagine retiring at age 62 and living in retirement for twenty or more years! It's a fact, Jack! In 1900 the life expectancy for men in America was about 47 years. Today, reverse the numbers. It's 74 for men and 78 for women. According to the Social Security Administration, the source of these data, if you are age 105 you are expected to live another 1.46 years.
The good news is we're living longer. The bad news is we're living longer. It's a mixed blessing. Assuming good health and adequate financial resources, the last one, two or three decades of life might be quite wonderful. Again, because no one is promised tomorrow, a rose garden or anything not in writing, we should all consider investing intelligently and not emotionally. You and I could actually live much longer than we ever thought. We don't want to run out of money. How should one invest for a lifetime? There are several choices.
- Real Estate, the ownership of land, buildings, houses:
Our homes are usually our largest single asset. Additional real estate can be accumulated for future growth and rental income. Not without risk, real estate has built many a fortune. - Bonds, the loaning of money in return for interest income:
For the past eight decades the rate of return on U.S. short term bonds has been just a little more than the rate of inflation. Take away income taxes and you're about even. Municipal bonds have paid similarly but are federally income tax free. Corporate bonds carry higher risk and yield correspondingly higher rates. - Stocks, the ownership of shares of companies that provide customers with products and services:
During the past eight decades the compounded rate of return on large company stocks in America as measured by the S&P 500 or its equivalent has been about 10.5% per year. I suspect that if every adult man and woman in America could be polled regarding investment risk most would say that the real risk in investing is losing principal due to a drop in prices. That would, of course, be the wrong answer. The real risk is not the temporary, though often painful, lowering of prices. The real risk is the loss of purchasing power over time.
Before looking at lifetime investment choices we have to discuss the emotional block that has kept millions of investors from achieving their stated financial goals. A recent study conducted by Dalbar, Inc., Quantitative Analysis of Investor Behavior 2006, a study of mutual funds and mutual fund investors revealed the following: From 1986-2005 the S&P 500 gained on average 11.9% annually. The average investor gained only 3.9% annually. Why? The research determined that the difference was due to investor behavior- specifically bad behavior. Many in the do-it-yourself camp tend to follow the emotions of the markets, buying when prices are going up and selling when they are going down, instead of weathering the storms and holding on to their good companies.
Here's one possible reason: The formative financial event in the consciousness of Americans who were alive anytime during the last century was the Global Depression of the 1930s. My grandparents lost everything they had worked for not because of the stock market. No. They didn't own any stocks or bonds. They owned three retail stores and sold carpets, tiles and other floor coverings. Their bank collapsed and with it the $50,000 they had saved to buy next season's merchandise. There was no FDIC insurance then. Did I hear about the Depression when I was a youngster? Only a few hundred times. There's a widely held belief that the stock market break in 1929 caused the Depression. The market drop was a normal correction from a market bubble that occurred during the Roaring Twenties. A normal market correction and recession became the Depression for a number of reasons including: 1) Liberal lending in margin accounts - 10% down, 90% borrowed money to buy shares, 2) A succession of very bad laws passed by an economically ignorant Congress including the Smoot-Hawley Tariff which choked off global trade, 3) Congress voted in tax increases instead of tax cuts, 4) The Federal Reserve tightened money supply and raised interest rates. In other words, Washington did everything it could to make a difficult time horrible. Legislators are not known for their economic acuity, then or now. And yet we continue to return the same old faces to Congress every two and six years. There is a term limit for the President. Why aren't there term limits for Congress? Simple - they won't vote themselves out of a lifetime job. Only We the People can do that.
In our national subconscious dwells an irrational fear of the future. "What happened once before (the Great Depression) can happen again" our mental tapes play over and over again. "Don't buy stocks. That's gambling. Play it safe." To participate in the asset class that produced an average 10% annual return over eighty years, yes, including the 1930s, might make intellectual sense, but the little voice in our head says, "It could happen again."
An investor who isn't optimistic about the future of our economy and, by proxy, the shares of our great companies, is limited to a menu of offerings which guarantee the principal amount of the initial investment, such as FDIC insured bank accounts, fixed annuities issued by the strongest life insurance companies, U.S. Government bonds of short to medium duration and money market accounts.
Investors have allies on their side including a body of regulatory law designed to protect investors and an increasing understanding of the features and benefits of free market capitalism, the most successful system of human exchange yet devised. One of the important laws that help protect our economic system is the Employment Act of 1946, passed by Congress and signed into law on Feb. 20, 1946. The purpose of this Federal legislation is to help prevent another Depression. An Amendment to this law, known as the Humphrey-Hawkins Full Employment Act, passed in 1978, further empowers the Federal Government to do everything possible to ensure that every American who wants a job can find one. A noble concept, if impossible to implement 100% of the time, these two bills provide a national foundation upon which our economy operates. Every year the President must report to Congress under the statute with an annual economic report in addition to the national budget. So stop worrying about depression, also know as deflation. In my opinion, deflation is not the risk. I believe the real risk is inflation. Deflation is the condition wherein there's very little money in circulation and the prices of goods collapse, jobs are lost, people hoard what little cash they have and business comes almost to a halt. Inflation is the opposite condition wherein there's too much money in circulation, the prices of goods go up and up, the economy can become overheated, jobs are plentiful, etc. Balancing our economy between the forces of deflation and inflation is the goal of every good central banker. In America the Federal Reserve is the central banker. Its Chairman, Ben Bernancke, has a tough job. Wish him well.
If you're not yet retired, here are some things to think about. 1) You might need 20 to 30 years of retirement income. 2) The cost of everything is likely to go up and not down, there will be no more Great Depressions to bring down prices, remember the law? 3) You might get less healthy which means a higher cost of living than normal. 4) You'd like to leave your heirs something if possible.
The U.S. Department of Labor keeps track of The Consumer Price Index. According to their records for about eighty years the average inflation rate (the increase in the cost of living) has been about 3% per year on average. At this rate the cost of living doubles roughly every twenty-four years. In thirty years with the cost of living increasing at 3% you will need $2.43 then for what $1.00 will buy today. The loaning of money to banks and insurance companies will likely produce a return similar to the historic norm, from 4% to 6% per year. Should you need extra cash and dip into the principal, the remaining capital will be reduced. One can not get growth and income from a guaranteed investment. The only growth possible comes from reinvesting the income. When it comes time, hopefully there will be enough capital to produce the needed income.
Which asset class has historically produced a return that is three to four times greater than the rate of inflation? Answer: Equities, stocks and stock mutual funds. Of course, past performance is no guarantee of future results. The decision about how much to put in each investment asset category is part arithmetic, part faith in the future.
Wishing you success,
Robert W. Brimmer, CFP™
BRIMMER FINANCIAL
rbrimmer@nationalsecurities.com
P.O. Box 2806 - 19 Brewster Cross Road - Orleans, MA 02653
tel. 508-240-0320 fax 508-240-2309 toll free 800-237-9322
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