Investment Strategy Background

It has now been several years since the financial crisis and while the causes of the collapse are still in place (inordinate public and private debt and chicanery on the part of the financial industry) the world continues to move on so our investment strategy must continue to evolve.

2007 through 2008: Implosion of the Worldwide Financial System

Buying Treasuries in the Fall of 2007 worked well to preserve our principal. The Dow Jones (DJIA) declined from 14,000 to 6900 over a twelve month period; an approximately 50% drop.

The Federal Reserve embarked upon a daring and unprecedented strategy of giving CPR to the collapsed patient, the US economy. No one knew, including the Fed itself, how long this effort would continue but every time the Fed backed off the oxygen the patient (and stock market) collapsed. This was known as the QE Bubble that could have burst at any time because there was never complete agreement at the Fed that this was a proper strategy.

During this time I emphasized preservation of principal by investing in high grade corporate bonds. As of October 2014, the Fed has ceased QE for the time being so we no longer have to deal with the daily uncertainty of when and if the Fed will “pull the plug” and the resulting crash.

If you regret not being in the market during this time then you do not understand the magnitude of the risk you would have been taking. Remember without corporate buybacks and QE, the market would still be around 6900.

We have weathered that uncertain time with our principal intact and we have slept at night knowing our life savings was secure through the 1000 point down moves and flash crashes.

All the capital markets were ever designed to do was to keep investors even with inflation.

2014 Forward: No Growth, Low Rates, Rising Stock Market

It appears that for the foreseeable future there will be no growth in the economy. If there is no growth there will be no inflation so interest rates will remain low. The Fed wants to keep rates low to encourage borrowing for buying and to prop up the stock market which also encourages consumption. If the Fed sees what it thinks to be growth, it may allow rates to rise modestly to head off inflation.

As I detailed in my last seminar, The NEXT TWENTY YEARS, the business model that has been in place for the last 30 years is broken. Borrowing to pay for the present, past, and future was never sustainable. As we pay off the debt there will be no money for new consumption (demand), hence companies will not post profits.

The profits you read about are a result of cutting costs not increasing revenues. Companies are not investing their trillions of cash in their own businesses by hiring workers because they see no profit potential.

What would cause the Fed to raise rates?

If there is real growth in the economy the Fed may raise interest rates to head off any overheating that may lead to inflation. Higher rates slow borrowing and cools the economy down. The Fed has said it will not allow inflation to rise above 2%.

Some believe that the Fed will allow rates to rise modestly over the next year because it sees some indication of growth. Others think this growth is an illusion caused by manipulation of unemployment and profit numbers.

What would cause real growth?

Companies would have to spend their cash by creating new jobs and hiring workers or the government would have to institute another stimulus program by hiring workers for government programs (such as rebuilding the infrastructure).

So far, all companies have been willing to do with their cash is to buy back their own stock shares. Less dilution causes the share price to increase which pleases shareholders and hikes executive pay. This is the single greatest cause, other than QE, for the rise in stock market value over the last few years.

What about a stimulus? The Republicans have blocked all stimulus attempts on the part of the administration since 2009 and with the newly elected Republican controlled Congress that will not change. We will see further cuts, not new spending programs.

Implications for Our Investment Strategy

While bonds will be the backbone of our strategy, low rates and stock buy backs will continue to propel the stock market upward. Without the specter of a breaking QE bubble, it is time for some of us to take a look at stocks.

The stock market is outrageously risky for the small investor. Every aspect of it is rigged for the benefit of the large banks from Libor (interest rates) to Forex (foreign exchange), but it is the proverbial “only game in town” if you need a higher return than bonds.

Because the stock market really is a game now, you must hire someone who will not exactly “beat them at their own game”, but will protect you from the worst of the volatility. Writing covered call contracts or “hedging” on stocks is an old and conservative way to invest in stocks. In this market it is the only way for the small investor to not be swallowed by the sharks.

I have hired a money manager, Capital Wealth Planning LLC, who specializes in covered call strategies and many of my clients are already participating in this program. My current strategy calls for greater participation where appropriate. I stress that taking more risk never guarantees higher returns. Remember the DOW has only averaged a return 3.5% annually since 2000. But for some people not taking risk guarantees going poor slowly.

So here are current issues I am focusing on:

1. Rates may soon go up, so do I construct a new corporate bond portfolio at current rates or wait to reinvest at possibly higher rates later. If we do not invest now what will we do in the meantime?

I have been working with Invesco (formerly Van Kampen) over the past weeks to construct hypothetical portfolios at current rates. The best we could get for a new portfolio of high quality corporate bonds with a 5 year average maturity would now yield 1.5%. Five years ago a similar bond package would have yielded over 3%. If we lowered the quality and had 25% of the bond portfolio in BBB rated bonds we would be able to get just over 2% with additional risk. Rather than lock in these meager returns for 5 years, I’ve decided to wait. In the meantime we can invest in short-term CDs to be ultra-safe or we can use the Covered Call program.

2. What is the right mix of hedged stocks and bonds for each client?

The mix is based on your goals, which for most of you is related to having enough money to retire or stay retired in the style you prefer.

The “right mix” comes down to this;

  • What options does a person have who is currently retired but no longer has enough money to continue their current life style on what they are earning from bonds?1. Going back to work.
    2. Reducing living expenses.
    3. Taking risk on their investments.
  • What options does a person have who is trying to save for retirement but will not be able to retire on the amount they are accumulating on bond returns?1. Increasing their current savings somehow (different job, reducing current expenses, etc.).
    2. Plan to work longer.
    3. Reduce expectations for retirement life style.
    4. Taking more risk with their retirement portfolio.
  • What are the options for a retired individual who has sufficient savings to live indefinitely at their current expense level or someone who is on target to save enough for retirement?1. Take little to no risk by staying in short term high quality bonds.
    2. Take some stock market risk just in case inflation takes off in the future.