Katrina and the Economy - I

I have held up publicly commenting on Hurricane Katrina for the last two days because it did not seem right to me to be talking money when so many lives have been lost or dislocated. However, I have spoken to many of you, and I think it is appropriate that I pass on to everyone my thoughts of the short and long-term implications of Katrina. The history of natural disasters has followed a fairly regular course. There is a short-term dip in economic activity followed by a strong uptick 3 months to 12 months later. It may seem impossible that anything good can come out of such a destructive storm, but from a pure economic perspective, once the rebuilding begins there is a significant economic stimulus. I think the best way to understand this is to think of the economic implications of one family. For our purposes here, let's call them Mr. and Mrs. America. The Americans lived in a 30-year old home on a side street in a pleasant middle-class neighborhood. Their children are gone, and they both work outside the home. The storm's winds have completely wrecked their home, and they are living with friends in another part of town. We will assume that they will continue to receive their salaries from their places of employment. They have been in contact with their insurance broker and they have been told that they will be receiving a full settlement of $240,000 for their house and $50,000 for contents. They will also be receiving some bridge type support for living expenses while they rebuild. They have already talked with a contractor friend, and he has agreed to rebuild a home with approximately the same square footage and improvement as their old home. Some additional improvement they would like will add another $25,000. The biggest problem they have is that their street is still covered with water, and it will take weeks to clear the damaged trees and houses in their neighborhood. They could begin work much sooner if they rebuilt in a more suburban area farther from the center of the city. Thus even though they have a check waiting for them at their insurance office and a contractor ready to go, they must wait. The only thing they can do to get their lives back to some semblance of normalcy is to begin the process of shopping for the essentials that they know they will need, such as sheets, towels, and everyday clothes. They have leased a storage unit, and they plan to go shopping at a nearby Walmart that is powering its facility with a generator. To get at the implications of the storm's effect on the economy of the area, we have to make two estimates of the American's annual spending. The first is the amount they spend annually on the contents of their home. and the second is the annual maintenance cost on their home. Because they will still be eating and brushing their teeth at about the same rate as before the storm, the biggest change in their family expenditures is the money they would ordinarily be spending on their total living expenses that is now in suspension. Let's assume that the $50,000 they received from the insurance company for the contents of their home has an average life of 5 years. That means that the American's spend an average of about $10,000 per year on clothes, furniture, decorating, electronics, and appliances. That is an average of about $800 per month. To keep things simple, let's assume they have no mortgage on their house. The $240,000 they received for their home would have had an average life of 40 years, meaning maintenance and improvement on their home would have been about $6,000 per year, or about $500 per month. Finally, they spend about $700 per month on utilities, telecommunications, cable, and insurance. The items total about $2000 per month. This represents about 50% of the American's take-home pay. With some possible exceptions, the remainder of the American's expenditures will continue as before. If this 50% hit to spending were wide spread across the area, the economic implications for the New Orleans area would be devastating. Economically speaking, Mr. And Mrs. America would be fine: they have the insurance proceeds to replace their home and belonging, and they still have jobs. But the storm has essentially cut their spending by half for as long as the damage takes to clean up, and thus, the economy in the area will suffer. The ironic thing about the American's situation, however, is their current shortfall in spending will be more than made up over the next 12-18 months. At some point over the next 18 months, they will be spending the insurance proceeds of $240,000 plus the additional $25,000 for the improvements on their new home. In addition they will be spending the greater part of the $50,000 they received for the contents of their home. Looking at it from another perspective had the storm not occurred, they would have spent about $24,000 on items related to their home. Now, because the storm has destroyed their home, they will be spending $315,000. Multiply this times thousands of people and the Delta region will resemble a boomtown. In essence, it is hard to believe, but these natural disasters can actually spur economic activity on a delayed basis. For this reason, I do not believe the economic impact of the situation will be anywhere near as bad as some are now warning. The real risk to Katrina is the damage she did to the oil infrastructure in the area. I will not cite statistics that you can easily find elsewhere, but there is heavy damage to the offshore oil rigs as well as the refineries. I can not speculate on how much damage there is, or how long it will take to repair it, but I do know that the refineries in this country were already running near capacity. Thus, even if one refinery is severely damaged, the supply of oil will be cut and prices will rise. But even here, in my judgment, the situation is not catastrophic; repairs will eventually be made, and the supply will be back on line in time. In the meantime, the higher oil prices (they may go as high as $4 a gallon) and the awe that all of us feel at the incredible destruction that Katrina has wrought will act to dampen our animal spirits a bit and cause a general slowing of the economy. I cannot emphasize enough, however, that the slowdown will be temporary. The rebuilding will give a big lift in the coming months. The hypothetical situation above is neither a best case or a worst case scenario. The issues are far more complex for those people without insurance or are not able to maintain their jobs. In these cases, the burden falls to the state and federal governments. The costs will be terrific, but I believe all parties realize the magnitude of the problems and the consequences if any of them shirks their responsibilities. I am heartened that the state of Texas has not only offered the use of the Astro-Dome for the 25,000 refugees who were trapped in the Super-Dome, but has also opened their schools for the fall term to the school-age children who will living in the Dome. I will report more on the rebuilding in time. The key thing for the economy is how long it takes to pump out the water and how long it takes to clean up the damage. From that point on, the economic benefits of the rebuilding will be substantial. Rebuilding the Delta region will take years, but the economy will be stronger than many commentators now believe. The stock market is a discounting machine. It knows everything I have said here and more. I believe it will be able to look through Katrina's devastation and see that, in effect, she has slugged us, but our nation has proved over and over that we are resilient. Addendum: Many are now saying that Katrina is the worst natural disaster in US history. The "Big Easy" has fallen, and she needs our help. I would encourage anyone reading this to contribute whatever you can to help those who have lost everything. Check with your local Red Cross. It is my understanding that they can take your contribution and get it to the Katrina relief effort.

Summer Stroll #18 - Retirement Respite

You have just retired. You have a million dollars to live on the rest of your life. Who do you trust to guide you? What do you put the money in? Where do you start? The old Who, What, Where questions bombard you with a weight that is surprising and unrelenting. You may be good at sales, or a whiz at accounting, fly a plane like nothing, or sing like a bird, but you are leaving your active career, and you are now faced with a job just as big and potentially more important that the job that produced this wealth. You are about to enter the world of Retirement Roulette. I keep using the term Roulette because unless you are very wise, you will do what most "financial planners" are recommending, and the moment you start down that road you are sowing the seeds of depleting your assets, if not literally, then figuratively. The reasons are two fold: 1. The annual fees of the financial planning crowd, which can run between 2% and 3%, are too high to permit investing in much fixed income securities. 2. This means that advisors who use only mutual funds must rely heavily on stock funds, whose volatility we believe many people in retirement find psychologically difficult to live with. There is a way out of this game of chicken that is practical, doable, and livable. Let me go back to my idea of the buckets. In this case, I want to use the concept of what I will call the three buckets of retirement. The first bucket will be invested in fixed income securities. Today it is possible to buy investment grade fixed income securities that yield near 6%. Let's say we have put half of our money in the fixed income bucket. At 6% it will produce annual income of about $30,000. This bucket will not grow, but its contents are safe and its principal and income will be very steady. In bucket number two, we will invest in selected rising dividend stocks. The stocks we want in this bucket are stocks with as much dividend yield and dividend growth as we can find. Currently our Rising Dividend Model Portfolio yields 3.5%. That means if we invest the other half of our million dollars in bucket number two, we can expect to produce $17,500 in dividend income. Almost all of the companies in bucket number two have raised their dividends for years and possess strong finances so statistically we believe the odds are in the 90% range that this income will grow. At this point, our portfolio will produce $47,500 in annual income. The first question you should ask is, "Why don't we put more money in bucket one? If we put it all in that bucket, we would have $60,000 in safe annual income." Yes, you would but you would miss the rewards of bucket three. This bucket contains the price appreciation of the stocks in bucket two. Our Rising Dividend Portfolio has enjoyed annual dividend growth over many years of just over 7%. Indeed, over the past two years its dividend growth has been near 10%. But let's stick with 7% for the illustration. If dividend growth averages 7% over the next few years, we would expect the price appreciation of the portfolio to also grow by at least 7%. In addition, in most of the stocks in which we invest there is a high correlation (80%-90%) between dividend growth and price growth. Thus if we have the right stocks in bucket two, it is statistically a near certainty that we will achieve price growth in bucket three. Bottom line we expect bucket three will produce near $35,000 in average annual appreciation. Our best guess is that the three bucket approach would produce $82,500 in average annual benefits. That's good news, but the best news is that only about 40% is in price appreciation. The other 60% would come from the income out of the other two buckets. Another good thing about the three bucket approach is that it is only approximately one-third to one-half as volatile as the standard asset allocation being recommended by many investment people today. Or said another way, it is an order of magnitude more predictable, thus livable. We believe the secret to the three bucket approach is to keep expenses down by investing in individual stocks and bonds. In this way, we save the whole layer of fees that the mutual funds charge. We are money managers, and we charge a fee to manage accounts, but because we do not use mutual funds our total fees are a fraction of those that are routinely charged by the planning crowd. The money we save by cutting out the funds goes into our clients pockets. And because of our lower fees, we can invest in more income producing securities than can the typical recommended mutual fund asset allocation. Additionally, by investing in more income producing securities we can dramatically lower the volatility and risk. There are of course all the usual disclaimers about trying to project the future by looking into the past, and there are questions that I have raised and not answered, but at the end of the day, your retirement years should not be a time when you are timing the market or supporting a financial planner's lifestyle, needlessly. Ninty-nine percent of those of you who are reading this blog are probably clients or prospects of Donaldson Capital Management. If you are not, you owe it to yourself to see if an individually crafted three-bucket-investment plan would work for you. My email is gdonaldson@dcmol.com. My phone number is 800-321-7442. Email me or call me. I'll get you in touch with one of our portfolio managers. It does not make any difference where you are. We have clients in 28 states. In the past week we have been in Arkansas, Alabama, Kentucky, Illinois, Tennessee, and Indiana. We are harping on this not because we think we have the only answer, but judging from the new accounts that our firm is adding every day, the name brand investment firms in the Midwest do not have a clue about how to construct a portfolio that will stand the test of time and provide "Retirement Respite," instead of a Retirement Roulette.

The Barnyard Forecast

Every day we get a new dose of economic data and depending upon the source(and political persuasion), of your news, you might conclude on some days that the the sky is falling, or on others that the sky's the limit. This is not a new phenomenon. We think it goes with the territory, so it is important to be able to zero in on just those few indicators that drive the markets. To provide a means of taking the pulse of the stock market's near-term prospects, many years ago we devised a very simple acronym, EIEIO, which helps us to focus our attention on the fewest and most important data points. Over time the acronym has become known as the Barnyard Forecast because EIEIO sounds like the chorus from the children's song, Old McDonald's Farm . EIEIO is taken from the first letter of Economy, Inflation, Earnings, Interest Rates and Opportunity. Each of the indicators is scored on a three point scale for its positive or negative implications for stocks in the coming 6-12 months. We give each indicator 2 points if we believe the trend of the indicator is positive for the stock market, 1 point if it is neutral, and 0 points if it is negative. Economy: The 80-year average of GDP is just over 3%, and we believe the ouch point for the Federal Reserve is 3.5% real growth. On a year over year basis, the GDP has grown at 3.6%. That is very good news for the economy, but not great news for the stock market because it means the Fed may well continue to raise short-term interest rates until the economy slows toward the 3-3.5% range. We rank the economy neutral for stocks, not because if its weakness, but because its strength will keep the Fed on the alert. 1 point. Inflation: We believe the Fed's inflation ouch point is 2.5% on the core CPI. On a year over year basis, the core CPI has risen 2.6%. That's close enough to the acceptable level of 2.5% that we will give it a neutral score. 1 point. Earnings: Earnings are nothing short of outstanding. Economy wide after-tax corporate earnings have risen nearly 20% in the last 12 months. That's good news anyway you look at it. 2 points. Interest Rates: While the Fed has consistently pushed short rates higher, our model looks at 10-year bond yields and long-term mortgage rates. Both of these long-term interest rates are almost exactly where they were a year ago. We rate them neutral for stocks. 1 point. Opportunity: Totaling the scores gives us a kind of short-hand view of the prospects for stocks in the next 6-12 months. At a total of 5 points (1+1+2+1) out of a total of 8 points, our model is suggesting a modestly positive rating for stocks. We believe the Barnyard Forecast is suggesting the sideways motion of the major indices may continue at least until the Fed sees economic growth slow a bit. However, we continue to believe that companies with above average dividend yields and growth can escape this sideways motion. A stock with a 3% dividend yield and expected dividend growth of 7% offers an implied rate of return of 10%. With 10-year rates at 4.25%, these solid dividend payers are too cheap, and investors are increasingly recognizing it. We will take a more in depth view of some the companies we like in the coming weeks.

Summer Stroll #17 -- Retirement Roulette II

You've just been notified that you have a million dollars in retirement benefits. As we said in our last edition, that seems like a lot of money, but it will produce surprising little income in simple investments, maybe $35,000 - $40,000. With stocks having produced over 10% per annum over many years, it is natural in this low interest rate environment, that you would turn to stocks in hopes of producing a higher level of annual income. This seems simple enough, and from an expected return perspective, it is recommended for most people. But there are problems. The first problem is what stocks should you buy and who should you buy them from. You have a broker, a banker, a CPA, and an insurance agent. All of them claim to be financial advisors, specializing in retirement planning. They are all good people, and you have known them for many years. Which one should you chose to work with on your retirement questions? In my experience, it won't make much difference which one you choose because they will all offer you programs that will look very similar: 40% in US large cap mutual funds, 15% in international stock funds, 15% US small cap stock funds, and 30% in bond funds. The reason they will do this is because that is what everyone's asset allocation software says. My biggest problem with this "classical" asset allocation approach is not the stock-bond mix. My problem is that the fees almost everyone will charge you to construct and supervise your retirement plan are sky high. You could pay as much as 5% ($50,000) of your assets in front-end loads, and as much as 2-3% in annual administrative and investment management fees. The retirement planning crowd are not portfolio managers in the strict sense of the term. The have little experience in individual stock selection; indeed, many would not know where to begin to analyze the value of a stock or bond. They leave the investment management up to the mutual funds. Their primary role is the selection of the mutual funds for the various categories. I don't want to minimize the skills and training required to do this, but in the end, it gets down to picking funds that have done well over a long period. It is not rocket science, but they are paid better than most rocket scientists to do it. On a million dollars, excluding the front end sales charge, the total annual fees may range from $20,000 to $30,000. That will just about wipe out the income from the "classical" asset allocation. That means, you will be living entirely off of capital gains as I described in the last blog. Now you can go to bed each night and wake up each more morning thinking about almost every kind of stock under the sun: big stocks, little stocks, and foreign stocks and experience their respective volatilities, which is the case of small stocks is over 30% per annum. Our firm has seen a steady inflow of clients who previously did business with a "friend" or neighbor in the investment business (and it seems everyone has a friend in the investment business). What they understood dimly when they began, they completely understand today: To bet their retirement comfort entirely on capital gains is nuts, especially if the reason they are doing it is to subsidize their friend's lifestyle. As a man in Terre Haute told us: "My friend is a great guy, but he has cost me a lot of money and if I hit the wall, he is not going to come over to my house and offer to support my way of life. He has no plan; he can't explain what's going on. I think he hopes I will move on so we can salvage our friendship." It ain't brain surgery and it ain't rocket science are two phrases that attempt to say investing is just not that tough. It's--you know--go with the flow. It'll be OK in the end. The rising tide lifts all boats. But there is another equally pithy phrase, "It ain't necessarily so." In this case, having your friend manage your retirement plan might be akin to having your friend perform brain surgery on you, or build a rocket that will safely send your to the moon. Not!!!!!!!!!! Get an expert. Get someone who charges a modest annual fee(no front-end loads), which will allow some of the income that your portfolio produces to make it to you, so you won't be living entirely off of volatile capital gains. Get someone who knows value. Get someone who is in the business of building and managing individual stocks and bonds. They are tough to find. They are a bit old fashioned, but they are out there and you need them much more than you know. Additionally, there are brokers we know who can construct a mutual fund portfolio using no-load funds with low annual fees. You are betting your life on your money manager. Think about it.

Summer Stroll #16 --Retirement Roulette I

Dividends matter because they are a direct contributor to the total return of a stock, and of equal importance because for many stocks, they are a predictor of the capital appreciation. Understanding the role of the dividend in the total return of a stock is helpful in building net worth, but it is critical when it comes time to live off of your assets in retirement. Let's say you are retiring and the HR department has given you the good news that your 401k plan is worth a million dollars. This good news won't last very long. In today's low interest rate environment, a million dollars won't buy much of a lifestyle. The highest yielding CDs pay only about 4%, a 10-year US Treasury bond pays about the same, and fixed rate annuities pay only about 3%. That means that the simple and safe choices available to you will only produce between $30,000 and $40,000 in income. In our experience, that level of income would be less than half of what you were earning before retirement. The need for higher "retirement income" will force you into stocks with at least some portion of your million dollars. Before we go any farther, let's get straight what this million dollars really represents. It is the capital from which you and those who depend on you must live for the rest of your lives. Stocks have produced a total return of approximately 10% over many years. Ten percent of $1 million is $100,000; now that is more like it. You can probably live on that kind of income, but if you go this route with a hundred percent of your money, we can assure you that your sunset years will feel more like "retirement roulette, " instead of retirement living. The reason is as simple as it is dangerous. An all growth stock portfolio will require that you tap your principal regularly to pay living expenses. To explain what we mean by retirement roulette, let's say we assume that growth stocks are going to make a 10% average annual return over the next 10 years. That would seem to make for pretty clear sailing for the all-stock retirement plan. The problem is the current dividend yield for the S&P 500 is about 1.5%. That means your portfolio will earn only about $15,000 per year in actual cash flow. The remaining $85,000 must come from capturing capital appreciation. I personally, believe this is possible for the coming decade, but the problem is it won't happen at precisely the rate of 8.5% per year. History shows us that the stock market is up about 7 out of every 10 years. Anyway you slice it, over the next the next 10 years, there are going to be lots of months and years when you will be taking money out of your account at the same time the market value is also falling as a result of the weak stock market. On paper this does not seem such a big deal, but history also shows that the annual gains in the stock market usually come suddenly in just a month or two, and the rest of the time it just wallows around. In actual experience, if you try to take $85,000 per year two bad things are going to happen to you. One is psychological and one is statistical. From a psychological perspective, even if the market does average 8.5% capital appreciation for the next decade, much of the time it will feel like your retirement bucket has a hole in it. Every time you get a distribution from your portfolio during times when the market is falling, you will have that gnawing feeling that you are going to run out of money. From a statistical perspective, if we experience another three-year bear market like 2000-2002, your portfolio could take such a hit that it would be permanently damaged, and with it your standard of living. Before I offer a solution to "retirement roulette," let me discomfort you even more by revealing another impediment to your retirement standard of living that you also may not have considered. I'll do that in part 2 next time.