Tuesday, November 9, 2010

Q&A Series - Quantitative Easing

This week's question comes from Al, a long-term client who would like a better understanding of quantitative easing.

Q: Why is more ‘quantitative easing’ a good thing? As the dollar gets further weakened, and as the Fed buys back more assets and the Treasury prints more money, how can that be good?

Considering the Fed’s announcement on Wednesday that they will go forward with their second round of quantitative easing (QE2), this question is on the minds of many investors. The Feds announcement detailed that the Federal Open Market Committee (FOMC) members voted to buy $600 billion of government securities to hold in their own inventory through the middle of 2011.

Taking this measure is what economic nerds refer to as ‘quantitative easing’ – and what non-economists call ‘turning on the printing press.’ Basically, it’s a monetary policy wherein the Fed increases the money supply by increasing the excess assets of the banking system. This is usually accomplished through purchasing the federal government’s own bonds to steady or increase their prices, with the hoped result of lower long-term interest rates.

Understanding just how QE helps the economy is complicated, but I will give you some examples of how it works and the potential upsides and downsides. In Fed Chairman Ben Bernanke’s opinion piece in Thursday’s edition of the Washington Post, “What the Fed did and why: supporting the recovery and sustaining price stability,” Bernanke explains his concern about the economy’s lackluster growth and the high national unemployment rate. He additionally indicates that the U.S. inflation rate is below 2%, a percentage that is inconsistent with a healthy economic growth rate. Therefore, the FOMC’s goal in QE2 is to increase employment by increasing the inflation rate. Sounds simple, right? Not so.

In explaining QE, it’s important to understand some other background economic information. During the 1930s, economist John Maynard Keynes wrote The General Theory of Employment, Interest and Money, the basis of ‘Keynesian Economics.’ In its simplest form, Keynesian Economics dictates that when the economy is slow and unemployment is high, the public sector (the federal government) must utilize deficit spending to create additional economic stimulus and to increase employment. This is the method that was employed under the TARP to stabilize the economy from the financial crisis that started in the fall of 2008. Unfortunately, it hasn’t been spectacularly successful and the public hasn’t been very happy with the results thus far.

It must be pointed out, however, that the stimulus bill wasn’t really Keynesian Economics. Under that theory, the stimulus bill would’ve been created to put employees back to work and to create jobs specifically in the private sector. While some of the stimulus plan was designed to do just that, a significant portion of it was not.

A key component of the stimulus bill was to give money to state and local governments to protect the jobs of state employees and local teachers and firefighters. While that undoubtedly saved jobs by giving the states and municipalities enough money to employ these people, it did not create jobs. Private industry and corporations create jobs, not the public sector. By virtue of spending the stimulus bill to allow the states and local governments to employ people for one additional year might have been helpful in the short-term, but it didn’t help when the employees were ultimately laid off when no funding was available the following year.

Therefore, a large portion of the stimulus bill was misdirected in a fashion that did nothing to help employment. Unfortunately, the Keynesian Economic theory was criticized for being unsuccessful as it relates to the TARP in 2009 and 2010 when, in fact, it was misapplied. The Fed’s plans for QE2 are to create employment by increasing asset prices and reducing the value of the dollar.

Ironically, it is somewhat paradoxical that the federal government is currently issuing approximately $125 billion per month to fund the federal deficit for fiscal 2011. As you may recall, the deficit for 2011 is projected to be $1.5 trillion. In order to fund that deficit, the Department of Treasury must issue approximately $125 billion in new debt each month. Wow - this is really scary!!

Federal Reserve Chairman Ben Bernanke is a scholar in economic downturns, and he has written extensively on the Great Depression and Japan’s deflation woes. Even though inflation in the U.S. today is at approximately 1.8%, there doesn’t appear to be any imminent danger of the country slipping into deflation. However, it’s clear that Dr. Bernanke does not intend for that to happen.

Reviewing Japan’s economic record over the last 25 years will give you a better understanding of just how dangerous deflation can be. Even though Japan’s interest rates have been at virtually zero during that entire time period, the country has stumbled to create growth. In fact, during many of those years Japan had a negative GDP growth, causing the country and its people to suffer.

Dr. Bernanke believes that for the GDP to grow, inflation must be greater than 2%. The QE2 policy is designed to create that growth. It should be emphasized that in taking this measure, the Fed isn’t doing anything unordinary. At various times during all economies, the Fed enters the open market and purchases bonds from banks to create liquidity. However, in the case of QE2 in particular, the banks and corporate America are currently flooded with excess cash. There’s no reason to create additional cash in these areas since ample supplies already exist. It’s now believed that corporate America and the banking institutions hold approximately $4 trillion in available cash. The question is how to get them to implement it for additional growth.

About a month ago, the Fed announced that they would be purchasing additional debt in the open market to replace the maturing debt in their current portfolio. Most experts estimate that this Fed-owned debt that rolls over every month is approximately $30 billion. Therefore, every month for each debt that comes due and the interest they receive, they use that cash to replace other debt of approximately $30 billion. We are talking real money after a few billion.

When you hear that the Fed is going to purchase $75 billion of debt each month, you may wonder exactly where this money comes from. This is the classic situation wherein the federal government breaks out its printing press to produce brand new money so they can purchase new obligations. With the $75 billion in brand new money printed by the Fed, along with the $30 billion from notes that are rolling over, the Fed has approximately $100 billion to purchase government securities. I suppose that new jobs are created to run those printing presses.

As mentioned above, the Treasury is ironically issuing about $125 billion in new debt each month, with the Fed being the buyer of approximately $100 billion of this money. It is now estimated that approximately $7 out of every $10 in new debt over the next year issued by the U.S. government will be purchased by the U.S. government. Yes, that seems odd.

There are many purposes for the purchasing of this debt: First, it squeezes out all new borrowers since the government will be the ultimate purchaser of the debt. By creating a mass buying mechanism for the debt, interest rates will be forced down even lower than any rate we’ve ever seen in U.S. history. For example, the one-month Treasury as I write this post is .122%; the one-year rate is .206%; the five-year rate is 1.096%, and; the ten-year rate is 2.539%. Therefore, if you invest $10,000 for one year, you make $20.60. Now they want interest rates lower?

These incredibly low interest rates have created quite unusual financial circumstances. On Friday, the Coca-Cola Company issued three-year bonds with an annual coupon of .75%. Ironically, these new Coca-Cola bonds – which were oversubscribed by the public – have a coupon rate of .75% while the common stock has a dividend rate of 2.9%. This means that you can borrow the debt of the Coca-Cola Company at .75% annualized, or invest in its stock, and make 2.9%. This is the intended result of QE2, and it shouldn’t take long for investors to figure out that while the purchase of securities contains more risk, they create more wealth. As we all know, the wealth effect trickles down to higher consumer spending.

The Fed has said that, even though they will buy Treasury obligations of all terms, they will focus on the mid-range (5-6 year) Treasury bonds. Therefore, this concentrated purchase will force interest rates down below five years and higher for longer term bonds. The purpose of this is to make interest rates so low that it will force investors out of interest rate certificates into higher risk investments. While this hurts CD investors, the intent is to move them away from these forms of low-yielding investments by making stocks, bonds, commodities and other types of higher risk investments more attractive.

Naturally, many are wondering why the government is taking this route. The most important reason is the wealth effect. If the value of stocks, bonds and other commodities are increased, then consumers and corporations will feel enriched and will more likely spend the money. It has been often proven that as the wealthy effect increases, consumers will spend more and utilize their newfound wealth to purchase consumer goods, personal property and real estate. All of this is good for the economy.

It’s absolutely true that everything I’ve discussed up to this point is inflationary because it creates the effect that all components of finished goods become more expensive, this is exactly what the government is trying to accomplish. The government would like to see higher inflation to avoid the risk of the country falling into a deflationary cycle.

In the Great Depression of the 1930s, the single largest financial problem was deflation. Assets were worth less each year than the year before, making it undesirable for anyone to purchase hard assets since they would lose money in time. If the government is able to create of inflation by forcing investors from low interest rate certificates, it benefits the holders of these risk assets, and ultimately, the economy as this wealth effect is passed on to other consumers.

The other interesting aspect of these low interest rates is that a five-year Treasury today is yielding 1.09% per annum. If you purchased that security today, with the Fed’s intent to increase inflation above 2% per year, then the bond you purchased would have a negative rate of return. The Fed presumes that it won’t take investors long to figure out that their bond securities are generating negative rates of return, and therefore, they will migrate their investments to other types of risk instruments such as stocks, corporate bonds and real estate.

There’s another important aspect of inflation that is rarely taken into the public’s consideration. Corporate America realizes even more of a wealth effect due to inflation than the average investor. Inflation makes corporate America’s inventory immediately more valuable. It increases the value of their real estate holdings, and therefore, creates real net worth to these corporations. Since the private sector is the generator of new jobs in America, the wealth effect of this increase in assets will presumably make the corporations feel more secure about their futures, and therefore, unleash their purse strings for additional employment.

The other major effect of QE is that is almost assuredly will hurt the value of the dollar. On CNBC’s “The Kudlow Report” last night, Larry Kudlow railed for almost an hour regarding the negative effect that the Fed’s action will have on the U.S. dollar. I think he’s probably missing the point: The Fed would very much like to reduce the value of the dollar in respect to other foreign currencies.

The reason for the Fed’s action to reduce the dollar is that as the dollar becomes cheaper in respect to foreign currencies, all imports in the U.S. are more expensive. This means that U.S. manufacturers become more competitive with international manufacturers who import to the U.S. Hopefully, this will stimulate the expansion of U.S. manufacturing. Additionally, these same manufacturers will be more competitive in international commerce, creating higher manufacturing rates in the U.S., and therefore, an increase in employment.

There’s no question that a lower dollar is inflationary, and in most circumstances, would be considered non-desirable. However, this particular action is designed to create higher inflation, not eliminate it.

The principle positive benefits of QE would be to reduce interest rates, forcing investors away from low return investments into higher risk investments, creating the inflation effect of hard assets, which improve the wealth effect to all Americans. Additionally, it forces down the value of the dollar, which improves the competitiveness of U.S. manufactures against foreign manufacturers and makes exported goods more competitive in international commerce. All of these are the hoped positive outcomes of QE2.

There are many potential negatives to QE2, and the Wall Street Journal has even referred to it as Bernanke’s ‘Hail Mary’ pass. Of course, the primary risk is that inflation will get out of control and we will have a Jimmy Carter-type era, wherein inflation hits 12% annualized. While the Fed fully intends to withdraw QE2 before such inflation occurs, many are questioning whether or not they can see inflation becoming any better than what they saw during the 2007 crisis. By risking such a large sum of money, it is perfectly possible that the Fed would not be able to withdraw the liquidity before inflation becomes ominous.

While pushing down the value of the dollar is a short-term positive for manufacturing in the U.S., there is certainly no guarantee that other countries will not respond in kind. Already, Brazil and Indonesia have announced programs to reduce their currencies to keep massive capital from exiting the United States into their countries, seeking higher interest rates. In fact, the Japanese yen is selling at its lowest point ever against the U.S. dollar, and the Japanese certainly won’t tolerate that for long.

A potential risk of QE2 is that open trade wars will break out between the U.S. and other countries that are devaluing their currencies. Therefore, our devalued currency will not be any more competitive than before. Since this is not a coordinated global effort, it is possible that other currencies will adjust in lockstep, making the plan ineffective.

Several countries in the world have already locked their currency rates to the United States anyway. China and Korea, for example, have never allowed their currencies to float in the international marketplace. They simply adjust their currencies to a standard of the U.S. dollar and do not allow it to adjust one way or the other very far.

While inflation is good when moderate and under control, it is dangerous over time. The wealth effect is effective when it trickles down to consumer spending; but it will not be long before the effect of inflation eats into every family’s budget. Inflation will create higher prices for almost everything, and soon, employees will be demanding higher wages and benefits to offset the additional costs they are incurring. This spiraling up of prices can have a devastating effect to an economy if not controlled.

One of the biggest concerns, of course, is that QE2 takes the pressure off the federal government to even attempt to control deficit spending. By the government purchasing all of the debt that they have issued, they will always have ready and willing buyers. Dr. Bernanke expressed that concern in his Washington Post Op-Ed, and everyone should read his closing paragraph in that editorial:

“The Federal Reserve cannot solve all of the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.”

QE2 has never been tried before, and as such, there’s no way for anyone to know for certain whether or not it will be successful. However, I have been greatly impressed with Dr. Bernanke and his ability to adjust the economic measures he takes accordingly. We can only hope that if Dr. Bernanke sees in the coming months that QE2 is no longer needed, he will completely abandon the entire project.

From an investing standpoint, we could not ask for a more favorable investing environment. With the federal government flooding the system with cash and attempting to increase asset values, that makes all of our current investments more valuable. If they are successful in devaluing the dollar, it makes our international investments even more valuable.

I continue to be confused by the number of people who continue to invest in low-interest bearing CDs when the stock market is up close to 80% since March of 2009. If investors are unhappy with the low interest rates provided by CDs now, they’d better watch out, because they are only going to get lower in the coming months.

Al, I hope my explanation above has given you some understanding of quantitative easing, why the Fed is using this method, and the pros and cons of this technique.

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

Thursday, November 4, 2010

An Outstanding October!

From the Desk of Joe Rollins

All the dire forecasts and predictions of gloom and doom going into September and October of this year wound up being off target, as further evidenced by the excellent market performance during October. During October, the return on the S&P 500 was 3.8%, reflecting that September and October had the best performance ever for those two months in the history of the U.S. financial markets. In fact, the S&P is up 8% for the last three months, and up 16.5% for the one-year ended October 31, 2010. How do these returns compare to the returns of your money market account?

Rollins Financial’s total portfolio under management was up 9.8% compared to 7.8% for the S&P through October 31, 2010. Coupled with the S&P gain during 2009 of 26.46%, Rollins Financial’s total portfolio had a very impressive 12 months in 2009 and 10 months for 2010.

My “Why is Everyone so Jumpy?” post published on October 16, 2010 garnered a lot of emails from clients, many of whom expressed outrage with my supposed presumptuousness in that post. A few people told me that everyone was jumpy because of all the negative financial news and the never-ending media reports of the almost assured U.S. economic catastrophe that they believe we are facing.

There is almost universally good news about the economy. I agree that it’s not great, but it’s also not catastrophic. In the last few days, it was announced that the GDP’s growth for the third quarter of 2010 was at 2%. This means that the last five consecutive quarters have reflected gains in the GDP, which should be encouraging to even a doomsday reader.

Thirty-year fixed-rate mortgages in Atlanta dropped below 4% last week. Even though there continue to be reports that the Federal Reserve wants to push down interest rates further, it is hard to believe that right now you can secure a 30-year mortgage at a sub-4% interest rate. If you are buying a home today, you can easily do so.

Corporate profits in America are nothing short of breathtaking at the current time. Corporate America is reporting unheard of profits in the history of American finance. As I have stated in several prior posts, corporate profits lead to higher stock prices.

I've had conversations with several of my clients this week about investing additional money in their portfolios. Unfortunately, I heard all too often that they were leery of doing so because of the horrible economic news being reported by the media. Sadly, many of them are scared to invest. My answer to their concerns is that there is rarely a better time to invest than when times seem bad. Here are a few quotes to illustrate my point:

“The time to buy is when there’s blood in the streets.” – Baron Rothschild

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett

As we all know, yesterday was the mid-term election day. I’ve fielded a lot of calls from concerned clients who ask my opinion on the potential impact to the stock market from the election results. Frankly, I think that the market will go down for a few days regardless of who wins. There’s an old Wall Street saying that would definitely come into play here: “Buy on the rumor; sell on the news.” Once the news is out, the market will go down for a short period of time, but this will only be a temporary adjustment.

The trend in the market is clearly up, as the two very strong months of September and October have illustrated. If the market does pull back after the election results – regardless of who wins – you should be a buyer in that market.

Over the last few days, I have had no choice but to watch way too many political ads and commentators on the election. The one thing that seems to be missing in politics today is a candidate that is fiscally conservative but socially liberal. We seem to have a choice of either the far right or the far left, but no real moderate candidate. The Democrats are free-spenders who are greater advocates of individual freedoms. The Republicans are more fiscally conservative but seem to meddle in citizen’s private issues. I’m more interested in someone who will stay out of our wallets and our bedrooms. If that candidate ever arrives, I’m going to bet that he or she will be wildly successful.

Our current leaders are learning the hard way that they do not have an unlimited checkbook to spend and pay back their political allies. Because of that, the next two years will likely be much more fiscally conservative, and I cannot help but think that will be a good thing for stocks and for the U.S. economy.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Important Disclosures
Rollins Financial's investment results noted above are actual historic returns as represented by our entire portfolio of assets under management. They are neither the best nor the worst portfolios; they are simply the average of all of our portfolios combined. Data presented reflects past performance, which is no guarantee of future results. Investment results and principal value will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. These results also do not include the effect of our management fees on investment results. The results do, however, include all fees charged by mutual funds and any expenses charged by account custodians.

Wednesday, November 3, 2010

Q&A Series - When Should I Start Drawing Social Security Retirement Benefits?

This week's question comes from Jane, a reader pondering her Social Security retirement benefit options.

Q: I’ll be 66-years old in February of 2011.  I am still working, and to this point, I have not drawn any early Social Security retirement benefits.  My most recent Social Security statement indicates that I’ll be drawing $2,356 per month at full retirement age, but if I wait until I turn 70, my monthly benefit will be $3,096.  Should I start drawing benefits when I turn 66 or would it be better for me to wait until I’m 70?

A: This is an interesting question, Jane, and a topic that I’m asked frequently about – Social Security retirement benefits.  There’s a lot to consider when it comes to deciding when it will be best for you to start collecting these benefits, and it’s important to think carefully about your personal situation when figuring out which route to take.   

Your choices are to start collecting retirement benefits early at age 62 (which you have decided not to do – I’ll talk more about that option in a future post); wait until you reach full retirement age (between 65 and 67, depending on your birthdate), or; hold off even longer (you can continue earning delayed retirement credits, which increase your benefit amount, until age 70).  Some important questions to consider are:

·         What are your current cash flow needs?
·         How much do you anticipate needing in retirement?
·         Are you in good health?
·         Do you plan to continue working in retirement? 
·         Do you have other forms of retirement income?
·         How much would you receive in the form of a Social Security benefit? 

For illustration purposes, I’m going to assume that Jane is single and will have some other form of income (either retirement income or from continuing to work) that will take care of her cash flow needs.  Therefore, the Social Security benefits she receives would simply supplement her income. 

From the information Jane provided, she would clearly receive a higher monthly benefit - $750 more per month – if she waits until she turns 70 to start collecting Social Security retirement benefits.  However, the risk in waiting to start collecting benefits until age 70 is that if she dies before then, she will have received nothing and her beneficiaries would be left nothing via her Social Security.

In a similar scenario provided by the Social Security Administration, they indicate that if a person retires at full retirement age (age 66 in this scenario), the accrued benefits after four years would be $112,608 ($2,346 x 48 months).  If you divide $112,608 by the additional $750 per month you would receive by waiting to collect benefits until age 70, then it would take 150 months (12½ years, or until age 82½) to reach the breakeven point (not considering the time value of money) between collecting benefits beginning at full retirement age or waiting until a person turns age 70. 

Therefore, at age 82½, a person’s accrued additional payments for waiting until age 70 to start drawing benefits is exactly equal to the first four years of total payments received by a person who begins collecting at age 66.  By this illustration, it appears that if you live beyond age 82½, you would be better off starting retirement benefits at age 70.   

In my opinion, there is an excellent alternative that many of our clients are taking advantage of today and that warrants your consideration.  If you save 100% of your Social Security retirement benefits from age 66 through age 70 while you are still working or have other forms of retirement income and earn 5% per annum, you would have an accumulated balance at age 70 of $124,891 ($2,346 x 48 months = $112,608 + $12,283 interest).  Then, at age 70, if you start withdrawing the $750 difference from this account on a monthly basis but still earn 5% on the remaining balance, it would take 23½ years to get to the breakeven level using the age 70 monthly benefit amount.  With this method, if you were to die early, then you would still have a nest egg to pass on to your beneficiaries. 

As you can see, by using this method you could live to age 93½ (11 years longer) before it would have been better to wait until age 70 to start drawing Social Security retirement rather than starting benefits at full retirement age.  While we hope all of our clients live at least that long, it’s highly likely that many will not.

In short, if you properly invest your Social Security benefits, we believe you are always better off starting them at full retirement age rather than at age 70.  However, if you intend to spend all of your benefits as they are received, you would be better off waiting until you are age 70 to start drawing your retirement benefits.

Jane, I hope my explanation above has given you some understanding of when and how we suggest individuals start drawing Social Security retirement benefits.  It’s always best to thoroughly evaluate your particular situation to determine the best way to maximize your own benefits, and in that regard, Rollins Financial is here to help.  Navigating Social Security benefit options can be tricky, but we can help you make the best decisions to positively impact your retirement years. 

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.
Best regards,
Joe Rollins