May 17, 2023:
In this article we’ll discuss a new financial planning/portfolio tool we’ve added to our arsenal, as well as sharing our current thoughts on I bonds, the problems in the banking system, and the general market outlook.
A next-generation tool to build better financial plans
Old-time PGA golfer, Doug Sanders, once joked about his financial state of affairs:
“I’m working as hard as I can to get my life and my cash to run out at the same time. If I can just die after lunch on Tuesday, everything will be perfect.”
Part of our job is to help our clients plan so that they can enjoy a long retirement and not run out of money. To that end, we need to remove the mystery regarding retirement as much as possible.
To aid us in that endeavor, we employ a great financial planning software system that we’ve used with many of you over the years. We’re excited about having added a recently released technology that works in conjunction with our existing systems to increase the probability of retirement success. It does this by optimizing portfolio construction based on both expected returns for different asset classes and the individual’s unique circumstances. The portfolios incorporate personalized glidepaths (systematic reductions in volatility over time) that are based on each client’s goals, expected future cash-flow needs, age, and market conditions. These state of the art systems improve upon the previous technologies’ ability to predict the likelihood of retirement success, and also help us to maximize the chance of getting there.
To give you a better feel for what this looks like, below is an example of a glidepath for a 50 year old, planning to retire at 65 who can tolerate a moderately aggressive level of volatility. As a reference point, the light blue area is the exposure to stock at various points along the way.
Importantly, as markets change over time, the asset classes that comprise the various shaded categories change because not all stocks are created equal at any given moment in time. We spend a lot of time deciding what areas of the stock markets to fill that blue part of the portfolio up with. There are many categories of stocks and usually some are priced to deliver much higher returns than others and some with low expected returns and high risk that it makes sense to avoid. The same goes for the non-stock categories. A focus on valuations and a diversified allocation to attractively valued areas is a way that we believe we can put the odds in our favor.
Furthermore, the glidepath itself is dynamic in the sense that the sizes of each category at a given point in time will be adjusted up or down based on market valuations (e.g. more stock when stocks are cheap and less when they’re expensive), as well as whether the investment goals have changed in the meantime.
Lastly, the glidepath is sensitive to any changes to a client’s situation such as goals, risk tolerance, age, and cash flows. All of these things work together to increase the odds that our clients own the portfolio best suited to their needs, wants, and circumstances, reducing the chance of not having sufficient funds when they are needed. We’re already using this tool to develop our portfolios and we’re working on scaling it for more individualization.
I bond update
In the beginning of last year, we recommended I bonds. These are government issued bonds with a rate that is based on inflation and fixed for 6 months at a time. At the time, they were yielding over 6% during a time when the best banks and money markets were still only in the 1-2% range. The I bond rate proceeded to rise to over 9%, then fall back to 6.8%, and has just adjusted down to the current 4.3%. This is a good thing as it’s a sign that inflation has moderated. At this point, we are recommending that you hold on to your I bonds, but not purchase any new ones. 4.3% is a fine yield at this point on a safe, liquid investment that is also state tax free. We’ll reassess later in the year as we see how inflation affects the next rate adjustment. (1)
Banking system stress: not good, but not 2008 either
In our last article, we noted that 2022 was the worst calendar year for the US bond market in over 200 years, with longer-term US Government bonds down roughly 25% for the year. The recent stress in the banking system, including multiple outright bank failures, are the direct result of that steep decline in bond prices.
The basic dynamic is that, back when rates were very low, banks were sitting on a lot of cash without enough borrowers to lend it all to. Instead of accepting the next-to-nothing yields available on cash and short-term bonds, they bought longer-term bonds with that excess cash, hoping to benefit from the higher yields that the long-term bonds offered. But there was risk in that decision as longer-term bonds lose value if interest rates rise, and rise they did. Things then went very wrong when the banks needed to come up with enough money to meet heightened customer demands for their cash. Banks were looking at having to sell positions at a big loss to raise the necessary funds and they soon realized that there wouldn’t be enough capital to meet customer requests.
The scale of this problem was, and remains, big: “U.S. banks had $620 billion in unrealized losses on securities at the end of 2022, according to the FDIC. A March study from professors at New York University and Wharton estimated that their unrealized losses are closer to $1.7 trillion when accounting for all loans and securities.” (2)
At present, the Federal Reserve, the government, and other banks are trying to manage the situation without it resulting in too much damage to the financial system and the broad economy, and without any support creating too much bailout moral hazard, debt, or inflation.
We have observed that when some people hear “bank failures” or “banking problems,” they reflexively assume it might be like the 2008 Global Financial Crisis (GFC), but the current situation is very different. Back in the GFC, loans/bonds went bad — they were never going to be paid back as a lot of the loans were home loans, given to borrowers that didn’t declare income, didn’t need to pay interest, had adjustable rates, lost their jobs, all while the houses backing the loans were falling 30-40% in value. Bailing out those lenders was very controversial. This time though, the loans/bonds are good — they will be paid back because the borrower is, for the most part, the US Government. The problem is that the current price has them temporarily worth less than the banks paid for them in many cases. It is a problem of timing, not of solvency.
It’s still difficult and complicated, but the government, Federal Reserve, and other banks so far seem willing to do enough to keep things together and depositors are ok so far. But there are risks to the economy since these regional banks will be less willing and able to lend out money for a while and that will not be good for the businesses that would otherwise be borrowing from those banks.
Summing it up: the issues in the banking sector, while significant, seem very unlikely to lead to a 2008-style bank solvency crisis. However, the resulting decline in lending growth could be a fairly serious economic headwind.
Market outlook
Our market view hasn’t changed a lot since our last article. We recognize several near term risks (e.g. aggressive Fed tightening, the still-not-deflated US growth bubble, and now banking system stress and the debt ceiling standoff). At the same time, several areas of the global markets have gotten so cheap that we expect unusually high returns from them in the years ahead.
We think valuation-based expected returns are a much more reliable guide than short term predictions about the markets and economy, so we are taking the opportunity to invest at great prices. However, we try to mitigate the risks in the following ways:
- heavily tilting towards the best-valued areas of markets (which reduces the risk of long-term loss, though it may or may not help with short term panics)
- avoiding the really expensive investments which are especially vulnerable to long-term loss
- employing alternative strategies that are uncorrelated with traditional markets and stand to benefit should growth stocks resume their relative decline
- leaving some dry powder to use in case of another leg down in markets
Also worth noting: international stocks have continued to outperform US stocks since late last year, so in addition to the tailwind provided by the huge valuation differential, we’ve got momentum on our side now as well. If the tide really has turned on that relationship, this trend could have a very long way to go.
1 – Rates and other I bond info available at Treasury Direct
2 – Source: thehill.com