When you ask someone what is the opposite of “in,” they automatically say “out.” But when you ask them “What’s the opposite of income?”, some might immediately start to say “outcome”, but that’s never their final guess.
Such are the vagaries of the English language.
Interestingly, in a broad sense, “income” and “outcome” are actually somewhat similar. “Income” is an “outcome” of an investment in bond funds or other fixed income investments.
Investors often separate themselves into income investors and stock investors. The former characterize themselves that way because income is what they seek.
One of the major dilemmas presently is that it is hard to exist on the traditional, “safe,” sources of income investing – bonds and bond funds. Interest rates are low. We live in what is being termed a zero interest rate environment.
Overseas we even see negative rates on some nations’ treasury bonds. Did you ever think investors would pay for the right to save?
Rates have fallen so low that many commentators have started to realize a sobering fact. While it is great to see the nation’s economy rise as the Federal Reserve follows its zero rate policy, in large part the recovery and certainly this policy has been built on the back of pensioners and others traditionally living off of their interest income.
Many media commentators have expressed concerns over whether these historical income investors can find the income they need from their traditional sources – bond funds, savings accounts, treasury bonds and bills, and certificates of deposit. For most, the answer is “no.”
Financial planners have also been worried. There once was a time when a 5% portfolio payout was assumed for income planning purposes. Then it fell to 4%. Now there is talk that, too, is too high. Maybe, say some, the target should be 2%!
Since I started Flexible Plan Investments, Ltd. back in 1981, I have suggested that what income investors should be focusing on is outcome, not income. That means that the total return of their portfolio should be their focus. After all, it is the sum of their income and their gain that is the true outcome of their investments.
By focusing on total return – the outcome – a greater amount of dollars becomes available to satisfy the cost of their standard of living. Instead of one source, income, there are two sources – income and gains – to meet their needs.
This leads one to an understanding that it is not income from one’s portfolio, but instead its potential cash flow that should be important to the “income” investor.
During the past 30 years, this realization did not need to take the would-be income investor into another world of investment choices. We have been in a bond market rally of historic proportion for over 30 years now. Often the gains from rising bond prices have offset declines in rates. The outcome was a total return that was not falling.
Wise financial planners realized this and installed systematic withdrawal plans (trust companies can pay out a fixed dollar or percentage amount to their account holders once or twice a month) for their clients that, rather than extracting just the income from the account, also took some of the gains. In this way their clients’ standard of living could be maintained, especially as long as inflation remained moderate, as it has in recent years.
The alternative to this approach has been to take on more risk. Investors have sought higher income in higher rate instruments. But with those higher rates came much more risk. Longer maturities have meant more interest rate risk. Lower quality bonds (corporate and junk instead of Treasuries, for example) have meant more credit risk. Moves into specialty investments, like energy MLP and REITs, probably involve increased risk of both varieties.
In contrast, with the systematic withdrawal approach, income investors have been able to maintain their desired limited risk and their cash flow. This, however, may be about to change.
With interest rates rising, the gain portion of the portfolio is likely to turn into losses. Remember, when interest rates go up, bond prices go down.
This may be mitigated to some extent for those investors with laddered portfolios in individual bonds that can be held to maturity, but it is actually a frightening possibility for those investors solely invested in bond funds, since they never “mature.” Past periods of rising rates have led to downturns in bond funds that rivaled bear markets in stocks!
Even the holders of laddered individual bonds may not be completely safe in the times that are coming. Inflation, which has been practically non-existent, is showing some signs of perhaps awakening. This means that the purchasing power of the dollars committed to the bonds each year in these portfolios will be declining (along with their price if the investor has need of the funds before they mature).
Source: Bespoke Investment Group
Because the bond rally is nearing an end, bond investors need to consider expanding the type of investments that they will use in their portfolio. For example, for some time now the S&P has yielded more than ten-year Treasury bonds. Convertible bonds can pay out higher yield and participate in stock market rallies. Funds specializing in quality, low volatility, dividend-yielding stocks exist, as well.
So a systematic withdrawal plan with one’s portfolio that includes these instruments can avoid bond selloffs, participate in stock rallies, and keep up with inflation. And the after-inflation cash flow to investors can be maintained.
But what about stock market volatility. Aren’t we presently in the third longest bull market in stock market history? Won’t that be coming to an end soon and doesn’t that mean losses to come from stocks as well?
That’s where dynamic risk management of portfolios (whether income, alternative, or equity) comes into the picture. By actively monitoring not only the returns but also the risk of the portfolios, the goal is to reduce that volatility and risk. That’s what Flexible Plan was formed to do over 30 years ago.
We seek to make the returns of a portfolio more stable (less subject to fluctuation), regardless of market environment, to enable a systematic withdrawal plan applied to these mixed portfolios of stocks and bonds to maintain inflation protected cash flow and survive for a longer time than traditional income solutions. And we seek to do this with no-load mutual funds!
The outcome can be more income in the form of total return and cash flow.
Speaking of income and higher rates, we have certainly seen quite a bit of volatility in yields and the resulting prices of bonds this year. And we may be poised for a breakout of yields to even higher levels, as is evident from the return to the early-March highs in yields demonstrated by the chart.
Source: Bespoke Investment Group
However, the early stages of interest rate rallies are often not bad for stocks. And it is my belief that the Fed rate hike will be delayed further and that, regardless, the immediate level to which rates are likely to rise is still historically low and will not be a drag on the economy. Still, it’s true that Fed action to lower interest rates was fuel for the stock market rally and that will no longer be there for us in the future.
Adding to that worry is the current earnings reporting season. As it draws to a close (ending May 19th with the Walmart report), it is apparent that while earnings were not terrible (with about 60% of companies reporting so far beating expectation – down but not overly so), revenue reports are not nearly as good, with only about 50% of the firms beating expectations, the third lowest level since the financial crisis.
Source: Bespoke Investment Group
Similarly, economic reports continue to concern. Most observers had felt that the steady drumbeat of disappointing economic reports experienced in the first quarter were weather related. While I have cast doubt on this theory in the past as it relates to meeting or surpassing forecasts made when the weather was already occurring, it does not make me feel any better to review the reports that came in in April – after the “bad weather” was over.
In April, of the 34 reports announced, only 61% exceeded economists’ expectations, while 32% failed to meet them. And last week, the trend continued. Of the 21 reports, 9 failed to meet expectations and only 6 exceeded!
Finally, offsetting each other are seasonality and sentiment. Seasonality has turned sharply lower until near month’s end. While the expressed sentiment of investors in the AAII survey continues to eschew bullish rhetoric, we are now at bullish sentiment levels not seen since April 2013. This is normally positive for the short- and intermediate-term trend.
As usual, it seems, the tiebreaker is the primary trend of stock prices. This continues higher by almost all time measures. After all, we are within 2% of the all-time high set just weeks ago. Still, for most of this year we have been in a tight 6.3% price range and returns have been flat.
Of concern short term is that Friday’s jump on the employment data created a ”gap” that stock prices often return to fill and shifted us back to overbought territory. This could lead us to a dip yet this month, but as of now it appears to be nothing worse than the 5%-10% variety, if it comes at all. The primary trend remains up.
That’s the ins and outs of the stock and bond market this week. May your “outcomes” continue to exceed your “incomes”!
