I am writing this on Friday, December 8, 2017.  The Department of Labor released its monthly jobs report earlier today.  There is a lot of good news on the employment/unemployment side but perplexing news on wages.

The good news:

• Unemployment is way down to 4.1%, which is at least a 17 year low.
• Employment is up, as the economy added 228,000 jobs in November.

The perplexing news:

• Labor force participation rate remains low, at 60.2%.  It was 63.4% in 2007, prior to the financial crisis.  If you think about that 3.2% difference times the size of the American workforce, that’s a lot of workers who aren’t working for one reason or another.
• Wages are up, but only by 2.5%.

The sources for my data are articles in the Wall Street Journal, linked here as follows:

https://www.wsj.com/articles/jobs-strong-but-weak-wage-growth-could-fluster-fed-1512754002

https://www.wsj.com/articles/the-incredible-shrinking-workforce-1512692004

https://www.wsj.com/articles/u-s-employers-hire-at-healthy-rate-in-november-1512739921

Why is this news perplexing?  Because if the unemployment rate is that low and the economy is really adding that many jobs, one would think wages would go up and more people would want to work.  Supply and demand laws – if demand for workers goes up more than supply, then the price should go up.  But it’s not – at least not that much.  What gives?

Why?

There are several reasons that I believe may contribute to the low labor participation rates and depressed gain in wages:

• Demographics:  The percentage of workers and of the general population that are older is rising.  The Baby Boomer generation is retiring in droves as they reach their 60’s and even their 70’s.  There aren’t enough younger workers to replace the Boomers.
• Corporate mergers and downsizing:  If an older worker is a victim of layoffs through poor corporate performance or due to a merger with another company, “made redundant” in British parlance, the older worker is more likely to “take a package” from the former employer and say Sayanora to working again.  Hopefully, they had a good financial planner to guide them through what they need to maintain a decent lifestyle for the rest of their lives, which could be a long time.
• Work is difficult:  Work is a 4-letter word for a reason.  If one has the wherewithal to avoid working, one may very well choose to do so.
• Plateauing of personal preferences:  For a lot of people, I believe there is a desire for a basic level of lifestyle, and the money required to pay for that lifestyle.  Above that, if one has to work very had for the marginal gains in one’s lifestyle, many people decide it’s not worth the marginal work.  Especially if that person is older.  “I have all I need to live well.  Why should I bust my butt for something I don’t really need at this point in my life?”
• International labor competition:  Like it or not, we are in a global economy.  If you like to shop at Wal-Mart, where do you think all of that stuff comes from?  Most likely other countries.  Not the USA.  Except maybe for the food.  Those other countries do not pay their workers like we do here.  That’s who American companies and American workers have to compete with.  The global economy keeps US wages low and it will continue to do so.
• Disincentives for smaller businesses:  Licensing and regulation hinder new businesses from forming and from growing.  Continuing compliance with these regulations is expensive for businesses.  For instance, in the financial services and banking industry, many smaller banks have opted to merge rather than to continue to pay for compliance with greater regulations.  Fewer smaller banks mean fewer options for small businesses to grow.  All of this keeps wages low.
• Housing underperformance:  Housing and other construction is one area where employment typically grows during a period of economic growth.  Yet, since the housing crisis of 2007-2008, growth has been there, but proportionally much less than in previous recoveries.  Housing prices are strong and resale housing inventory is very low, but new housing construction is not robust enough to fill the gap.  Much new housing construction caters to the upper-middle and upper end of the market.  There are not nearly enough new housing being built for entry-level and working-class buyers in areas where there has been job growth.  Costs and fees are so high that lower-end new housing doesn’t pencil for builders or investors.  Consequently, employment in construction is not as high as it should be and wages therein are kept lower than they should be given 4.1% unemployment.

There are probably other causes for this low unemployment/low wage growth situation that we currently have.  We need to figure out how to increase wages.  I believe in reducing the costs and the regulations that are hindrances to economic growth.  Others believe in raising the minimum wage and increasing oversight of how workers get paid.  I always believe that less government is the answer, but there are and will be cities and states that will address the problem differently.

Hopefully, you have a 401k or a similar retirement plan.  Or, maybe you manage your own IRA. Typically, when you look at how to invest that money, you look Morningstar or a similar service and you decide among various mutual funds.  Morningstar classifies equity (i.e., stock) funds as either Value or Growth (or a blend of the two).  They also use Small Cap and Large Cap, but that’s not part of my point.

If you have tried to diversify your equity funds, perhaps you have put some of your money into Growth funds and some of your money into Value funds.  Over the past year, if you have allocated thus, you have probably noticed that your Growth funds have gone up more than have your Value funds.

Growth Rules

According to a recent Wall Street Journal article, growth stocks have outperformed value stocks by 19% this year alone.  Here is the link to the article:

https://www.wsj.com/articles/investors-finding-little-value-in-value-stocks-so-watch-for-the-rebound-1511804545

I believe there are several reasons why growth stocks have outperformed.  Some are mentioned in the WSJ article, and some are not.  Here are my thoughts:

• It is difficult to find “value” when the indexes are trading at all-time highs, as they are as I write this blog.  “Value” implies that an asset is undervalued, and undervalued assets are harder to find if everything is up.
• The markets haven’t had a major correction for almost 10 years.  It is during and coming out the other side of corrections when one finds the best value investing opportunities.
• Interest rates are low, so TINA – there is no alternative to investing in stocks.
• The Tech sector has been particularly on fire and tech is not a sector one looks at to find value, typically.
• Value stocks are usually found in more mature industries or sectors.  New technologies and new entrants to the marketplace are forcing out more mature players.  The best example is Amazon and online retailing wreaking havoc on the traditional retail sector.
• Index investing is particularly harmful to value investors.  Value investing is rooted in the superior analysis of individual businesses and learning something about an individual business that the rest of the market is unaware of.  Index investing is the antithesis of that type of thorough analysis.  As more and more money flows toward index investing and away from the traditional search for undervalued assets, the values of the assets which make up the indexes get inflated to the detriment of the value assets.

Value Opportunity?

If Growth has outperformed and Value has been left in the dust, does that mean Value is dead?  Or does it mean that there are opportunities to find undervalued opportunities?  I don’t know, but it is something to keep your eye on.  If you believe in Mean Reversion – that Growth and Value stocks will trade within a certain range of one another, and that the past year has been an anomaly and that the historic range will return – then possibly Growth and Value stocks will start again to trade in tandem.  But does that mean that the 19% of over-performance by Growth over the past year will be rectified?  Again, I don’t know, but I would look to the future rather than the past.

Catalyst

If Growth and Value stocks are to return to historical proportions, then I would say there will need to be a catalyst to make that happen.  In other words, one or several of the reasons why Growth has outperformed over the past year will need to change.  Do you believe any of the bullet-point reasons I outline above will change in the near future?  They very well may, particularly if something on the outside changes – perhaps a geopolitical catastrophe, or another disruptive tech phase, or an investing bubble exposed.  The stock market has always corrected in the past.  Could this time be different?  Unlikely, but we will see what form any correction takes, and how deep it is.

IMO

I am not recommending that you reallocate some of your Growth funds over to Value funds because Value is undervalued.  I am simply pointing out a phenomenon in the stock market over the past year and providing my take on why this has occurred.  Remain vigilant.

It’s the Christmas Shopping Season and we are all looking forward to the Battle of the Heavyweights.  No, I am not referring to boxing, the sport.  I am referring to Big Box vs. Online.  Big Box is WalMart, and Online is dominated by Amazon.com.  Like McGregor vs. Mayweather earlier this year, wherein MMA-fighter McGregor agreed to a boxing match against boxer Mayweather for big money, WalMart vs. Amazon will be played out in the milieu of online retailing, which is Amazon’s forte.  Upstart Walmart (can any firm as huge as WalMart be considered an upstart?) has beefed up its online presence.  WalMart is now offering different pricing for the same products online vs. in the store.

WalMart Advantages

I believe WalMart can gain market share in online retailing because I believe they have some advantages over Amazon:

1. WalMart has more proprietary products that are sold directly by WalMart or WalMart.com.  Think of Amazon as a website middleman wherein you can purchase products offered by other, independent producers or retailers.  Often, on Amazon, you are not purchasing an Amazon product.  WalMart.com has some of that as well, but mostly you are purchasing directly from WalMart.  You can also limit your product search to WalMart-only products.
2. Speaking of Search, I believe WalMart’s search and product screener is superior in some ways to that of Amazon.  In Amazon, of course, you can type in the product that you are looking for and you can go right to that product.  In WalMart.com, you screen down to the product that you are looking for, and you can view a number of options within that product.  I believe WalMart’s screener allows you to view a greater number of options from which to make a purchase decision.
3. I believe WalMart’s website is more user-friendly and easier on the eyes than that of Amazon.  Amazon’s website can be information overload, thereby making it difficult to make a decision.  WalMart’s is more orderly, in my opinion.
4. WalMart has a greater inventory and selection of some products, less of others, than Amazon.  I’m not a retail expert, so I don’t know which product lines favor WalMart, but some do, and this is an advantage for them.  Amazon’s inventory selection sometimes gets thin.

Amazon Advantages

1. Amazon Prime.  WalMart doesn’t have anything like it.  Shipping costs can quickly eat up any savings you might have on a particular product.  Currently, WalMart offers free shipping on some products, or if you spend more than a certain amount (when I checked today it was $35, which isn’t a high hurdle).  But, Amazon Prime and its shipping and other product benefits are a big Amazon advantage and one that will foster customer loyalty for Amazon.
2. Shipping:  Time will tell if and how WalMart can match Amazon with regard to the various shipping costs and options offered by Amazon.  Amazon even has the US Postal Service working on Sundays!
3. Amazon is an organizational and logistic miracle.  I don’t know how Amazon gets it all done and on time, especially working with third-party shippers such as the USPS and UPS, in addition to working with the third-party retailers who sell through Amazon.com.  Kudos to them and all they do.

IMO

I am not advocating purchasing WalMart stock, Amazon stock, or in pair-trading one against the other.  I do believe WalMart has some advantages over Amazon, and that if WalMart can match or come close to Amazon regarding shipping, I think WalMart can gain market share.  We will see how this plays out over this Christmas shopping season.  This is something to keep an eye on when sales and earnings results come out during the First Quarter of 2018.

The end of the calendar year or the beginning of next calendar year is a good time to review your account balances in your retirement savings accounts (IRA, 401K, and the like).  This post serves as a reminder:  Don’t neglect this year to do this.   You should every year.  Many people don’t.  If you don’t, you are shooting yourself in the foot.  Also, don’t use no double negatives.

% Allocations

If you have a 401K plan, you probably had an idea of how you allocated your money when you opened the plan.  Your employer’s plan probably had several investment options – mutual funds in different categories.  Maybe a Large Cap US Growth Fund, a Small Cap Fund, a Bond Fund, an International Fund, and maybe several others.  You likely opened your account and said something like “I will put 25% each in 4 different funds in 4 different categories.”  That is a typical, sound investment decision.

If you have an IRA instead of a 401K, you probably started small and only bought 1 or 2 positions and didn’t diversify.  That’s ok when you are younger, but as you get older, if you are still contributing to that IRA, you need to diversify and you need to think about a percentage allocation into broader categories, using mutual funds or ETFs.

Proust

French author Marcel Proust wrote, “In Search of Lost Time”.  Scottish singer Al Stewart sang “Time Passages”.  Both are about the passage of time.  What else happens as time passes?  Correct:  Your account balances change.  Hopefully, they grow.  What won’t happen is that your positions won’t change in the same proportions.  Again, don’t use no double negatives.  If you were 50% stocks and 50% bonds a year ago now, you aren’t 50/50 now; you are probably something like 60/40 stocks because your stocks portfolio grew more than did your bonds.  What should you do now?  First of all, realize you are in this position.  Second of all, look at re-allocating your portfolio.

Two Methods

You can reallocate by one of two ways:  You can sell stocks (or whichever account is now above your goal percentage), and use that money to buy the category that is under your goal percentage.  That way you can reallocate immediately.  Alternatively, you can leave the current balance alone, but put more new contributions into the under-allocated position until you are back in line.  That way you don’t sell any of the over-allocated position, the one that outperformed, and it will take more time to get your overall portfolio back in line.

Sell High, Buy Low

Investors are sometimes reluctant to reallocate their retirement portfolios back to their stated allocation percentages because, at the heart of it, reallocation involves selling a better-performing asset to buy more of a lower-performing asset.  That’s a hard mental bridge to cross.  Reallocation is based on the underlying premise of mean-reversion:  Asset classes that outperform during a short time period (such as a year) will underperform during some future time period.  By reallocating now, you are betting that the mean reversion will occur over the next year.

Get Rich vs. Don’t Lose

This is not to say, for instance, that you think bonds will outperform stocks, with both going up.  Instead, reallocation from stocks into bonds is a downside-protection play.  Stocks have outperformed bonds over the long period, but stocks are more volatile, with some rotten years mixed in with some excellent years.  Bonds are more steady and have at times (but not always) negatively correlated to stocks, meaning bonds go up when stocks go down.  Thus, when you reallocate from stocks to bonds, you are trying to keep from losing, rather than trying to win more.  Sounds maybe like a country music lyric.

IMO

Plug for my services as a financial planner:  There are several theories out there on how and when to reallocate.  Strategic allocation bands are one of the theories.  Also, how often should you look to reallocate, or simply monitor the portfolio to see if you should reallocate?  There are several theories out there on this as well.  It is all good intellectual fodder.  However, the point with this posting is that you should not forget to look at your 401K or IRA or other retirement portfolio and reallocate it to your original percentage allocation or to your new percentage allocation based on the changes in your current life circumstances.  I can help with any of these issues.  It is always good to have an educated, experienced third party opinion.

Typically I don’t like to opine on things until they become facts.  However, it looks like the new tax code starting in 2018 will involve at least some limitation (if not total elimination) of the Federal exemption for State and Local Taxes (SALT).  If this comes to pass, I think it will accelerate the migration of wealth from high-tax states to low-tax states.  Furthermore, I think the hardest-hit states will be the Northeast and Illinois, and the greatest beneficiary will be Florida, which has no state income tax.  Texas will also benefit because it is a huge jobs engine, but the aging Northeast population will migrate to Florida.  California will also be hurt, but at least California has nice weather.  Someone living in the Northeast (New York, New Jersey, and Connecticut primarily) who has to live through the hot, humid Summers and the cold, snowy, slushy Winters, and now has to pay an extra 10%-15% to the government will be more motivated to pack up and move South, to warmer weather and lower taxes.

The Great Progressive Tax Escape

On November 13, 2017, the Wall Street Journal published an op-ed titled “The Great Progressive Tax Escape.”  Here is a link to it:

https://www.wsj.com/articles/the-great-progressive-tax-escape-1510614707

The article researched changes in Adjusted Gross Income (AGI) from tax returns filed in New Jersey, Connecticut, Illinois, and Florida from 2012 to 2015.  Analyzing changes in AGI is a good way to filter how wealthy people migrate.  As you may have surmised, the article showed that AGI is already declining in the high tax states (NJ, CT, and IL), and increasing in the zero tax state (FL).   To me, this proves that people, and wealthy people, in particular, do actually adjust their behavior and pick up and move because of already-high taxes.  Keep in mind the SALT deduction was still in effect for 2012 to 2015.  Just think what the Delta AGI will be like if the SALT deduction is taken away!  The Southbound lanes of I-95 could be very crowded.

That people are moving to Florida in droves is not exactly headline news – it has been happening for many years.  People like to live in a warmer place.  However, what is a new development is the increasing level of state and local taxes.  This includes property taxes, which typically fund schools and Medicare.  As the population has declined, especially in rural areas in high tax states, property taxes have ballooned.  More tax revenue is needed from the remaining population to pay for the increasing school and Medicare costs.  Some of the states with the highest income taxes also have among the highest property tax rates.

Update:  Check out this recent Bloomberg article that addresses certain hedge funds moving to Florida:  https://www.bloomberg.com/news/articles/2017-11-27/in-greenwich-and-manhattan-tax-hike-fears-fuel-talk-of-exodus

How Do I Profit?

The most direct way to profit from this upcoming trend (if you agree with me) is to move there yourself if you are now living in a high tax state.  Just by moving there, and assuming you keep a job that pays the same (I know, big If), you have given yourself a raise equivalent to the State taxes you used to pay.  Next, buy a home or condo in Florida; it is likely to appreciate, all things being equal.  Worried that Global Warming will flood the coasts?  Buy a home inland, in a place like Orlando.  Your kids and grandkids will love living near Disneyworld.  St. Joe (NYSE: JOE) is a publicly-traded landowner and homebuilder in Florida, but its stock has not done great over the past year, so I don’t believe it is your best Florida pure play.  Next Era Energy (NYSE: NEE) is a Florida utility that has a $73 Billion market cap and has done very well – up about 38% in the last 12 months and paying about a 2.5% dividend.

IMO

The prognosis is not good for high tax states.  I believe the exodus from high tax to low tax states will accelerate if the SALT deduction is limited or eliminated.  I am not necessarily advocating changing your investment portfolio as a result.  I am only pointing this out as a trend that I think will play out over the next several years.

My November 21 post titled “Open Enrollment” suggested that you Go for the Bronze, meaning that you should strongly consider a Bronze health care plan with an HSA over a Silver or Gold plan.  My main reason was the availability of the HSA.  I want to expand on the HSA and its benefits in today’s post.

Health Savings Accounts

HSA stands for Health Savings Accounts.  You must be enrolled in a Bronze plan that is HSA-eligible in order to contribute to an HSA.  (I like that it is “an” HSA but “a” Health Savings Account.  Same consonant – H – but a different article.  Makes learning English difficult.)  Your employer will tell you if your health insurance plan is HSA-eligible.  If you get your health plan from the Exchange website, the website will tell you if a plan is HSA-eligible.  If your employer or the Exchange don’t tell you that a health plan is HSA-eligible, it isn’t.

The following are the limits of how much you can contribute in 2018:

• Self only:  $3,450
• Family Total:  $6,900
• Catch-Up Per Person If Over Age 55:  $1,000

Tax Advantages

There are 3 ways that an HSA is tax-advantaged:

1. You contribute to the HSA account with pre-tax money, so you don’t pay taxes on the money you contribute to the HSA.
2. Any growth that the HSA account generates while the money sits in the HSA is tax-deferred.
3. If you withdraw the money in the HSA account and use it to pay for qualified medical bills, you don’t pay ordinary income or other tax on the withdrawal.

Therefore, an HSA is even better than an IRA or 401K.  With a regular IRA or 401K (i.e., not a Roth), you pay ordinary income taxes on withdrawals from those accounts, no matter what you spend the withdrawals on.  With an HSA, if you use the money for medical expenses, the withdrawal is not considered ordinary income.  You have to keep track of what you spend the money on, but that is a worthwhile endeavor if you save money on taxes.

Save for Future Medical Bills

HSA’s are not “use it or lose it”.  Unused balances in HSA accounts can be rolled over to be used for future years’ medical expenses.  Think very far in the future.  Think of an HSA as a way to save tax-free and tax-deferred for your medical expenses that you probably will incur when you are older.  When you hit Age 65 and go on Medicare, you will probably want to purchase a Medicare Advantage plan.  Advantage plans effectively provide a cap on what your out of pocket medical expenses will be as an older person, but such plans can be expensive.  This is when you are probably retired and not making as much money.  So, it is highly advantageous to save when you are working to pay for your medical expenses when you are older.  Use your unused HSA account balances to pay for your Advantage plan premiums.

Tax Bracket Play

Depending on your current and projected future tax brackets, another play to consider is to forego using HSA balances to pay for current medical expenses in order to save the HSA balance to pay for future medical expenses.  This strategy works if you have enough money now to cover your current medical expenses, and/or if you don’t go to the doctor often now so you don’t incur a lot of current medical expenses.  Contributing to and holding the HSA now may not help you that much in your current tax bracket, but it may really help you in the future to have the tax-free income to pay for your medical expenses when you are older.  Also, if you have contributed money to a tax-advantaged account such as an HSA, you realize the benefit more if you leave the money in the tax-advantaged account.  The account can grow over time without paying taxes so that you will have all that much more available when you are older to pay your medical bills.  If money is currently tight for you and you need to use your current year HSA contributions to pay for your current year medical bills, then so be it.  But, you should consider covering your current medical bills with other funds, if you have them available to you, and let the HSA grow tax-deferred.

IMO

These are just ideas for you to consider as you enroll for 2018 Benefits.  I believe HSA’s have a lot of advantages and you should look at how to use them if your situation permits it.

November is typically Open Enrollment month for next year’s health insurance.  This is both through your employer or now through the Exchanges if you are not covered by an employer’s plan.

Options

The types of plan options that you have are pretty standardized throughout the country.  You have HMOs and PPOs.  Most of you probably know the difference, but if you don’t, the difference is basically this:  An HMO is less expensive, but you need your primary care doctor’s referral to go to see a specialist, and a PPO is more expensive but you don’t need the referral to see a specialist.

The Olympic Medals

Within these plan options, there are further options that are named the same as the Olympic medals:  Gold, Silver, and Bronze.  There is also a Platinum option, which the Olympics don’t have, but which is a higher, more expensive level of coverage than the Gold.  The following is a link to the Health Benefits Table from Covered California, which is the California health care exchange website.  The table shows what is covered and what the costs are among the various Gold, Silver, and Bronze (and Platinum) plans:

https://www.coveredca.com/PDFs/2018-Health-Benefits-table.pdf

Go For Bronze!

Unlike the Olympics goal (Go for Gold!), today I am encouraging you to Go For Bronze.  That is, I believe the Bronze plans may be the best option for a lot of people out there.  This is especially true if the following are true:

• You are younger and/or you don’t go to the doctor very often and you aren’t on expensive medications.
• You want a plan that will cover catastrophic issues (hospital stays and the like) but you aren’t as concerned about standard doctor visits.
• You want to save money.
• Your company actually offers a Bronze-level plan.  Some companies don’t.
• The Bronze plan opportunity allows you also to invest in a Health Savings Account, or HSA.  You can only put money into an HSA if you have what the IRS considers to be a “high deductible” plan.  Your employer will know if a Bronze plan is HSA-eligible (some Bronze plans are not).  If you are on the Exchange (Covered California and the like), you can check a box to show only Bronze HSA-eligible plans.
• Your company may even offer to fund or match-fund part of your HSA.  This would really make the Bronze plan appealing.

HSA vs. FSA

To review, a Health Savings Account is different than a Flexible Spending Account (FSA).  An FSA is actually a salary reduction up to a maximum of $2,650 per family in 2018.  You then incur a qualified medical expense and you submit to your FSA for reimbursement.  Effectively you pay for the qualified medical expenses with pre-tax money.  An FSA is use-it-or-lose-it, meaning if you don’t incur and submit the amount you have withheld in your FSA, you lose it – you can’t carry it over to future years.

An HSA is different.  With an HSA, you earn the salary, but before you pay tax on it, you deposit it into a tax-deferred account.  Since you earn the money, it’s yours, and you can save it and carry it over to future years if you don’t use it during the current year.  There is no time limit – you can carry it over for as many years as you would like.  This is an excellent way to save for future Medicare Advantage premiums – save as much as you can in an HSA when you are making good money, but don’t spend all of your HSA every year.  Then you will have money saved to pay your Advantage premiums pre-tax.  Great deal!

HSAs also have higher limits than FSAs.  The maximum HSA contribution for a family in 2018 is $6,900, plus a “catch-up” contribution of $1,000 per person age 55 and over.

IMO

If you are currently healthy, don’t go to the doctor that much and/or aren’t on expensive medications (most generics aren’t expensive), and you have an opportunity to open an HSA, I strongly encourage you to look closely and consider the Bronze-level plan during Open Enrollment.  I understand everyone is different and their health situation is unique, but, in general, Bronze plans offer good coverage for less money, with the added kicker of a potential HSA account.

President Trump on November 2, 2017, nominated Jerome Powell to succeed Janet Yellen as Chairman of the Federal Reserve Bank.  The consensus in the media and among economic pooh-bahs is that Mr. Powell will “stay the course” – keep going with the same programs and strategies the Fed has employed over the past several years.  Also, Mr. Powell is a consensus-builder, and as such will work within the Fed Board of Governors to make sure there is unity among the Governors as to what course to take.  Maybe we need some consensus-building in other areas of government!

Interest Rates

The media is focused on interest rates.  As most of you know, the Fed sets short-term interest rates including the discount rate.  If the Fed believes the economy is getting stronger, they will raise interest rates in an effort to keep the economy from getting overheated.  Conversely, the Fed will lower (short-term) interest rates to encourage economic growth if the economy stalls.  Lately, the Fed has raised interest rates incrementally – up about 1% total over the past 2 years or so.  It is likely the Fed will raise rates by another 0.25% when they next meet in December.  It is believed Mr. Powell will not change the Fed’s program of raising rates.

Fed’s Balance Sheet

Among other programs, the Fed combatted the 2008 Financial Crisis by going on a bond-buying binge.  When the Fed buys bonds in the open market, this puts money in the market for others to put to other uses, thereby (theoretically) juicing the economy.  Where did the Fed get the money to buy these bonds?  The short answer is:  The US Treasury printed it.  But, that’s not my point.  My point is that the Fed still owns most of the bonds that they bought as a result of the Financial Crisis.  Bonds that the Fed buy go on the Fed’s own Balance Sheet as Assets.

The following is a chart by the Heritage Foundation that shows how much the Fed’s Assets have increased over time.  The chart shows the period from 2008 to 2014; the Fed’s Assets have remained about the same since 2014:

The following is a link to the Fed’s website that shows the current Fed Balance Sheet.  The chart there is interactive so I couldn’t copy and paste it, but at least I can link to it and you can see it for yourself:  https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm  

$4.4 Trillion

You are reading that correctly:  The Fed owns about $4.4 Trillion of assets, maybe $4.5 Trillion now – mostly mortgage and other notes and bonds.  That’s with a Capital T.  That’s a ton of money, and it has remained that high for the past 3 years.  Prior to the Financial Crisis, The Fed’s assets were under $1 Trillion.  In October 2017, the Fed commenced an “unwinding” program whereby they will reduce their holdings by $10 Billion per month and increasing gradually over time.  So, the Fed is now reducing its balance sheet.

Enough?

My questions:  Is $10 Billion per month enough?  Does the Fed really need to keep $4.4 Trillion of assets?  Shouldn’t the Fed “unwind” its Balance Sheet much quicker?  The Fed’s twin objectives (per Congress) are to minimize inflation and maximize employment.  Currently, inflation is low (under 2% annually) and unemployment is also low (well under 5%, at least how the Department of Labor measures it).  One could argue that the Fed’s past policies succeeded – that the reason we have low inflation, low unemployment, and a relatively healthy economy now is precisely because the Fed went bond-buying buying spree after 2008.

IMO

The media and others have increased their focus on the Fed in recent years, especially since the 2008 Financial Crisis, because for many years Congress couldn’t get its act together and pass an actual budget.  Recall all of those times the US Government was funded based on “continuing resolutions”.  Fiscal Policy (i.e., congressional spending) was off the table due to congressional dysfunction, so Monetary Policy (promulgated by the Fed) took center stage.  It was never solely the Fed’s responsibility to “save” the economy during and after the Financial Crisis, yet the media portrayed it as such.  Currently, the economy is much stronger, yet the Fed’s Balance Sheet remains at crisis levels.  $10 Billion of “unwind” per month doesn’t make much of a dent in $4.4 Trillion.  At $10 Billion per month, that’s 10 months for $100 Billion of “unwind”, and 100 months (or 8.3 years) for $1 Trillion of “unwind”.  I think the pace of the unwinding should be much faster, and I think the focus should be on this instead of on the short-term interest rates.  The US Economy is currently strong enough to handle the Fed unwinding its balance sheet much faster.  The Fed should use this opportunity to “re-arm” in a sense, so as to put itself in a better position to deal with the next financial crisis, if and when it arises.  Perhaps the Fed is, in fact, planning to do so.  Perhaps Mr. Powell will use his consensus-building skills to point the Fed in the direction of more rapid unwinding.

The Wall Street Journal on October 26, 2017, published a front-page story about Morningstar, the mutual fund ratings firm.  Morningstar is famous for its star ratings.  Five star is the best, and one star is the lowest.  Morningstar also has a grid – for stock mutual funds, the grid axes are market cap and income or growth.  Here is an example of the grid for stock funds:

The Journal article was more concerned with the star ratings.  The Journal went back and looked at Morningstar’s star ratings and then researched the performance of the funds subsequent to their ratings.  The Journal found that fewer than 15% of funds that got the coveted 5-star rating was able to maintain that rating a couple of years later.  Smaller funds, in particular, were very volatile in their star-ratings.  Here is the scenario:

• Small fund starts up and does well for the first few years, for whatever reason.
• As a result, they receive a 5-star rating.  Money managers and investors pick up on this new hot fund and send money their way.
• The fund’s AUM grows quickly.
• However, due to the new money, or due to changing market conditions, the fund managers aren’t able to invest the new, larger fund the same way they had on the way up.
• Performance suffers.
• Morningstar downgrades the fund from 5 stars down to something lower.
• Investors flee the fund.

It’s a sad story, but one that has played out many times before:  Investors chase returns, but the world changes and they lose money.  It happens in sports pretty often:  Manager or coach does well with a young team, the team overachieves and maybe does well in the playoffs or even wins a championship.  Coach is rewarded with a contract extension.  However, maybe due to injuries or better competition, the team underperforms the next couple of years.  All of a sudden, the coach is no good and he gets canned.

Over-Reliance

The problem here is not Morningstar.  They are just a rating agency.  The problem is that money managers and investors have over-relied on Morningstar and have not done their own due diligence on the fund and its managers.  Morningstar’s star system was meant to be one piece of the decision to invest in a certain fund – not the entire decision, as it has been too often.  The Journal article illustrated how some money managers point out with pride that they only put their clients into 5-star funds.

CYA

Why do some managers do this?  To provide cover for if and when they get sued.  If they put a client into a 5-star fund and it loses money, the manager can fall back on the Morningstar rating to say they weren’t negligent.  If instead, the manager puts the client into a 3-star fund and it loses money, the CYA argument is weaker.  Another example of the overly-litigious society we have, and the pressure that money managers are under when they stand to lose more than a client’s money if an investment under-performs.

Only Morningstar

The Journal article addresses the above issues (it was a lengthy article).  One issue that the article didn’t address is that Morningstar holds too dominant of a position in the mutual fund ratings business.   There are others out there, but no other firm’s ratings hold the sway that Morningstar’s do.  For other sectors wherein ratings are important – debt issuance and insurance companies, for example – there are Standard & Poor, Moody’s, Fitch, and AM Best.  An investor or manager can choose among these rating agencies and make up their own mind.  With mutual funds, it seems they look only to Morningstar.  This is not a criticism of Morningstar.  It is a criticism of those that have put all of their eggs in the Morningstar basket.

IMO

There is no substitute for doing your own research and making up your own mind about your own investments.  Morningstar is a great tool, and certainly factor the Morningstar star rating as part of your decision, but also look at the manager’s strategy and how that fits with your investment objectives.  Look at the fund’s top holdings and see what you think about them.  Determine if you are comfortable with a new fund with a high Morningstar rating even though the fund is new and hasn’t gone through multiple market conditions.  Maybe you are instead more comfortable with an older fund that might have a lower rating but that fits with your objectives and has been through the wars.  Use other ratings services – Value Line rates funds, and you can access it for free through your library’s website.  Understand what the Morningstar ratings mean and what they are supposed to be used for before making an important financial decision.

A new restaurant opens in your town and you decide to try it.  One of two things happens next:  1)  You like the restaurant and you decide you will try it again sometime, or 2) You don’t like the restaurant and you won’t go back again.

Voting With Your Feet

The second option – deciding not to go back there again – is a version of Voting with your Feet.  You register your displeasure with the restaurant by not going back there again.  If enough other people don’t go there, the restaurant will either improve to win people back or not improve and go out of business.  Then maybe someone else will buy the restaurant and it will be good again.

Stocks

Stocks act in a similar way, even more efficiently.  You buy stock in a company.  If you like it, meaning presumably that the price goes up, then you hold onto it, or maybe buy some more.  If you don’t like it, you might sell it.  If enough people sell it, the price will trend down, and management will notice.  Maybe management will change something and the price will head back up.  In the stock market world, you vote with your feet by selling your stock or by not buying it in the first place.

Proxy

Stocks have another way for owners to affect change that restaurant patrons don’t:  Stock owners vote every year on the composition of the Board of Directors.  This is because stock owners actually own the company, whereas restaurant patrons don’t.  (What if you could vote on how a restaurant was run or what was on the menu?  That might be fun!)

If you think management is doing a good job, then you probably will vote to keep the Board in place.  If you disagree with management but still own the stock, then you might reject the current Board.  The threat of shareholder revolt and the pressure to keep performing well helps to keep management focused and its collective eye headed in the right direction.

Peltz

In October of this year, Procter & Gamble announced that it had beaten back a bid by maverick investor Nelson Peltz to win a board seat by a very slim margin.  Peltz wanted to affect change at P&G and sought a board seat in order to do so.  Peltz tried to convince enough other P&G owners to back his bid but he fell just short.  Time will tell if Peltz gets his desired changes at P&G despite his losing the board seat bid.

Index Funds

One thing that was interesting about the Peltz bid was that the various index funds that owned P&G were collectively divided over whether Peltz should win his bid.  Index funds were the three largest P&G shareholders.  State Street and BlackRock sided with Peltz but Vanguard voted against him. (Wall Street Journal, October 19, 2017).  I don’t know why each fund voted the way they did, but I think it was unusual that the top three shareholding funds were divided.  Most of the time fund owners will vote with current management.

IMO

The point I am making is that an index fund or ETF investor typically doesn’t have an opportunity to effect a direct change in management.  They have ownership in the ETF, not in the underlying company.  An owner of stock in a company, however, does have the direct opportunity to change the company, either by selling (voting with their feet) or by voting in a proxy.  This opportunity to vote is a major thing to lose by choosing to own funds rather than owning individual stocks.  If you own a fund, you indirectly own the underlying stocks and you can only hope that your fund manager feels the same way you do about a certain company within the fund if a proxy battle such as Peltz’ P&G battle occurs.  But, you gain the diversity of owning a basket of companies rather than just one individual company.  There are always trade-offs with anything you do.