Divorced From Reality

A divorced from reality Chicago Fed bank President Charles Evans helped spur a rally in gold today with calls for aggressive monetary stimulus. Evans is in favor of QE3 and would have voted for it at the Fed’s last policy meeting. Like Fed Chairman Ben Bernanke, Mr. Evans believes that QE2 was successful. Successful at what—temporarily propping up stock prices and raising food and fuel prices? Unemployment hasn’t come down meaningfully and the economy is weaker now than it was when the Fed announced QE2 last year. Mr. Evans policy prescriptions are wrongheaded, but sadly I fear his views are shared by a majority on the FOMC.

The Trouble with Annuities

You may have learned about the trouble with annuities. In its simplest form, an annuity is an arrangement in which you give an insurance company a lump sum of money and in exchange you receive payments over time. For a fee, that is. At the end of the day, what you’re really doing is giving up control over your money to some investment board that promises to pay you back over time. Assuming, of course, that it stays solvent.

When you enter an annuity contract, liquidity can become an issue. I hope you don’t need the money right away, because it becomes costly to withdraw in an emergency. Investors can be hit with steep penalties for early withdrawals above the contracted amount. And if you opt for a death benefit, don’t forget it’s not free. For that matter, all the bells and whistles that sound like a good idea often come with added surcharges that add up to a hefty fee.

One selling point used for annuities is their tax-deferred growth. But don’t forget that investment gains in an annuity portfolio or sub-account are taxed at your ordinary income rate, not the lower capital gains rate. And it makes little sense to invest your IRA money in annuities since that money is already tax-deferred. It’s always good practice to review your tax-related concerns with your accountant before you jump in head first.

Let’s not forget your purchasing power over a 20-year period. There’s a good chance inflation will eat away at your annuity payments. Consider this: $60,000 in income in 2010 isn’t the same $60,000 in 2030 when it’s up against a 3% inflation headwind. According to Global Financial Data, Inc., that $60,000 will only buy you $32,243 worth of goods and services in today’s dollars. Inflation, without an inflation-indexed option, could destroy your annuity payment’s buying power. But if you opt for the inflation index option, it usually comes with—you guessed it—an added fee.

So make sure you do your homework before buying an annuity. Once you get through the hundreds of pages of small print, you may discover they’re not worth your trouble. The good news is it won’t be too late.

Consumers Forecasting Recession

Consumers are now forecasting a recession. The Thomson Reuters / University of Michigan final index of consumer sentiment was released today. The index fell to levels not seen since the height of the financial crisis. The expectations component of the survey plummeted to a three decade low. In the almost 60 year history of the Michigan consumer sentiment survey, every time the index dropped below 60 as it did in August, the economy was in recession.   

Counting on QE3

Is this becoming a tradition? I am of course talking about Wall Street’s calls for the Federal Reserve to fire up the free money truck. It was this time last year at the Fed’s annual Jackson Hole symposium that Chairman Bernanke first signaled QE2 was on the way. Now as then, Wall Street is demanding that Mr. Bernanke signal another round of money printing during his keynote speech.

The Street has read in Mr. Bernanke’s playbook that for years now, the Fed has been targeting stock prices. Anytime the Dow tumbles, the Fed eases monetary policy. Just look at its latest action to prop up the market.

Only a few weeks ago, Mr. Bernanke thought that economic growth was going to pick up in the second half of the year. But at the FOMC’s August meeting, the chairman announced that the Fed would hold interest rates at zero for another two years. What had changed in only a few weeks? The Dow fell more than 15% from late July to early August. Bernanke panicked. He still clings to the belief that propping up the stock market stimulates the economy.

Clearly it does not. In the first half of this year with the Fed printing billions of dollars each week to prop up stock prices, GDP growth slowed to a mere 0.8%. Printing money doesn’t lead to sustainable growth. But that won’t stop the Wall Street crowd from demanding another liquidity injection from the Fed. When Mr. Bernanke fires up the money printing presses, stock prices rise and Wall Street bonuses go up. And that won’t stop Mr. Bernanke from moving forward with another dose of misguided monetary stimulus.

According to Barclays Capital, investors are already discounting another $500–$600 billion in quantitative easing. You can see the anticipation of more quantitative easing in the equity markets today. Economic data released this morning came in below expectations, but instead of falling, stock prices are up more than 3.5%. Traders and speculators are anticipating that the weaker economic data make QE3 more likely. If Mr. Bernanke doesn’t give into the Street’s demands, stock prices could tumble—just the opposite of what Mr. Bernanke wishes.

Wall Street is counting on a QE3 (or something like it) announcement from Mr. Bernanke. The only question is when: this week in Jackson Hole or after a bigger drop in the Dow.

Inflation Threatens Long Bond Yield

The Labor Department released July numbers for consumer, producer, and import price inflation this week. The results were troubling. Consumer prices increased 3.6% compared to last year, producer prices increased by 7.6%, and import prices increased by a whopping 14%. Even the Federal Reserve’s preferred measure of inflation (core consumer price inflation, known as core CPI, which is inflation minus food and fuel) came in ahead of expectations. Core CPI increased by 1.8% over the last year. The Fed’s unspoken growth target for core CPI is 2%.

Because the Fed still believes inflation is contained, Mr. Bernanke recently pledged to hold interest rates near zero for another two years. The Fed’s rate commitment has pushed short- and intermediate-term Treasury yields below 1%. A five-year T-note now yields 0.92%—after adjusting for inflation of 3.6%, investors are losing money. The only Treasury security that even comes close to covering inflation is the long bond. Today, a 30-year Treasury security will pay you 3.57% in interest. 

Should savers and retired investors take the Fed’s bait and invest in long bonds? Not when you have a Fed chairman with a money-printing habit and prominent economists such as Ken Rogoff, the former chief economist of the International Monetary Fund, calling for a “sustained burst of moderate inflation, say, 4–6% for several years.”

Rogoff’s prescribed dosage of inflation would swiftly decimate a portfolio of long bonds. In the chart below, we show the buying power (as a percentage of initial value) of a hypothetical retired investor’s portfolio of 30-year Treasuries (at a 3.57% yield). We assume our retired investor draws 4% of the initial principal, adjusted for inflation annually.

In blue you can see the effects of Rogoff’s plan of 6% inflation, and in red are the effects of the Fed’s implied inflation target of 2%. In green is a zero-inflation environment.

Both the Fed’s and Rogoff’s plans offer little protection for investors’ wealth, but Rogoff’s plan strips retirees’ buying power at a rapid pace. After five years, Rogoff’s plan cuts the buying power of a portfolio of long bonds in half, and after 20 years the portfolio is depleted.  

If you are in need of income, long bonds aren’t the place to look. In our monthly strategy reports, we help subscribers craft portfolios that offer a steady stream of income without the risk of a portfolio of long Treasuries. 

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The Biggest Annuity Mistake

I don’t like annuities. I know there are ways they can make sense in some portfolios, but for the majority of investors they’re a bad move for several reasons. First, they’re pushed on unsophisticated investors by well-trained salesmen. Second, the fees, especially surrender fees, can be devastating if you need your money in an emergency. Third, many investors make the egregious mistake of investing in tax-deferred annuities in a tax-deferred account. Unfortunately, common sense is lost on most because of the aggressive sales tactics of the guys closing the deal, who are compensated heavily for success. And that’s why there’s around $1 trillion of annuity money in U.S. retirement accounts. Don’t let it be yours.

A Historic Week

Even with the relatively calm day in the markets on Friday, this past week has been one of the most volatile on record. Only during the 2008 financial crisis, the 1987 stock market crash, and the Great Depression have stock prices been as volatile as they were this past week.

Worst 5 Bear Markets

Developed world equity markets have been hammered in recent weeks. In U.S. dollar terms, many have entered bear market territory—defined as a peak-to-trough decline of at least 20%. We have compiled a slideshow of the 5 MSCI developed world stock market indices with the biggest bear market losses. If you are curious, the U.S. is one of the few MSCI developed country stock markets that has managed to avoid a peak-to-trough drop of 20%.