Retirement Compounders Portfolio is comprised of 32 dividend and income-paying securities from around the world. A well-diversified, 32-stock portfolio can give you over 90% of the diversification of owning every stock, for example on the NYSE.

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The broker-dealer game is all about in-house trading desks and distributing securities. Research is mostly intended as a tool for the investment banking side of the business as a means of capturing commissions from institutional accounts. A side business includes solicitation of private clients, either as brokerage accounts or investment management accounts. Broker dealers profit from charging management fees and, more importantly, from offloading underwriting-stocks and bonds on retail accounts. The big institutions have huge power. As such, the institutions, knowing they hold all of the cards, demand any good new offering or secondary offering. No way prime offerings ever see the light of day for any retail account. Retail accounts, whether brokerage or advisory accounts, have no leverage against billion dollar institutions. 

I was involved with every aspect of retail and institutional sales, as well as of research and trading. I dealt with the biggest institutions in the world on a daily basis. Wall Street is much like Las Vegas in that the deck is always stacked against the customer, who never sees the inside mechanics. When I started our investment management firm, I wanted nothing to do with the Street and continue on the same course today. My goal is to provide our conservative small business owner and retired clients with Tiffany-like service in an uncompromised setting. Unlike when dealing with broker dealer organizations, our clients are free of the conflicting self-interests. We do not engage in underwriting and securities distribution. We do not have investment banking clients. We do no proprietary trading. We use an outside, strictly independent custodian and trading desk. In other words, we avoid, on behalf of our private clients, all conflicting self-interest. We do not sell our research, provide our research to others, or use our research as a marketing tool for investment banking clients. Our clients deal with family members and in fact are thought of as family in terms of the close personal relationships developed. Our only compensation from clients is in the form of modest management fees. In sum, at Richard C.Young & Co. Ltd. our client’s best interest is our only business.

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Many investors are familiar with compound interest, but few appreciate its awesome power. Until you fully appreciate the power of compounding, attempts at crafting a successful long-term investment strategy will likely fall short. If you are among the millions of Americans who still believe investing is buying a security today and selling it at a higher price tomorrow, the power of compounding has not yet sunk in.

Here’s some compelling compound interest arithmetic for you to consider. Let’s say you invest $10,000 at 10% for 20 years and draw your interest out each year to spend at Whole Foods or your local Harley dealer. At the end of 20 years, you will still have your $10,000 principal plus the value of $20,000 in interest drawn over the period—a total economic value to you of $30,000. Now let’s assume that you instead made no draws and reinvested at 10% for 20 years. Your economic value at the end of 20 years would be $67,274. That’s $10,000 original principal, $20,000 in simple interest, and $37,274 in interest on interest (to total $67,274). Wow! Over half of your total economic value comes from interest on interest. Over long periods, interest on interest can account for over 60% of your returns. That is power! That’s investing.

If you invest for a compounded rate of return of 10%, it’s easy to think that your long-term return would be twice the return gained by investing at 5%. That is not the case—not by a long shot. Let’s take a long-term look here. Investing $10,000 at 5% for 40 years gives you $70,000—a respectable sum, to be sure. But at 10%, $10,000 grows to a staggering $452,000. You end up with not double the money, but almost 6.5 times the money you would have earned at a 5% return. Double the growth rate again to 20% (admittedly unrealistic, but useful here), your $10,000 would become a mind-boggling $1.47 million (over 21 times the return). And you thought you understood compound interest?

When you invest in portfolio securities, your first question should be: What am I getting paid? If you want to harness the power of compound interest, avoid securities that pay you neither interest nor dividends. Do not put your hard-earned capital at risk with the view of buying a portfolio security today and selling it to someone else tomorrow at a higher price. To me, this is called speculation, not investing.

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 Just this week China reported GDP numbers for 2010. Yes, somehow China, a country with a per capita income that is a fraction of U.S. per capita income manages to report GDP figures before us. Makes one wonder, but that’s a topic for another day. China’s real GDP growth came in at 10.3%—exceeding analysts’ estimates. The comparable U.S. figure is likely to come in near 3%. That’s a big differential. In nominal terms, economic growth was even stronger. China’s nominal GDP increased almost 17% in 2010. 

The stock market must have surged on the better-than-expected growth figures. At least, one would have expected as must based on the pitch from the China bulls. 

So how did Chinese stocks actually react to the GDP news? With a big thud. The Shanghai Composite Index tumbled almost 3% in one day. 

Chinese stock investors are concerned that China’s economy is overheating. Despite government efforts to slow the economy, GDP momentum is accelerating and inflation remains stubbornly high. The concern is that policymakers may have to clamp down even harder to slow the economy. That could be unpleasant for the Chinese stock market. 

The China bulls will likely tell you that the one-day sell-off in the Shanghai Composite was an overreaction to the GDP news. A one-day return doesn’t disprove the notion that Chinese stocks will provide superior returns because China’s economy is booming. That’s probably true, so let’s take a long-term view.

A decade’s worth of GDP data and stock-market returns should suffice. The chart below compares China’s annual nominal GDP growth rate to the Shanghai Composite Index. The blue bars are nominal GDP growth, the black line is the Shanghai Composite, and the grey horizontal line is the average growth rate of nominal GDP over the last decade.

 If the China bulls are right, my chart should show a strong correlation between nominal GDP growth and Chinese stock returns. It doesn’t. Over the last decade, GDP growth averaged 14.6% while the annual total return of the Shanghai Composite Index was only 4.63%. Investors would have fared better by investing in a slower-growing developed country such as Canada. Canadian stocks compounded at 6.57% over the last 10 years. 

Crafting a global portfolio based exclusively on economic growth is a perilous strategy. Economic growth in China is robust, but many other factors are alarming. I continue to avoid direct investment in China, and I advise the same for my subscribers and investment management clients.

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 Investors are buying stocks indiscriminately—the riskier the better. Investor sentiment is at multi-year highs. Brokerage analysts are bullish, investment managers are bullish, and individual investors are bullish. The mantra on the street is “don’t fight the Fed.” Stocks are a win-win. If the economy sours, Ben will print more money. If economic growth improves, that’s good for the stock market too. The speculative fervor is disturbing.

 I can’t disagree with the logic of the stock market bulls. Economic data is, in fact, improving and monetary policy is the most accommodative in the history of the United States, but when everybody is bullish, the good news is often already priced in. There are many risks that could derail this recovery or snuff out the stock market rally.

 I continue to invest with a balanced approach and a focus on dividends and interest. It is a strategy I have followed for decades and one I advise for my subscribers and money management clients.  

 For some hard data on just how speculative this rally has been, I’ll leave you with an insight from John Hussman. Hussman is the portfolio manager of the Hussman Strategic Growth Fund.

Ned Davis Research tracks a set of “factor attribution” portfolios, which measure the performance between the top 10% of stocks ranked by a given factor, and the bottom 10% of stocks as ranked by that factor. The factors are things like market beta, dividend yield, 26-week momentum, and so forth. Essentially, these factor portfolios track the return of hypothetical portfolios that are long the top 10% and short the bottom 10% of stocks based on any given variable.

The performance of these 133 factor portfolios over the past 13 weeks offers tremendous insight into the extent to which the Federal Reserve has encouraged speculative risk. Investors are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk and volatility. Conversely, securities demonstrating reasonable valuation, stability, quality, or payout have been virtually abandoned by investors. Here is a sampling:

The problem with this outcome is that the speculative factors being rewarded over the short-term have nothing to do with the characteristics that have historically been rewarded over the long-term. Despite various periods where valuation is out-of-favor, value has been the clear winner over time. Moreover, it has been destructive to discard valuation in preference for chasing momentum and relative strength after the fact. In contrast, chasing high beta or momentum has conferred no durable benefit for investors. Here is a sampling of 10-year factor returns:

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However, if you are like the other 308 million of us who prefer to eat with the lights on in a warm house, core inflation is not at all useful. The headline Consumer Price Index (CPI), which includes food and energy, is a better measure of inflation, but it too has flaws. Don’t forget that the CPI is a government statistic—and one that is published by the same government that oversees the central bank that is responsible for controlling inflation. Clearly, there is motive to downwardly bias the “official” inflation rate.

I’m not suggesting that there is something deceitful going on here. The original intention of the CPI was to measure the change in price for a fixed basket of goods; but, that is no longer true. There have been several important methodological changes to the CPI over the last 30 years. House prices have been replaced by a rental equivalence measure, hedonic adjustments have been added to the index, and calculations to adjust for substitution have been made. The CPI no longer measures the price changes in a fixed basket of goods to maintain a constant standard of living. It measures the price change required to maintain a constant level of satisfaction.

Satisfaction according to whom?

John Williams, an economist who runs the website shawdowstats.com, calculates that if all of the methodological changes that have been made to the CPI over the last 30 years were reversed, inflation would be north of 7% today compared to the official rate of 1.1%.

Even simple price indices show that the CPI is greatly understating the true rate of inflation. Take PNC’s annual Christmas Price Index by example. Since 1984, PNC Bank has calculated the cost of buying all of the goods and services listed in the song The Twelve Days of Christmas. PNC adds up the cost of buying everything from a partridge in a pear tree to five gold rings to twelve drummers drumming, and calls it the Christmas Price Index. The Christmas Price Index obviously isn’t a serious attempt to quantify inflation, but it measures what a price index should measure—the price change of a fixed basket of goods.

Below I’ve included a chart of the PNC Christmas Price Index with the annual inflation rate overlaid. In 2010, Christmas price inflation was 9.2%. Over the last five years, Christmas price inflation averaged 5%. The “official” inflation rate over the last five years was 2.04%.

I’ll let you be the judge of which price index is a better measure of inflation.

Merry Christmas and warm regards,

Dick

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Albert Einstein described compound interest as the greatest mathematical discovery of all time, but compounding is not so great when interest rates are at 0.1%. At 0.1%, it would take 720 years to double your money!

For income seekers and those in or nearing retirement, there is no source of risk-free interest.

To earn a decent yield in the fixed-income market today, you must be savvy and selective. You have to pick your credit exposure and an optimal yield curve strategy. This isn’t an easy task. Self-directed investors are at a disadvantage here. Few have the time or inclination to manage a mutual fund portfolio, let alone a fixed-income portfolio.

Some investors will inevitably attempt to pick up yield by investing in long bonds. Many already have. Whatever you do, don’t join them. The folk who took a shortcut to higher yields by investing in long bonds just got a wake-up call. Long-term interest rates are up a full percentage point from their August lows. Long-bonds prices have cratered. The PIMCO 25+ Year Zero Coupon US Treasury Index ETF is down more than 26% from its August high.

If you want help navigating the current fixed-income environment, I’ll point you to Young Research’s Global Investment Strategy (GIS). GIS covers the global equity and fixed-income markets, as well as currencies and commodities. If you prefer an advisor, please consider my family-run investment company. We craft fixed-income and balanced portfolios with a focus on income.

On the equity side of portfolios, it is just as challenging to pick up income as it is in fixed-income markets. The S&P 500 dividend yield is only 1.89%. At a 1.89% return, you would double your money in 38 years. That’s better than the 720 years it would take in T-bills, but not at all satisfactory.

The pitiful dividend yield in the U.S. is caused by both an overvalued stock market and a low payout ratio. Far too many U.S. companies retain their earnings instead of distributing them to shareholders. And many of the companies that do distribute earnings to shareholders favor buybacks over dividends.

Dividends are superior to buybacks. Dividends are consistent and reliable. Companies only cut dividends when there is no other option. Stock buybacks, while a better use of cash than acquisitions, by example, are opaque and variable. It is most often the case that companies with buyback programs repurchase shares when stock prices are high and suspend buybacks when prices are low. The intention is to conserve cash during tough times, but it is in tough times that stock prices are at their cheapest levels.

U.S. companies could learn something from Brazil. In Brazil, dividends are mandated. Brazilian companies are required to distribute at least 25% of their earnings to shareholders. It is doubtful that the Brazilian dividend mandate is intended to be a shareholder-friendly regulation. This is Brazil we are talking about. The country isn’t exactly known as a bastion of free-market capitalism. The mandate is most likely in place to ensure that the government can collect more tax revenue from shareholders.

Whatever the motivation, the dividend mandate has appeal to income investors. As long as a Brazilian company is profitable, you can count on a dividend. Wouldn’t it be nice if all profitable U.S. companies paid a dividend? It would certainly make for a more attractive income-investing environment.

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It is no wonder that House Democrats took a beating in November. The provisions that the Pelosi-led liberals want stripped from the bill are the only two Republican proposals in the deal. This was a compromise, not a liberal wish list like the 2009 economic stimulus boondoggle.

The estate tax provision that has the Democrats outraged would tax estates over $5 million at 35%. Most conservatives would have favored permanent repeal of the estate tax, but the GOP presumably negotiated the next best thing. The estate tax is an immoral tax that disproportionately hurts family farms and small business owners. Those with the largest estates simply hire attorneys and accountants to avoid or greatly reduce their estate tax liabilities. The liberals on the left never seem able to come to grips with the notion that high tax rates encourage tax avoidance.

This misunderstanding also explains their opposition to the extension of today’s tax rates on high-income earners. Changing the highest marginal tax rate has no sustainable impact on the amount of revenue that the Treasury collects as a percentage of GDP. High-income earners are the best equipped to avoid taxes. When you raise the highest marginal income tax rate, you simply increase the incentive to avoid taxable income. You also discourage economic activity, which depresses the level of GDP.

Click to Enlarge

My chart below presents a more than five-decade history of personal federal income taxes as a share of GDP. The blue line is personal federal income tax receipts (excluding capital gains taxes) as a percentage of GDP. Personal federal tax receipts as a percentage of GDP have fluctuated in a narrow range over the last five decades. The average since 1954 has been 7.35%. The red line in my chart is the highest marginal income tax rate. The highest marginal income tax rate has been as high as 91% and as low as 28%. In 1954, the highest marginal income tax rate was 91%, and personal federal tax receipts amounted to 7% of GDP. In 1989, the highest marginal income tax rate was 28%, and personal federal tax receipts were about 7.4% of GDP. And in 2008, the highest marginal income tax rate was 35%, and personal federal tax receipts were 7.3% of GDP. Notice a pattern here? Of course you don’t, because there isn’t one. Raising tax rates on the richest Americans doesn’t generate a sustainable increase in tax revenue. Instead, higher marginal rates generate an increase in tax-avoidance schemes.

In return for giving the Republicans the estate tax provision and extending tax rates for high-income earners, Obama gained a one-year extension of unemployment benefits, a one-year extension of refundable tax credits, a payroll tax holiday, and accelerated depreciation for business investment. Obama’s proposals are nothing more than a backdoor Keynesian stimulus program, but avoiding what could have been a recovery-killing tax increase is worth the price.

The additional tax provisions added by the president are likely to give the economy a temporary shot in the arm next year, but the most potent stimulus will come from the greater certainty created by an extension of the current tax rates and new congressional leadership.

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Of the 33 commodities on our scorecard, only four are down YTD. In the energy sector, gasoline prices are up 14%, coal prices are up 46%, and heating oil prices are up 16%. In agricultural commodities, I have already mentioned the price gain of cotton, and corn prices are up 33%, soybeans are up 24%, and wheat is up 35%. Sugar is up a mere 6.5%, but that follows a 128% gain in 2009. Coffee prices are up 51%, and live cattle prices are up almost 20%.

In the industrial commodities space, copper is up 20%, nickel is up 28%, tin is up 51%, iron ore is up 80%, and rubber is up 55%. Besides the 88% gain in palladium in the precious metals sector, silver is up 73%, gold is up 28%, and platinum is up 18%.

In the face of these gains, there are those who still contend that deflation is a problem. Look for Fed chairman Bernanke to bring out the deflation bogeyman when he makes an appearance on 60 Minutes this Sunday. If you don’t hear about deflation from the Fed chief, he will certainly justify his money-printing crusade by pointing to the high unemployment rate. But if he tells you the Fed can increase employment by printing money, he is delusional. Our latest featured video should help debunk that myth.

Those who are concerned with deflation are using backward-looking price measures. The core inflation index, which is the Fed’s preferred gauge of inflation, strips out food and energy, which happen to be two of the most price-sensitive components of inflation. Once you strip out food and energy, you are left with an index that is weighted about 50% toward housing. With an excess supply of homes on the market, real-estate prices will be one of the last Consumer Price Index components to respond to inflationary pressures. If the Fed waits for inflation to show up in home prices before reining in its ultra-accommodative monetary policy, the economic impact could be devastating.

What if the inflation we are seeing in materials prices doesn’t make its way through to consumer prices? That won’t be good either. If businesses aren’t able to pass on rising raw-materials costs, their profit margins will shrink. Shrinking margins will make a corporate sector that is already reluctant to hire even less inclined to add new employees. Slower job growth has never been bullish for the economy—especially when unemployment is approaching 10%.

Keep your inflation antennas tuned to sensitive raw materials prices. If inflation begins to accelerate, you will see it here first.

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To generate investment ideas for our dividend-focused strategy, we occasionally run the obligatory stock screen, and we of course generate ideas through reading and other research methods, but one of our most fertile sources of investment ideas is Mergent’s Handbook of Dividend Achievers.

Mergent’s Handbook of Dividend Achievers is a compact, easy-to-use reference guide of U.S.-listed companies that have increased their dividend annually for 10 or more consecutive years. Only 7.3% of listed dividend-payers qualify. The handbook is published quarterly and is available for $53 at Amazon.com.

My latest copy of the handbook is the summer 2010 edition. In it, you’ll find a detailed one-page snapshot of each of the Mergent dividend achievers. You get a stock price chart, a quick business description, a summary of recent developments, and a seven-year history of selected financial data. The Mergent book also provides the number of years of consecutive dividend increases, as well as the 10-year dividend growth of each company. All in all it’s a handy little reference for the dividend-focused investor. If you are a do-it-yourself investor, I would advise you to pick up a copy.

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