Will Inverted Bond Yields Cause Your Investments to Crash?
At the beginning of last year, we asked if you should be concerned about the inverted yield curve. The fact is that many previous market crashes and recessions have been preceded by “inversion” of rates on long term versus short term bonds. The timing of this “predictor” is such that it may be a year or two after bond rates change that the market crashes or the economy suffers. There are two questions here for investors. One is whether or not this episode of interest rate inversion will be followed by a collapse of the longest bull stock market in modern history. The other question is this: Will inverted bond yields cause your investments to crash. The uncertainty of the protracted Trump trade war with China and everyone else makes it difficult to predict where the economy and the market are going. And, already-low interest rates may make it difficult for the Federal Reserve to respond to a downturn in the economy.
What Is an Inverted Yield Curve?
Investopedia discusses the inverted yield curve.
An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.
Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed.
Normally, bond investors demand a higher interest rate for locking up their money in a fixed-rate instrument for longer periods of time. Right now they are willing to purchase five, ten, and even thirty-year Treasuries at lower rates of interest. This means that these folks believe that interest rates will be lower in the future and will stay low for a long time. If the economy tanks along with the US stock market, the Federal Reserve will most-likely lower interest rates.
Japan: An Example of Long-Term Low Interest Rates
Normally, we would not think that rates in a major economy would remain low for years or even decades. But, one only needs to look at Japan. In the 1970s and 1980s, during Japan’s boom times, rates ran between 4% and 9%. By the late 1990s, their rates ran between 1% and 0% with brief periods of negative interest rates. (Trading Economics)
Will Inverted Bond Yields Cause Your Investments to Crash?
The first part of this question has to do with how often inverted yields have preceded a market crash and/or recession and by how many years. Is this really a reliable indicator?
Accuracy of Inverted Yields as an Indicator of Recession and Market Correction
Reuters writes that this is a countdown to recession.
The U.S. curve has inverted before each recession in the past 50 years. It offered a false signal just once in that time.
So, this is a pretty reliable indicator that economic troubles are ahead. But, how long will it take after yields invert before the economy and stock market tank? The yield curve inverted in 2005 and again in 2007. Although the 2007 yield curve inversion immediately preceded the Financial Crisis, the 2005 inversion preceded it by slightly more than two years. The thing to avoid here is to believe that the 2005 inversion was a “false alarm.” Long term bond investors are a cautious group. As such, they may sniff out economic trouble and make smart decisions with their bond purchases while everyone else is happy buying into a market that is ready to correct or crash. These folks are using the same sort of approach as with applying intrinsic stock value to their stock purchases. Is should be noted that before the dot com crash that Warren Buffet pulled lots of money out of the stock market because he said did not make sense. And today, he is doing the same as we noted in our article, Silent Warning for Investors.
Will Your Investments Survive a Recession and Stock Market Crash?
This is really what the inverted yield curve issue is all about. Last year we wrote about how to invest without losing any money. The argument we made in that article is that part of your investment portfolio should be in vehicles like US Treasuries, AAA corporate bonds, and bank CDS that are protected by Federal Deposit Insurance. In this part of your portfolio, you will forego growth in favor of safety. And, if today’s inverted yields are an accurate indicator of a coming recession and crash, this part of your investments will be protected against devastating loss.
That having been said, are there ways to keep a foot in the market and protect your investments?
Using Stock Options to Protect Your Stock Investments
Last year we wrote about how to use options to protect your investment portfolio. Our suggestion was to consider buying put options on stocks that you believe are in danger of a correction but still have some room to run.
Market Watch also mentioned buying puts in an article about four ways to protect your stock portfolio using options.
When you buy puts, you will profit when a stock drops in value. For example, before the 2008 crash, your puts would have gone up in value as your stocks went down. Put options grant their owners the right to sell 100 shares of stock at the strike price. Although puts don’t necessarily provide 100 percent protection, they can reduce loss. It’s similar to buying an insurance policy with a deductible. Unlike shorting stocks, where losses can be unlimited, with puts the most you can lose is what you paid for the put.
This can be a very effective strategy for those who know how to use it. That includes picking the right strike prices and options expiration dates. Successful use of this approach also includes knowing when to use it and when to avoid the repeated expense of buying new put options when the old ones expire.
Bitcoin Pump and Dump Again?
And a bitcoin security warning
Remember the 2017 Bitcoin pump and dump? It seemed like an epic bull run for the cryptocurrency but ended in a crash. Bitcoin started 2017 just below $1,000 and rose during the year. Bitcoin “enthusiasts” hyped the cryptocurrency as the “investment “of the future while long term successful investors called it a scam. After Bitcoin fell from the $20,000 range to the $3,000 range at the end of 2017, all of the Bitcoin hype went away, for a couple of years. However, it appears that we are seeing a Bitcoin pump and dump again. This writer was watching the morning CNN business show and an interview with the “head investment analyst” of an outfit I had never heard of. The storyline was that central banks are all competing to devalue their currencies and that only gold and Bitcoin are safe stores of value. Then, we saw a security warning about Bitcoin in Forbes as well. What is going on?
Bitcoin and Pump and Dump Scams
Investopedia explains pump and dump scams.
A pump and dump scam is the illegal act of an investor or group of investors promoting a stock they hold and selling once the stock price has risen following the surge in interest as a result of the endorsement.
As Investopedia explains, the pump consists of an “information campaign” or series of “hot tips” suggesting that the stock, or in this case the cryptocurrency, is about to skyrocket. And, to the degree that the first efforts are successful, the “pumpers” can point to recent price increases as “proof” of the validity of their “predictions.” Usually, this approach is limited to OTC micro-cap stocks or penny stocks and is intended to corral a handful of unsuspecting (and greedy) investors. However, in the internet and mass information age, the approach can work with things like Bitcoin as well.
The old advice is that when you start hearing an investment being promoted by your taxi driver, it is time to avoid the investment or get out if you have already invested. This writer was looking at vacation and retirement property in Colombia in late 2017 as Bitcoin was passing the $12,000 mark. The realtor I was using was more interested in explaining how she had taken all of her savings out of the bank to buy Bitcoins and was thinking of putting a mortgage on her home. I never did hear how it worked out for her but two months later Bitcoin had peaked at $20,000 and was down to the $5,000 range on its way to $3,000.
Are Gold and Bitcoin Stores of Value?
Your home is a store of value as someone can always live there. Your farmland in Iowa is a store of value because people will always need food. A multinational company with a huge range of products, like 3M, is generally a store of value because they make things that people use all over the world. Investing in gold is being hyped right now along with Bitcoin as a way to protect your wealth as central banks rush to devalue currencies. The argument of gold is that it has held its value in relation to things like food and clothing for centuries. However, that is not really true. Gold goes up and down as investors worry about the stock market, their nation’s currency, war, and social unrest. Gold started the 1970s at $32 an ounce and hit $800 in the early 1980s before it crashed. It sat in the $200 range for nearly 20 years until the next bull market. Gold always has uses in industry and for jewelry. That is not the case with Bitcoin.
The Fiat Cryptocurrency
The current “pump” for Bitcoin is that paper currencies have no intrinsic value. And, central banks are working actively to devalue them all across the globe. But, currencies like the US dollar, Euro, Yen, and Yuan all have substantial economies to fall back on. Bitcoin, the other hand, has no backing, no economy on which it is based, and no “use” such as for jewelry or in industry. Nevertheless, the current “pump” for Bitcoin plays on the fear few or predicted economic collapse.
Can You Make Money Trading Bitcoin?
Anyone who had the good fortune to buy Bitcoin years ago for pennies each or even at the start of 2017 when it sold for less than $1,000 has done well by simply holding on to their Bitcoins. And, anyone who had the good luck to sell at the end of 2017 when Bitcoin sold for nearly $20,000 made out like a bandit. But, aside from listening to the “pump” arguments, there is no good rational way to buy and sell Bitcoin. If you believe that currencies across the world will lose their value, there are always precious metals like gold. Real estate in growing areas will tend to hold its value as well. These and other investments have two things in common. They have a bottom price that is not zero and they have a way to assess intrinsic value. The same cannot be said for Bitcoin and other cryptocurrencies. And, then there is the risk of having your Bitcoins stolen or being scammed in some other way.
Bitcoin Security Alert
Forbes published a report about a Bitcoin security warning.
Researchers have warned a staggering four out of the first five results returned when asking Google for a “bitcoin qr generator” led to scam websites.
If a user of one of these scam sites tries to generate a QR code for their own bitcoin address, it will create a QR code for the scammer’s wallet, researchers from ZenGo, a bitcoin and cryptocurrency wallet provider, found.
The amount of money that has been stolen this way is not clear.
Last month, it was found bitcoin and cryptocurrency fraudsters stole over $4 billion of digital currency from investors and users in the first six months of 2019, a significant increase on the $1.7bn stolen in 2018.
These stolen funds were a result of “outright thefts” from cryptocurrency exchanges, but also scams, according to U.S. cyber security research company Ciphertrace.
Money that you put in a US bank is insured by the Federal Deposit Insurance Corporation. US Treasuries are good unless the government collapses. Put your money into Bitcoins and no one is going to insure your losses when a hacker breaks the code and transfers a few million from your wallet to theirs.
Is This the Bitcoin Pump and Dump Again?
When we write about “stock tips,” we always recommend that you use some sort of fundamental analysis to make sure that the investment makes sense. Unfortunately, there is no way to examine fundamentals of Bitcoin and other cryptocurrencies as they have not basic or intrinsic value. Thus, all of the talk in support of investing in Bitcoin amounts to hype and a return to the pump and dump of 2017.
Why Invest in Berkshire Hathaway?
Warren Buffett has become one of the richest men in the world by using intrinsic stock value as a guide to investing for Berkshire Hathaway. But, Berkshire Hathaway is now a huge company with multiple holdings. There is a temptation to say that it has reached a mature state where there is not much more room to grow. Is that true? We don’t think so. So, why invest in Berkshire Hathaway today? The first reason is that the stock is undervalued.
Is Berkshire Hathaway Undervalued?
The Motley Fool says to in their article about three reasons to buy Berkshire Hathaway.
Over the last decade, Berkshire Hathaway has become a certified cash cow of the first order.
The gap between the stock price and the long-term value of the company has been widening lately.
They cite the profits that his whole owned companies generate and the fact that if they were to go public again, their values would be a lot higher than the book value at which they are now valued.
In addition, Buffett has been buying back shares. He has always been hesitant to do this, but as he sees his own stock as a bargain, he is buying his own shares at the rate of about $2 billion a year!
Why Invest in Berkshire Hathaway for the Long Term?
Many of us equate Berkshire Hathaway with Warren Buffett. As such, many might be tempted to get out of this stock when Buffet is no longer active in the business. However, the “Oracle of Omaha” has also been the planner and teacher of Omaha as well. Each of Berkshire Hathaway’s sixty business segments is run by someone who was trained by Buffett and follows his approach to fundamental analysis and working with the long view in mind. We can fully expect the company to follow the same approach to investing and business management when Buffett is no longer in the picture as now when he is still running the show.
Why Does Buffett’s Approach to Investment Work?
Buffett’s approach to investment, which he learned directly from non-other than Benjamin Graham, is simply to analyze an investment for its projected profit potential, determine an “intrinsic” value based on that assessment, and compare the intrinsic value to the current stock price. He has admitted that he and his team toss out 95% of stocks they analyze as being too difficult to make an informed judgement on. But, when they do pick a stock this way, they typically hold it for years. Buffett has been quoted as saying that his favorite holding period for an investment if forever. And, he and his team pick investments with that in mind. Thus, Berkshire Hathaway is comprised of companies selling products and services that are not likely to become obsolete with changes in technology and are likely to grow and produce more profits year after year after year.
Ready for the 2020 Recession?
The recovery from the Financial Crisis has been impressive and prolonged. However, a combination of factors is causing headwinds that the US economy may not be able to overcome. While pundits in the media, social and print, argue both sides of the issue, the bond market is betting heavily on an economic downturn. Are you ready for the 2020 recession? Here we will look at why next year is likely when the economic “ax” will fall and then what you can do to protect your investment portfolio.
Will There Be a Recession Starting in 2020?
The trade dispute with China has gone from being a protracted trade war to likely being a permanent trade war. The Trump tax cut was a bust for investment and hiring. And, on top of that, the national debt is soaring even higher as the promised economic benefits of more jobs, more income, and more taxes have not come to pass! But, analysis may be wrong and, maybe, we can just close our eyes and hope for the best. Right? Wrong!
The New York Times has a good article that looks at how the recession of 2020 could happen.
The chances that the nation will fall into recession have increased sharply in the last two weeks.That is the unmistakable message that global investors in the bond market are sending. Longer-term interest rates have plunged since the end of July – a shift that historically tends to predict slower growth, interest rate cuts from the Federal Reserve, and a heightened risk that the economy slips into outright contraction.
They refer to the chances of a “self-inflicted” recession with these causes:
- Business uncertainty tied to how Trump is playing the trade war game
- Softening of business spending as the tax cut windfall is wearing off
- Central banks across the globe with limited ability to respond to a financial crisis
- Populist turning inward in many major economies
An interesting observation they make is that previous recessions have followed the collapse of incorrect and irrational beliefs:
- 2001- The internet would lead to perpetual growth with a new kind of stock market.
- 2007- The housing market would never collapse in all parts of the country at once.
To their observations we add the 1929 crash which was preceded by the belief that a brand new world of wealth was in store and that one only needed to “play the market” to become rich. (For more on this topic take a look at our article about intrinsic stock value.)
Another is the lack of leadership that led the United Kingdom into the Brexit mess.
And, we add the ambitions of the Chinese Communist Party in believing that the rest of the world would passively stand by while they targeted all of the high-tech sectors for dominance over the coming decades. Their apparent short-sightedness is based on the desire of a small group of oligarchs to maintain their authority, power, and personal wealth above all.
Lastly, we believe that Donald Trump may be an effective rabble-rouser and outright demagogue who can get votes, command the attention of the media, and perhaps even get re-elected. But, we also believe that he simply does not have the horsepower for this job. The most effective ways to maintain peace and prosperity in the post-WWII era have been with coalition building, confidence building, and maintaining the strong historical alliances that were so painstakingly built in the aftermath of the last World War. Trump’s willful destruction of our alliances may, in the end, be that which causes the most damage.
What Does Money Say about a 2020 Recession?
Pundits can write what they want but, to our way of thinking, the best evidence is in what people are doing with their money. And, that is where an inverted yield curve and decreased corporate investing and putting money into stock buybacks are the canaries in the coal mine that have stopped singing and are warning us to get out now.
How Do You Get Ready for the 2020 Recession?
With the trade war being a major issue in a coming recession, many investors will look for stocks that are not affected by problems with China or elsewhere. As interest rates go down, utility stocks go up in value as their dividends do not necessarily fall with interest rates. A while back we wrote about how to invest without losing any money. This article focused on a buy and hold strategy for Treasuries, AAA and AA bonds, ladders of CDs at your bank. This is likely what many investors are doing now as they lock in today’s rates before the Fed is forced to cut rates again to fight the 2020 recession. The last part of that formula was to look for stocks that will weather the storm, will become bargains as the market crashes, and will turn into excellent long term investments. That may be the best strategy for getting ready for the 2020 recession. If you want to look for an example of someone getting ready to buy value investments when the market falls, look at our article about the silent warning for investors in which we note that Warren Buffett is accumulating an impressive hoard of cash. Many believe that he simply does not need any stocks that meet his criteria for value and price. We believe that he is also getting ready for the next recession and market correction or crash.
Silent Warning for Investors
The man who is perhaps the greatest investor ever is silent and that should concern investors. Warren Buffett is the prime example of a long term, buy and hold investor who totally believes in the power of the US economy and the US stock market to grow wealth. Buffett’s net wealth was about $10,000 in the middle of the 20th century and today he vies with Jeff Bezos and Bill Gates for the title of the richest person in the world with more than $80 Billion in net wealth. Buffet would, in fact, be the richest person if he had not given away $34.5 Billion over the last few years! And, Buffett has made his money by applying the concept of intrinsic stock value. He looks for companies with the potential to grow and reliably produce income year after year. And, he looks for companies that are underpriced. Thus, over the years, Buffett has always been making investments and now he is not! We should pay attention to this silent warning for investors as it has implications for all of us.
Should You Hold Your Investments Forever, or Not?
Buffett has been quoted as saying that when he purchases stock in a strong company with strong management that favorite length of time to hold that investment is forever. And now, according to the most recent Berkshire Hathaway quarterly report, they are holding $122 Billion in cash while in normal times they would be holding something like $30 Billion. This is because in almost four years Berkshire Hathaway has not made any major stock purchases or acquisitions. And, in the first two quarters of this year, Buffett has be a net seller of stocks. The two parts of intrinsic stock value are the likelihood of a stock making money over the years and the current price of the stock, or any investment. What is happening with Buffett’s company is that they are not seeing any investments these days that combine growth and money-making potential with reasonable or low prices. This is the silent warning for investors.
Why Is Buffett Not Buying Back as Much Berkshire Hathaway Stock?
A third piece of the silent warning for investors is that Berkshire Hathaway has reduced its stock buybacks as well. Buying back your stock is done to increase share price and put excess cash to the best use possible. According to company reports, stock buybacks went from $1.7 Billion in the first quarter to $400 Million in the second quarter. We recently wrote about the potential dangers of stock buybacks. In the case of Berkshire Hathaway, the company has not been trying to artificially raise its share price and has rather been putting its cash to the best use. The fact that they are now keeping a large hoard of cash implies that the “better use” of this money will be in invest in the near future after a substantial market correction or even a crash. The likelihood of the trade war becoming permanent is such that smart investors will do well to hold a large amount of their portfolio in cash until the future becomes clearer and until the prices for stocks and other investments become more realistic.
Investing During a Permanent Trade War
In the last year and a half we have looked at the evolving trade war between the US and China and, to a degree, between the US and everyone else. As the situation has evolved, we are now looking at investing during a permanent trade war. Here is how our thinking has evolved. To begin with, we appear to have been overly optimistic. In March of 2018 we asked what can you invest in and not get hurt by a trade war. At that time our belief was that companies in entertainment, like Disney, are generally safe from tariffs and other effects of trade wars and that companies that have little or no business in China, like Facebook, Amazon, Netflix, and Google are reasonably safe bets. Since that time Disney is up about 50%, Amazon is up by about 33%, Facebook is even, Netflix is about even, and Google (Alphabet) is up a percent or two. Here are more of our thoughts about how this has evolved and investing during a permanent trade war.
Investing in the Trade War That Was Not Resolved
Just a year ago, in a fit of optimism, we looked at what happens to your investments when the trade war is resolved. At that point we predicted a surge in the stock market and all sorts of success for companies that were being threatened by the trade war. Our rationale, at that time, was to look for stocks that would capitalize on reduced trade tensions and, perhaps, better investment opportunities in places like China. Of course, none of that has happened as China, and the USA, have dug in for a long struggle for global dominance.
Reasons for the Protracted Trade War
Last September we seem to have come to our senses and started to consider what happens to your investments if the trade war becomes permanent. We worried about US multinationals that would suffer more from a slower global economy that from a trade war with China. And, we suggested that companies like utilities, which are purely domestic, would be safe havens. However, the larger part of that article was devoted to looking the why the USA and China are having a trade war, the effects of trends like automation on employment, social unrest, and global politics. Anyone who wants to understand what is going on and how the trade war will very likely be a permanent fixture, should look at our comments about the rise and decline of US economic power and the rise of China. As we noted at that time, a major factor is the grip that the Chinese Communist Party has on power in China and its desire to hold onto that power no matter what.
We also looked briefly at social unrest in the West due to automation and other factors and how that is giving voice to demagogues with the potential for social, political, and military disasters!
The bottom line, as we saw it, was that the trade war would be very protracted until at long last the USA and China would come to some sort of mutually unsatisfactory agreement. We are no longer so sure about that.
Tangible Trade War Damage
Still last year, we looked at the trade war’s effect on investment in US agriculture. The loss of China as a market for US soybeans has undercut investments in places like South Dakota where farmers and investor poured money into storage and shipping facilities to sell soybeans to China. Many farmers and businesses will never recover. And, despite China’s assurances that they will buy soybeans again, they are still using it as a bargaining chip to allow them to keep stealing technology from the US or extracting technological secrets as a price for doing business there.
Winning the Trade War and Losing on Investments
Last February we speculated that a trade war “win” would be combined with reduced global trade, a lower trade deficit, and losses in the stock market. This though came from an article in Market Watch which in turn cited economic figures. Thus we could win the trade war and lose on our investments. Because the major concern of the government in this is long term competition with China for economic, technological, and military dominance, this may be a price that the USA will be willing to pay.
Will We Have Protracted Trade War or a Permanent Trade War?
In June we had come to believe that trade war would be very long term. In this view of a protracted trade war, we considered how trade between the USA and China and China versus the rest of the world could be reshuffled and where to invest and what investments to avoid. In this world, issues arise such as China being a major processor of the so-called rare earth minerals use in high tech devices and the reapportioning of global outsourcing to a ABC (anywhere but China) approach. As we noted, these are long term investment approaches and are reminiscent of dealing Russia and the entire Communist block for decades during the Cold War. As with the Cold War, the issue is not specifically a trade war but rather trade warfare for global economic, military, technological, political, and social dominance on the planet for centuries to come.
Are Stock Buybacks Dangerous?
Much of the windfall that U.S. corporations experienced with the Trump tax cut went into buying back their stock. The stock buybacks accomplished their intended purpose which was to support or drive up stock prices. This has helped keep the stock market rally going. But, is there a dark side to all this? Are stock buybacks dangerous at some level?
Stock Buybacks
Investopedia poses the question, why would a company buy back its own shares?
The most visible result of share buybacks is that it preserves or increases share price. But, there are three other good reasons to buy back shares.
Consolidation of Ownership
Reduction of Dividend Costs
“Remedy” for Undervalued Shares
Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason.
Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing.
Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn’t using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, back in 2016.
Another major motive for businesses to do buybacks: They genuinely feel their shares are undervalued. Undervaluation occurs for a number of reasons, often due to investors’ inability to see past a business’ short-term performance, sensationalist news items or a general bearish sentiment.
Therefore, a company that is not growing as fast as it used does not need to share ownership in order to raise capital to expand. It can reduce dividend costs by having fewer shareholders. And, the boost in stock price caused by share buybacks can fuel a bullish sentiment for their stock and further boost the share price.
Stock Buybacks Did Not Lead to Job Expansion in the USA
Part of what sold congress on the Trump tax cuts was the idea that US companies would bring offshore capital back to the USA and invest it. There was supposed to be lots of job growth as companies “invested in America.” The fact that much of the repatriated money went to buy back shares has not been appreciated by those in congress who thought they were essentially voting for job creation back home and not support of corporate share prices.
Are Stock Buybacks Dangerous?
The responsibility of a corporation is to its shareholders. As such, stock buybacks may well take precedence over R&D, expansion, or raising salaries. But, is there a risk to you, the shareholder? If you are seeing the share price of your favorite stock go up and up, what is there to complain about? The risk is that a company may be building a “house of cards” by artificially raising share price when business is not all that good. The answer to whether your company is doing this comes from an assessment of intrinsic stock value. The long term value of your investment will depend on its ability to make money with its business plan well into the future. If this part is solid, you can rejoice in your share price going up. If you do not see a happy future for the company, then stock buybacks are dangerous and simply being used to hide long term problems. At that point, you should start to sell and find other long term investments.
Annuities Pros and Cons
One of the safest ways to save for retirement is with an annuity. This is a contract offered by an insurance company. You pay them in installments or with a single lump sum and they pay you back on a regular basis, usually starting when you retire. Your investment in the annuity is boosted by interest paid by the insurance company. This investment vehicle usually belongs in our list of choices for how to invest without losing any money. If the idea of annuities appeals to you, you need to know the annuities pros and cons.
Annuities
Annuity contracts offer investors a safe means of saving for retirement with a low but reliable return. There are two basic choices. The first is to take your savings and make a lump sum payment for an annuity contract. You do this at retirement and the insurance company makes steady payments until the annuity is exhausted or until you die. In general, if you pass away before the annuity is used up, the residual can go to your spouse or estate but this needs to be spelled out in the contract.
The second choice is to make payments over the years into the annuity and defer payments to you until a later date, such as your retirement. Like the first choice, you receive payments until the annuity is used up or you pass away in which case the residual money typically goes to your estate.
In each case, you can choose when to start taking payments, either immediately or at a later date. When you go looking for an annuity, you will be told this a tax-deferred investment vehicle. The money you put it gains interest, so you receive more in the end than what you put in. However, your taxes are due on receipt of payments when you are retired and in a lower tax bracket. (Similar to an IRA or 401k)
Types of Annuities
There are three types of annuities. These are fixed, variable, and indexed. Fixed and variable are the most common. Indexed annuities are a hybrid and also called equity-indexed annuities or fixed-index annuities. Variable annuities are considered securities and subject to regulation by the Financial Industry Regulatory Authority.
Depending on who you purchase an annuity from, you may pay a commission as high as 7% as well as administrative fees. There are commonly surrender charges, mortality charges, and “expense risk” charges as well.
Fixed Annuities
A fixed annuity is an insurance product. You put in your money and receive a guaranteed rate of return. This return is based on your life expectancy, age, and the current interest rate. Other factors may also come into play, depending on who you are dealing with.
Variable Annuities
Although a variable annuity has insurance features attached, it is an investment product. You will choose from a wide range of investment choices including mutual funds. In this case, your payments will depend on how well the investment vehicle does over the years. And, this is why variable annuities are regulated as securities.
Indexed Annuities
You may like the idea of a variable annuity because of the potential of a better return than for a fixed annuity. But, then you worry that the investment (and your retirement savings) could be wiped out. Indexed annuities provide a guaranteed minimum interest rate return on your annuity capital as well as a higher rate which is typically market index-linked.
In regard to annuities pros and cons, indexed annuities may be the best option. But, they come in all shapes and sizes so they can be difficult to understand. And, when you are investing your retirement savings in something, you need to understand it!
Annuity Taxation
A common approach to retirement savings using an annuity is to use one in your IRA. When you do that, the IRA rules apply. This is “pre-tax” money so taxes on the initial investment, as well as earnings, are due upon withdrawal. Like with other IRAs, you are taking the money in your retirement years so your tax rate will be lower. Unfortunately, annuity payments are subject to normal taxes and not taxed as capital gains. The good side will be your low tax rate at the time.
If you put previously taxed money into your annuity, only the income from the annuity is taxable upon withdrawal.
It is a good idea to run this by your tax preparer before choosing an annuity and before withdrawing money.
Annuity Exclusion Ratio
Here is where an annuity may or may not work to your benefit but also gets complicated. Because an annuity is in total or in part an insurance vehicle, the exclusion ratio applies. For example, you put $50,000 into an annuity. You receive $5,000 a year for ten years (simply getting your money back) and this money is not taxed. When you start receiving payments the next year, this is considered income and is taxable. Again, discuss this with your tax preparer.
Annuities Pros and Cons
If what you want for retirement is a totally safe investment vehicle that will not crash with the stock market or real estate, a fixed annuity is a good choice. You can put it in the same class as a bank CD, US Treasury or AAA corporate bond. The only concern is the health of the insurance company.
If you want to stay in this kind of investment but get a better return, then things get a little murky. You will start seeing rather high fees and commissions and will get tied into investment vehicles like mutual funds that have commonly not done as well as the S&P 500 in recent years.
The fact is that you don’t need to go with just one investment approach in your earning years or in retirement. Rather, you could choose the totally safe route of CDs, bonds, or fixed annuities for a part of your investment portfolio. Then, other passive investment options include ETFs which have a much lower carrying cost than mutual funds.
Low Risk High Return Investments
You invest for two reasons. First of all, you want to put money aside for some future need instead of immediately spending it. Secondly, you want that money to make money over the years. You obviously don’t want to get into dumb investments and lose your invested money or you would have had a better time spending it! And, because there are things you want to do with that money eventually, you would prefer to see a healthy return on that invested capital. Many investors choose to split their investments into those with more growth potential but not a lot of safety and those with lower growth prospects but a lot of safety. The ideal portfolio contains low risk high return investments that both safety and growth.
Lowest Risk Investments
Some time ago we wrote about how to invest without losing any money.
Yes, there are ways that you can do this. You will have to settle for lower returns, but for a person nearing retirement, for example, this is a safe way to preserve capital and see and earn a little extra as well. These are the four categories we listed with the addition of dividend stocks.
Bank deposits with Federal Deposit Insurance
US Treasury Bills, Notes, and Bonds
Investment Grade AAA and AA Bonds
Long term value investing, intrinsic value including high-value dividend stocks
Bank Deposits with Federal Deposit Insurance
Every time that we write something about how to start investing, we note that your first task is paying off the credit cards and putting enough money in the bank to cover several months of expenses. This is a great idea at any stage of your investing career. And, bank deposits are covered by federal deposit insurance. According to the FCIC, you get $250,000 of insurance for each deposit category.
Single accounts (accounts not falling into any other category)
Certain retirement accounts (including Individual Retirement Accounts (IRAs))
Joint accounts (accounts with more than one owner with equal rights to withdraw)
Revocable trust accounts (containing the words “Payable on death”, “In trust for”, etc.)
Irrevocable trust accounts
Employee Benefit Plan accounts (deposits of a pension plan)
Corporation/Partnership/Unincorporated Association accounts
Government accounts
And, this insurance is good for each bank at which you have deposits.
(Wikipedia, Federal Deposit Insurance Corporation)
US Treasury Bills, Notes, and Bonds
Interest rates have been historically low ever since the Financial Crisis. And, the Fed may again lower rates. Nevertheless, the next safest investments, after your bank deposits, are US Treasuries. Bonds mature in 30 years. Notes mature in two to ten years. Bills mature in a year or less. Any of these, when held to maturity, is about as safe an investment as you can make. As with your bank CDs, these are for absolute security and for money that you will need in a few years.
AA and AAA Bonds
There are only two US companies these days that have AAA bonds. They are Microsoft and Johnson and Johnson. Both of these are very solid companies that are leaders in their fields. As with US Treasuries, the best way to guarantee safety is to purchase one of these bonds and hold it to maturity. Of course, if interest rates fall, you can sell the bond for a higher price, but what do you invest in then?
There are a lot more AA bonds available and many are nearly as secure and the AAA ones. They typically have a little bit higher return as well.
Stocks Chosen Using the Intrinsic Value Calculation
The concept of intrinsic stock value goes back more than 80 years to the era following the Great Depression. The first part of this approach is that you will select investments with the potential for excellent cash flow and thus stock appreciation. If they are dividend stocks, so much the better! The second part is that you will only purchase these investments when they are underpriced by the market and not when they are overpriced. Thus, you will be making low risk high return investments. Read our article about intrinsic stock value to get you started in this direction. The reason to include dividend stocks in this grouping is that many have excellent intrinsic value and when you use dividend reinvestment plans, you bypass the broker and don’t pay any commissions on reinvested dividends or on new stock purchases.
Investing in Your Home
The Federal tax deduction for mortgage interest makes investing in your home a sweetheart deal that no one should pass up. However, as many learned to their dismay a decade ago, you need to look at the market, interest rates, resale value, and the stability of your employment. Here is also where having enough money in the bank to cover expenses, like your mortgage, for a few months is so important. But, the bottom line is that you want your monthly payment to be going toward creating long term value for you and your family and not for the person from whom you are renting!
Tax-Deferred Investments
IRAs and 401 Ks are excellent ways to get low risk high return investments. You can choose investment vehicles with lower risk because of the spectacular advantage of not having to pay taxes on dividends, capital gains and the rest during the time your retirement investment is within its plan.
Investing in What You Know and Understand
No less of an authority than Warren Buffett, one of the outstanding investors of all time, only invests in companies when he understands their business plan and how that business plan will make money over the years.
None of us are necessarily the next Warren Buffett, but we all have areas of expertise. This can come from our education and work or from other life experiences. The point is that computer techies are more likely to spot the next Microsoft or Apple and folks in the medical profession are more likely to recognize a good opportunity in the medical products or services sector. The list obviously gets quite long when you look at all combinations of experience and study. The point is that you can find higher returns on your investments by investing in things that you know about and reduce your risk as well.
Is Ford a Good or a Bad Investment?
Henry Ford invented the automobile assembly line a century ago and his company has been a major automaker ever since. But, how about today? Is Ford a good or bad investment as carmakers need to invest hundreds of millions in new technologies or fall by the wayside? This thought came to mind as we read an article in The New York Times about how Ford and VW are set to cooperate in developing both electric and self-driving cars.
Battery powered, self-driving cars have the potential to eliminate tailpipe emissions and avoid accidents caused by human error. But a rapid shift toward these technologies could be perilous for established carmakers like Ford and Volkswagen.
They must invest hundreds of billions of dollars in coming years or risk becoming irrelevant. And they face new competitors like Google and Uber with access to enormous financial resources. Investors have been much more willing to back Silicon Valley companies than the dinosaurs of Detroit or Wolfsburg, where Volkswagen is based.
Car sales are going down everywhere. This is because cars are more complicated to make and thus more costly to produce than even. Even streamlined assembly processes with lots of robots cannot make automobiles affordable for many people. Detroit’s first response was to lease cars which they have been doing for years. But, now it is so easy to rent a vehicle, even for a few hours, that many folks in cities only use an auto for family vacations and pay for the use of a car for a few hours for weekend shopping.
The end result, if nothing else were going on in the auto industry, would be fewer cars being sold. But, the story is more complicated. Self-driving cars and electric cars are truly the wave of the automobile future. Those who get there first with the best technology will win and others will, painfully, fade away. We recently asked if it is time to invest in GM as they seem to be coping with the issue. But, how about Ford. Is Ford a good or bad investment today?
Investing in Ford
Today Ford stock trades for just over a dollar a share. If you bought a share 40 years ago in 1979 you paid about $1.79 and you purchased that share in 1981 you paid about $0.81 so today looks pretty good. On the other hand, Ford traded for $34.79 in May of 1999 and traded in the $17 range as recently as the summer of 2014. Then, your $10 for a share does not look so good. Ford, like GM, has thrived over the last decades when gasoline prices were low and they could sell lots and lots of high-end pickups and SUVs. Those vehicles with their healthy profit margins were life-savers. But, when times change, profits go away. And, now the world is changing.
Earlier this year we asked how to invest in artificial intelligence. In that article we looked at how AI can be applied to products that we use in the real world. Self-driving cars are a prime example but companies like Waymo (Alphabet subsidiary) are more likely to attract investment capital than the “Detroit Dinosaurs” like Ford, GM, or Chrysler.
A serious problem for Ford, as well as other large automakers, is that they will need to find the capital to continue funding research in high tech vehicles at a time when more and more people are just using Uber or renting cars by the hour.
We leave it for you to decide is Ford a good or bad investment but from our perspective, the venerable automaker has its work cut out for itself.