The Markets	9/30/13   Close	06/30/13   Close	3rd  Qtr.  Change	9/30/12   Close	12 Mo. Change	YTD       Change
Dow	15,130	14,910	+1.48%	13,437	+12.60%	+15.46%
NASDAQ	3,771	3,403	+10.81%	3,116	+21.02%	+24.87%
S&P 500	1,682	1,606	+4.73%	1,441	+16.72%	+17.95%
MSCI EAFE	1,818	1,639	+10.92%	1,511	+20.32%	+13.35%
10-yr Treas. yield	2.62%	2.48%	+0.14%	1.64%	+0.98%	+0.86%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

 

Volatility continued in the third quarter, with the S&P 500 up 6%, then down 5%, then up 3% again to finish the quarter with a decent gain. Year-to-date and last 12 month returns for all stock markets were very strong, with the S&P 500 hitting an all-time high and the NASDAQ hitting a 13-year high. The bond market began the quarter where it left off, with yields continuing to go up and the benchmark 10-year Treasury nearly reaching the psychological 3% level last seen in July, 2011. With the Fed looking less likely to taper their bond purchases, yields dropped steadily through September. However, with the government shutdown “risk aversion” appears to have replaced the “blind optimism” that has driven markets higher this year. The Dow industrials replaced three components for the first time since 2004, with Goldman Sachs, Nike and VISA replacing Bank of America, HP and Alcoa.

Initial claims for unemployment benefits trended steadily down, ending the quarter at their lowest level in six years. The unemployment rate also dipped to 7.3% but the labor participation rate (eligible workers who are either working or looking for work) also declined to 63.2%, the lowest level in 35 years. Economists continue to be concerned about job creation being concentrated in low-paying areas like retail and hospitality and in “underemployment” in which workers who would like to be full-time are working part-time or in lower paying jobs. August consumer spending rose for the fourth straight month and August income increases were the best in six months, with median household incomes staying flat after being down the prior two years.

Although mortgage rates slid along with Treasury yields toward quarter-end, the earlier increase in rates impacted the housing market only slightly. Pending home sales were down but both new and existing home sales hit multi-year highs, housing starts were steady and supply of homes remains tight. Health care cost inflation was only 1% in the last year, the smallest increase in 50 years. Core durable goods (a measure of private sector business investment) was mixed while indices of both manufacturing and services showed solid growth, with new orders for manufacturers particularly strong. The city of Detroit finally accepted the inevitable and filed for bankruptcy. All considered, second quarter GDP growth was revised upward to 2.5% from an initial 1.7%.

The Dallas Fed estimated the cost of the financial crisis to the economy at $14 trillion (90% of annual GDP) with $12.6 trillion in direct aid to and special treatment for the financial sector and the rest in unemployment and atrophy of worker skills. The daily speculation over when the Fed would taper bond purchases, once expected to be as soon as September, was finally exhausted with no firm expectation of when tapering will begin. In a quirky bit of Fed news, Larry Summers’ withdrawal from consideration as Fed chairman actually sent the stock market up sharply.

Internationally, concern over slowing growth in China was quelled with reports of Chinese export growth and benign inflation. A military strike in Syria, which seemed imminent, was avoided with a plan for Russia to accept and destroy Syria’s chemical weapons. Angela Merkel was soundly re-elected in Germany, lending continued support for the euro. The 17-country euro zone officially dragged itself out of recession in the second quarter with a whopping GDP growth of 0.3%, its first growth since the third quarter of 2011.

Looking Forward

As this is being written, the government is shut down. The last shutdown was for a total of 28 days in 1995 and extending into 1996 due to disputes over funding for Medicare, education and other aspects of the 1996 federal budget. (Unlike today, in 1995 there was a temporary resolution which kept the government running from October 1 to November 14.)

Many observers have noted differences between 1995 and 2013, including CNN:

• President Clinton and House speaker Newt Gingrich were more open to compromise.
• Partisanship is much deeper today, with candidates forced to extremes by challenges within their own parties.
• In 1995, unemployment was 5.6% (compared to 7.3% today) and the economy was growing strongly behind technology and internet start-ups.

In addition to resolving the funding issue, Congress is set to tackle an increase in the federal debt ceiling in just a few weeks. If an agreement is not reached, the US could go into default on its debts, which could have potentially devastating effects on our long-term ability to borrow and fund government obligations. When and how these both get resolved is the immediate focus.

There are more basic long-term questions, however, which rise above the political shenanigans.

• Will the government reach consensus and at least acknowledge that there are long-term fiscal problems?
• If so, when will they actually address the fiscal issues?
• Most importantly, how will those issues be addressed?

We find ourselves stuck on the third question and as a result our elected officials have collectively become an embarrassment. There are, of course, vastly different ideas as to what should be done, but if the first two questions can be answered it may be just a bit easier to agree on the “how”.

Our Portfolios

Our September article (Ripley Invests) acknowledged the understandable tendency to pursue investments that, in hindsight, had little chance of adding value or success. That article used three examples of unconventional investments and techniques, but the same tendency holds true in more conventional areas of buying stock or mutual funds.

The critical factor is whether an investment sufficiently adds to the likelihood of success with a commensurate degree of risk. The danger is that past performance will be viewed without the proper risk assessment and with the assumption that the performance could have been predicted (hence the standard disclaimer that past performance is not an indication of future results). And this is all fueled by financial media pundits who make it all look so easy and interesting. In reality, study after study has shown that with all their wisdom the professionals’ record is essentially random.

So what does an investor (and an investment advisor) do? One approach is to look at various markets and make a conscious decision whether active management has the opportunity to add value over a market index. Active managers do this through:

• Security selection: This is the most sexy and media visible technique, which amounts to stock and bond picking. Some funds maintain concentrated portfolios with relatively few holdings, which are “big bets” that may or may not pay off.
• Trading: Frequent trading, known as turnover, increases fund costs and rarely leads to strong results. Most successful funds with concentrated holdings have low turnover.
• Asset allocation: Balanced funds can move between stocks and bonds and all funds hold some cash. Funds adjust that mix based on their assessment of risks and relative opportunities.
• Sector allocation: Emphasizing or avoiding certain sectors (particular industries or types of bonds) is often seen as a way to beat the overall market. In practice it produces mixed results.
• Country allocation: For international or global funds, determining the relative strength or weakness of a country’s economy can influence the portfolio.
• Style “drift”: Investing in a market that is not central to the fund’s objective may differentiate the fund from its peers but makes evaluation of the fund very difficult because it becomes difficult to know how the fund will be invested over time. (For example, a value-oriented fund may suddenly buy growth stocks, which will likely make its performance differ from other value funds.) This is one way managers try to overcome the higher costs of a fund but the strategy often backfires and they are exposed.

If the sum of all these strategies does not outperform the underlying market, it makes more sense to simply own the market through a low-cost index fund. We attempt to combine index funds with managed funds which invest in certain markets or which have long-term solid performance records. Chasing short-term performance or relying heavily on some investment magic will most likely lead to nasty surprises and unintended consequences.

Retiring Minds Revisited

We last wrote in some detail about the state of retirement saving ten years ago (hard to believe, in Retiring Minds, August, 2003, still available n the Articles Archive at www.gordianadvisors.com). We discussed the key variables in meeting retirement financial goals and the extent to which they can be controlled.

Not surprisingly, the sad state of retirement saving has, if anything, gotten even worse in the ensuing ten years. Granted, the financial crisis dealt a big blow to many people, but the basic message just is not getting through. According to the Center for Retirement Research at the Bureau of Labor Statistics, 59% of workers had no assets in retirement accounts in 2010 and in 2013 only 46% of workers had tried to calculate what they need for retirement. Not surprisingly, 75% of households are at risk of failing to maintain their pre-retirement standard of living.

And while it may not be the preferred solution, 7.2 million people over age 65 were still working in 2012, a 67% increase in the prior 10 years.

Which leads us to a prominent story that first appeared on Bloomberg News and spread to other media. The headline was disturbing – “At 77 He Prepares Burgers Earning in Week His Former Hourly Wage”. Tom Palome had earned six figures and traveled first class as a vice president of marketing for Oral-B. He worked hard, paid off his mortgage and put his kids through college but didn’t save enough for retirement. He now works two part-time jobs as a $10-an-hour food demonstrator at Sam’s Club and at a golf club grill for just over minimum wage. He gets backaches and leg cramps from standing all day. Tom is an example of “seniors who spent much of their careers as corporate managers and professionals . . . competing for low-wage jobs”.

Tom’s life, though, tells a different story. He had left the corporate world to avoid relocating and uprooting his family. A consulting practice generated wildly fluctuating income so he turned to managing restaurants. His wife was killed in a car accident so he raised his kids alone. And he spent his income on his kids and his parents at the expense of his own savings. Tom lost over half his $90,000 nest egg in the 2008 financial crisis.

But he also chose to give his kids the proceeds of selling his New Jersey home rather than saving it for himself. And because he lives modestly outside Tampa, Tom could actually get by on Social Security and his small monthly pension, but his jobs keep him active and pay for extras like the theatre and traveling.

While he regrets not doing a better job of saving and investing, Tom is happy with his life and proud of his career and raising his kids. He knows other seniors who could work but won’t take a lesser job. Tom has a different attitude about his jobs, including mopping the floors. “You have to respect the job you’re doing and not be negative about it – or don’t do it.”

“I’m not going to sit on my laurels and say I was an executive making six figures and traveling the world”, Tom said. “I tell people I demonstrate food and I do short-order cooking. I don’t mind saying it. What’s important is that I can work today.”

Clearly, many seniors are not able to keep working and even if they were able it would be preferable for work to be an option rather a necessity. Changes are needed in our overall retirement system and workers need to grasp the need to save much earlier in their careers.

In the meantime, Tom Palome and his attitude towards work and his own circumstances are a model for all of us.