FWIW #32 Interesting Debates

Posted by Eugene Kelly(E. Aly) on Feb 2nd 2023

There are two debates going on in the offices of Wall Street. They are debates about retirement strategies called into question due to short-term market developments.

1. The 4% Rule

The first debate surrounds the 4% Rule, which says an individual can take 4% from their portfolio each year, based on its value at the end of the prior year. The theory goes that the portfolio will grow during good years and make up for the loss of value during the years the stock market declines. Lately, investment managers don’t believe this is a viable approach. Their concern comes from three events: the lofty levels of the stock market prior to and in 2021, the Fed’s suppressed low interest rates for 12 years, and the 18% decline in the S&P 500 during 2022. The concept of taking a certain percentage from the portfolio each year implies a willingness to accept the possibility of running out of money—unless the portfolio is designed using the total return strategy. Most portfolios don’t meet the longevity test because their strategy is based primarily on potential capital appreciation. Wall Street preaches that the stock market always goes up over a decade. While that claim depends on which ten years comprise the calculation, the real issue is what happens with volatility within those ten years and how the portfolio decision-maker reacts to this interim market volatility.

As an example, look at 2022. The S&P 500 declined 19.4%, and if dividends were included, the decline was 18.1%. Taking 4% of the previous end-of-the-year value would have brought the dividend-included loss to 22.1% or more, depending on the portfolio’s composition. It will take a 28.36% gain to recover to the prior (end of 2021) portfolio value, not including the 4% annual withdrawals during the time necessary for the market recovery. Concerning? Yes, if the wrong portfolio strategy is in place.

2. The 60% - 40% Asset Allocation

Tied to this withdrawal debate is the discussion about the traditional 60% common stocks and 40% fixed-income securities asset allocation. Since fixed-income securities and common stock both declined in 2022, some managers want to scrap the balanced mix. No credence is given to the Fed’s change in their long term rate suppression causing the fixed-income decline in price.

While 19 Rules for Getting Rich and Staying Rich Despite Wall Street proposes a 70% common stock and 30% fixed-income asset allocation, its strategy is night and day from what either side of the Wall Street debate proposes. It increases the common stock allocation to 70% in recognition that the Federal Reserve is now an activist in fostering US systemic inflation. A primary method of protecting against inflation is investing in good operating companies at a fair price over a long period. At the same time, higher systemic inflation with Fed-manipulated interest rates is challenging for fixed-income securities. The investment and maturity strategy of the 19 Ruleshelps minimize the impact of these destructive Fed policies on your portfolio. One key to downside protection against stock market pressure is the total return strategy of the 19 Rules. If an investor maintains the 3% average annual dividend yield for initial equity investments, over time, the annual dividends have a probability of increasing. This income discipline for common stocks makes the 4% idea viable in all markets. The profile of companies placed in the portfolio will also be different from the market’s highly volatile favorites. A major part of the 19 Rules total return strategy is less downside volatility. This dampening of volatility assists in increasing the average annual investment return (AAIR). The discipline of including companies in each economic sector further dampens portfolio price volatility. The cash flow and the stocks’ volatility profile are key to the strategy.

On the fixed-income side, many on Wall Street use just one maturity for their portfolio, many suggestions promote a ten-year maturity, and interest and dividend rates are of several levels, seeking some capital appreciation as well as income. The 19 Rules do not take these approaches. In this era of active Fed suppression of interest rates (yes, they still are) and Fed activist use of its balance sheet to fuel excess liquidity in the money supply, being caught in a trap of suppressed interest rates while the monetary authorities deliberately create inflation can be brutal. Rather investing in ten-year Treasuries, its yield should be a guide, with you placing fixed-income assets in a range of maturities giving you the flexibility you need to offset some of the Fed’s value-destroying policies.

Reading the room

The Fed has set the rate increase in February a modest .25%, and it is likely to pause rate increases later this year. While that policy is questionable, the key issue for reducing inflation is shrinking its balance sheet. If the Fed continues to do so, taking liquidity out of the economy, steady demand for money along with the shrinking supply of money will push rates higher in the open market. If the Fed slows or stops shrinking its balance sheet, there will be the soft landing and little or no recession; however, inflation will decline to the 3.5%–4.5% level and stay there. The Fed and the administration will wring their hands and promise to do whatever is necessary to lower inflation, but they won’t. With the 2024 presidential election twenty-two months away, the probability of sliding on the inflation fight is high. Time will tell. With the 19 Rules fixed-income strategy based on the important ten-year US Treasury yield, the 3.4% ten-year rate today implies investing in fixed-income maturities of six to twelve years. Since the rate is in the middle of the range, the maturities six, seven, and eight are the best. The average yield for these maturities is 3.5%.

The fixed-income and stock markets are signaling the Fed will not continue with inflation fighting. This is interesting because of the signals other markets are flashing. In the last two weeks, I’ve seen the following, which, to be frank, are mixed but basically point to a serious recession or market disruption.

1.There has been massive movement of trillions of dollars into the Fed Reserve reverse repro facility, which indicates it is parking assets in ultra-safe securities.

2.For five of the last six weeks, gold has moved higher, coming close to its all-time high, which indicates steady movement of funds into assets away from the regular markets.

3.Bitcoin, the favorite non-asset of the gambling crowd, has moved from $16,000 to $23,000 in the last couple of weeks, implying either the parking of hot money or the resurgence of gambling interest.

4.The ten-year US Treasury note yield has been declining while the Fed Reserve is still raising the Fed Fund rate, implying the market (if the Fed is not still manipulating the ten-year rate) is expecting a return to lower inflation and weak demand, i.e., a recession.

5.Private investments, both venture capital and private equity, have come under scrutiny for not reducing the value of their investments in line with the decline in public markets. Some private real estate investments are experiencing maximum allowable withdrawal requests. Attention has also been put on the securitization of some private investments into collateralized funding obligations (CFOs) that mimic CLOs and CMOs, major culprits in the 2008 financial crash.

These may be unrelated and lead to nothing; however, it may be a time to look at stocks

you have an interest in and select a price at which the investment would be attractive. Be prepared to invest if external factors put pressure on the stock market.