Monthly Archives: April 2018

3% – Why It Doesn’t Matter

The stock market reacted negatively when the yield on the 10-year U.S. Government bond reached 3%.  There was a major one-day sell-off the first time that benchmark was reached.  Here’s what Brian Wesbury, Chief Economist at First Trust has to say.

Just a few weeks ago, the Pouting Pundits of Pessimism were freaked out over the potential for the yield curve to invert. They’ve now completely reversed course and are freaked out over a 3% 10-year Treasury note yield.

All this gnashing of teeth is driven by a belief that low interest rates and QE have “distorted” markets, created a “mirage,” a “sugar high” – a “bubble.”

These fears are overblown. Faster growth and inflation are pushing long-term yields up – a good sign. And, yes, the Fed is normalizing its extraordinarily easy monetary policy, but that policy never distorted markets as much as many people suspect. Quantitative Easing created excess reserves in the banking system but never caused a true acceleration in the money supply. That’s why hyper-inflation never happened and both real GDP and inflation remained subdued. Profits, not QE, lifted stocks.

And our models show that low interest rates were never priced into equity values, either. We measure the fair value of equities by using a capitalized profits model. Simply put, we divide economy-wide corporate profits by the 10-year Treasury yield and compare these “capitalized profits” to stock prices over time. In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships. The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled long-term rates down, too. As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued.

In other words, stocks never priced in artificially low interest rates. If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

But we have consistently adjusted our model by using a 3.5% 10-year yield. Using that yield today, along with profits from the fourth quarter, we show the stock market 15% undervalued. In other words, we’ve anticipated yields rising and still believe stocks are undervalued. A 3% 10-year yield does not change our belief that stocks can rise further this year, especially with our expectation that profits will rise by 15-20% in 2018.

The yield curve will not invert until the Fed becomes too tight and that won’t happen until the funds rate is above the growth rate of nominal GDP growth. Stay bullish.

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Identity Thieves Now Targeting Social Security Benefits

I wanted to pass the following story along as a warning to people who are approaching Social Security age.

On Good Friday, as I was baking my Easter Bread, I received a frantic call from an old friend in Pittsburgh. Natalia (not her real name) received a letter in the mail from the Social Security Administration (SSA) thanking her for setting up her Social Security Account online. The problem was, she never did. Earlier in the week, when she and her husband attempted to file their income tax return electronically, the submission was denied by the IRS, as somebody had already filed an income tax return for 2017 using Natalia’s social security number. She was understandably desperate for advice on what to do next.

Equifax Data Breach & Its Implications

The Equifax breach, which occurred between May and July of 2017, may have been the source of Natalia’s problems. The breach impacted as many as 143 Million people in the US, plus others in Canada and the UK. Credit card numbers of over 200,000 Americans were breached, as well as “personal identifying information” of 143,000 Americans.
When this breach was announced, many were concerned about the “normal” identity fraud problems: fraudulent credit cards, auto loans, or even mortgages being opened up in their names. In addition, ID theft artists are getting better at filing fraudulent tax returns using stolen social security numbers to claim “refunds” of the withholding of their victims before the victims file their own tax returns. Many of Natalia’s co-workers have experienced this problem over the past 4 years.

The big surprise that has surfaced after the Equifax breach is that some of the devious con artists are now filing for social security benefits using the stolen numbers. This approach works best if the person whose identity was stolen was at least 62 years old (the earliest you can collect retirement benefits), still working, but not yet collecting. Those not yet collecting social security would not know if someone had tapped their account and was receiving their monthly benefit. Also, it would be very easy for these folks to discard a letter from the SSA (like the one Natalia received) thinking it was junk mail or one of those annual benefit estimate statements. On the contrary, if a retiree who was already collecting retirement benefits was a victim of this scam, they would likely notice a missing monthly payment immediately and would contact the SSA.

Therefore, a person who is at least age 62 but still working is the perfect target for this scam. I have read a number of reports over the past 3 months of this occurring. One Michigan resident received a double whammy. In 2017, somebody filed for and collected social security benefits using his number. In January of 2018, he received a SSA-1099 from the SSA for the amount the con artist collected, so now the IRS is looking for him to report the Social Security income and pay any tax due on his 1040!

Natalia’s Problem Resolution

Natalia spoke with the SSA, he shared with Natalia that this scam actually happened to him personally! He deleted Natalia’s online account, so going forward, Natalia will need to appear at her local Social Security office and take care of any business in person, and she will never have an online SSA account. She alerted her bank and credit card companies that her information had been breached, and pulled and reviewed her credit reports from all three credit bureaus. They were all clean, but she is monitoring her reports regularly and has signed up for a credit monitoring service. She also reported the identity theft to the Federal Trade Commission athttps://www.identitytheft.gov/ and was instructed to report the incident to the local police. Finally, Natalia and her husband are working directly with the IRS on the fraudulent filing and they will file a paper return.

Takeaways

Identify theft is never pleasant to deal with. Nobody likes even a “mild” breach involving a stolen credit card number. However, this new scheme of targeting Social Security benefits is especially disturbing, as it targets what a person has accrued throughout their entire work history. If you are of eligible Social Security age (62 or over) and you are still working, pay particular attention to any correspondence you receive from the SSA. You may want to proactively establish your online SSA account using their enhanced security to sign up. Better yet, you may want to emulate Natalia’s approach and set up your relationship with SSA the old-fashioned way…in their offices. It is not as convenient as setting it up online, but at least you can proactively protect yourself against this new threat.

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Scary Headlines and bad advice.

I was listening to the car radio the other day and hear an ad by someone who was predicting the end of the financial word. After listing the all the things that will go wrong, he promised that if you invested with him you could enjoy all the gains of the stock market but would not risk losing a penny.

Sound too good to be true? Of course it is, but it works by appealing to people who want to believe that there’s such a thing as a free lunch.

I was reminded of that radio commercial when I read this article by Gil Weinreich at Seeking Alpha:

All investors are looking for astute analysis, but in order to appreciate it when you see it, it is worthwhile considering what bad analysis looks like. Jeff Miller does just that, critiquing analysts who make spurious connections between long-term economic trends and specific portfolio recommendations. I’ve seen scary headlines to this effect offering “sell now”-type advice in 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 up until today. Even though such analysts had all kinds of valid concerns, investors following the serial bad advice have missed out.

When seeing representative articles from this genre, I ask myself what manner of benevolence prompts a writer to offer ever fresh warnings of doomsday. What’s going on with these analysts? Jeff hits the nail on the head. I quote in pertinent part:

Their business model seems to be one of supporting the insatiable appetite for confirmation bias from investors who have misjudged the market. Unfortunately, many average investors stumble on these sources and take the material seriously. They do not know about past errors or track records.

You never see a retraction or admission of an error. The only clue is that these sources monetize their audience with a ‘solution’ to fear – gold, annuities, a no-fail trading system, or some other seductive, high-commission product.”

The point is a critical reader must understand not just what an author’s main point is, but what is his interest in writing the article. This is not to say that someone with a point of view and a business interest should be ignored. Such a combination often prompts very good content. But understanding these elements can help you evaluate the analysis. Is it tendentious or is it instructive? Strong financial communicators educate; salesmen agitate.

There is so much bad advice generated by the media that it pays to ask what’s in it for the advice-givers. Too often it’s a fat commission on a product that is deceptive.

 

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Transfer on Death

Who inherits when you die?

Most married people own their home, their bank account or their investments jointly as a couple. The most common designation on an investment account is “joint tenants with right of survivorship” (abbreviated as JT/WROS). What this means is that each has full power over the account. Either can deposit, withdraw or make changes in the account. And when one of them dies, the other automatically becomes the full owner of the account.

There are some accounts that cannot be owned as a couple. An example is an IRA, or a retirement account like a 401k. When the owner of this kind of accounts dies, the assets go to the persons named as “beneficiaries.” Therefore it’s important to review beneficiary designations on retirement accounts when life changes take place like death or divorce.

But what about accounts that are in the name of just one person without a named beneficiary? This is very often the case of people who were never married, are divorced, or widowed. Under those circumstances, when the owner dies the assets in these accounts are distributed under the terms of a will. This requires a process known as “probate.”

Probate is the legal process whereby a will is “proved” in a court and accepted as a valid public document that is the true last testament of the deceased.

There are two ways of avoiding probate. The first is place your assets in a trust and designate who will receive the assets on death. This requires an estate planning attorney.

The second way is to add a Transfer on Death (TOD) designation to the account. A TOD designation names the person (or people) who will inherit the account. Since the assets go to the named beneficiaries directly, probate is not required. The other advantage is that it does not require a lawyer so there is no cost.

Review your investment accounts, your IRA and retirement accounts and your estate planning documents on a regular basis. It can prevent a lot of problems later.

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How interest rates are determined

From our favorite economist – Brian Wesbury:

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined.

Lots of this confusion has to do with the role of central banks. Many think central banks, like the Fed, control all interest rates. This isn’t true. They can only control short-term rates. It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time. If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future.

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation. Credit risk – the chance a loan will not be repaid – is also part of any interest rate. And, of course, those who earn interest owe taxes on that income. After taxes, investors deserve a positive return. In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they? In July 2012, the 10-year Treasury yield averaged just 1.53%. But since then, the consumer price index alone is up 1.5% per year. An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes. In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off. The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing. The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand. But this is a mistake. Bonds aren’t like commodities, where if someone buys up all the steel, the price will move higher. A bond is a bond, no matter how many exist. Just because Apple has more bonds outstanding than a small cap company doesn’t mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)? It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon. It should have the same yield. It didn’t become a collector’s item; it still faces competition from a wide array of other investments. It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future. If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero. And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well. The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing. That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise. Why? Because the Fed has held short-term rates too low for too long. Interest rates are below inflation and well below nominal GDP growth. The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow. Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher. It’s true the Fed is unwinding QE, but that’s not why rates are going up. They’re going up because the economy is telling savers that they should demand higher rates.

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2017 Top 40 Under 40 Honoree: Stephen Korving

Stephen 40 under 40

At work: President of Korving & Company, a financial planning and investment management firm focused on helping families plan for a secure retirement.
“I love helping people create their financial plan, working with them to implement the steps and follow the plan, and then being there to see their excitement and sense of accomplishment when they achieve their goals.”
Home and family: “I live in Western Branch with my wife, Megan, and our three kids who make every day an adventure and an amazing learning experience: Madeline, Mason and Ty.”

Volunteer activities: “I’m fortunate to serve on the boards of local organizations whose missions I get excited about and that make a direct impact on the areas where I live, work and play:”
• Portsmouth Museums Foundation (vice president),
• Portsmouth Partnership (secretary),
• Southeast Virginia Community Foundation (development committee chair),
• LEAD Hampton Roads,
• Portsmouth Assembly.

Motivating factor: “I strongly believe in loyalty, respect, integrity and doing what I can to try to make my little part of the world better.”

Advice for young people: “Two simple things: treat others the way that you want to be treated, and if you say that you will do something, do it.”

Professional goal in five years: “To continue growing our practice without losing focus on what’s made us successful – getting to know our clients very well and providing fair, honest unbiased financial advice.”

One thing I’d change about Hampton Roads: “Instead of competing against one another, it would be nice for the cities of Hampton Roads to work together, sharing resources to compete against other regions in order to grow and attract new business.”
Region’s biggest asset: “It’s a tie: the people and the location. Having lived in other parts of the country, these two things are what set this area apart and what drew me back home.”

Downtime: “I spend most of my downtime with my family. I like to be outside, so when the weather is nice I like to work in the yard, head to the beach or go for a run.”

 

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Ignoring the Invisible Hand

Our favorite economist, Brian Wesbury, of First Trust, has some comments about the culture and Higher Ed.  Thought provoking.

One of the most important questions we have about our country’s future is whether prosperity itself will make the American people lose sight of where that prosperity comes from; whether we’ll forget to cultivate the attitudes about freedom, property rights, and hard work that have made not only us great but also all the other places that have followed the same path.

To be clear, this has nothing directly to do with who is president or which party controls Congress. It has nothing to do with the tax cut passed late last year, or recent tariffs, or increases in federal spending, or red tape being cut or added. Instead, it runs much deeper than that and will affect all of these issues over the very long term, multiple generations into the future.

The issue comes to mind for personal reasons, as a couple of us travel around the country with our high school juniors looking at colleges, hither and yon.

We’re not here to shame any particular school, so we’re not going to name any. But here’s what we notice on our visits: at some point, the college admissions officers in charge of the meeting will talk about great accomplishments by students or recently-graduated alumni. Invariably, the accomplishments are volunteer efforts of various sorts that help people in some far off land or, sometimes, here in the US.

Don’t get us wrong, stories like this deserve to be told. They’re important and worthy of honor. But, not once, in all our collective college tours have we ever heard a school bring up someone who, say, grew up in tough circumstances, was maybe the first in their family to go to college, and has since gone on to become a very successful entrepreneur, investor, or key officer at a large company, like a CEO or CFO,…someone who has gone on to create wealth for their own family and others as well.

Not once.

Which is odd because we know these colleges must have tons of these stories to tell. You can tell when you’re taking the tour after the admissions sessions when you walk through the campuses and see the dorms, classrooms, and athletic centers many of which are named after alumni who’ve cut enormous checks.

Maybe stories of business-oriented success are just not on the radar of the kinds of people who run admissions offices. Or, worse, maybe they think it’s embarrassing or that there should be some sort of shame associated with striving to generate wealth.

Either way, they seem out of touch with why so many of their students want to go to college in the first place. “Making the world a better place” is not just about volunteer work; it’s about personal ambition and desire mixing with the invisible hand to raise the standard of living for everyone.

Capitalism isn’t a dirty word and the long-term success of our civilization means making sure our children know it.

 

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