Round numbers have an outsized impact on people's thoughts and decisions. Whether it is deciding to wait for a round-numbered price when buying or selling a stock or giving special attention to the transition to a new decade or century. We have been writing Outlook & Trends every quarter for what will be 25 years since the beginning of 2002. That makes this our centennial issue. And, in keeping with the precedent to make round-numbered changes, this O&T #100 will also be our last issue. We hope that you have enjoyed reading for at least a few of the 25 years and perhaps gathered some information that made your financial life just a little better.

The Economy

The Federal Reserve characterizes recent economic growth as modest. GDP increased by 1.5% through the end of the 2nd quarter, but a more up-to-date GDP Now estimate is currently coming in at a steaming 5%. In response to the apparent changing conditions, the Fed reversed policy and raised their short-term interest rate a notch to 3.88%. The renewed economic activity is largely due to the persistent Federal over-spending moving through the economy like the metaphorical pig in a python and investment in artificial intelligence. The budget deficit will be $ 2.1 Trillion for this fiscal year, and the national debt has now exceeded $40 Trillion.

The spending is financed by the government selling debt, a process which inserts money into the economy that otherwise would not exist. This money-printing exercise, as well as Iran war-based energy costs, has increased the 10- year Treasury bond rate to 5.29% and the 30-year mortgage rate to 7.3%. The zero-interest rate regime of the last decade went out the window with government’s “helicopter money” response to the Covid pandemic and is not likely to return any time soon. The decade of the 1970’s was marked by a yo-yo monetary policy that allowed inflation to grow with the backdrop of an oil supply crisis. So far, there are some remarkable similarities. On-going inflation may become a primary policy tool to resolve the continuing debt and growing interest expense problem. Inflation allows debt repayment in cheaper dollars.

The Markets

The artificial intelligence story continues to dominate stock market news, and although the S&P 500 average rose 3% during the quarter, it was the technology sector that kept it afloat. The venerable Dow Industrials lost 1%. Since the beginning of September, 8 out of the 11 S&P sectors are lagging the S&P 500 and all of them have underperformed technology. This sluggish action is not unusual for the 3rd quarter of any year, especially a midterm election year. If history provides an indication though, this may change soon. Since 2002, on average October and November have produced a combined gain of over 6% in mid-term election years.

Also weighing on the markets has been an increase in interest rates. The 30-year bond rate is now 5.6%. That rise caused its price to drop by over 5% during September. Despite its nearly 5% yield, the long bond’s annual total return has averaged only about 2% for the last three years and has lost 44% of its value since 2020. This performance has done some damage to the set-and-forget 60% stock / 40% bond portfolio advice that was ubiquitous while rates were consistently falling from their peak in the 1980s. For the last several years, short-term fixed income and money market funds have been the place to be in the fixed income category.

 

Reflections on Retirement Saving

Since we started writing Outlook & Trends in 2002, there have been both secular bear and bull markets. Within those, there have also been four cyclical bear markets. At the bottom of the 2009 bear market, the valuation of the S&P 500 was 41% of GDP. Today it is 212%, a five-fold increase.

In addition to large stock and bond market fluctuations, since 2002 there have been significant changes in how people can (and must) participate in the economic growth of the country to provide for their retirement. The dominant pension plans of the late 1900’s have given way to 401(k) plans. These employer-based retirement plans have shifted investment risk away from the employer and onto the individual worker. 401(k) plan assets have increased a phenomenal 787% to $10.8 trillion during this time. An entire generation of employees, most of whom have little financial experience, are now exposed to growing market risk. This looming problem generated other innovations: the index fund and more recently the target date fund. The advent of the index fund era has promoted investing without financial knowledge. Periodic automated contributions from salary in 401(k)s has allowed people to save, invest, and participate in the economy’s growth effortlessly.

Historically, the basic mechanism of a free market is for a willing buyer and a willing seller to agree on a fair price for whatever is being exchanged. This process continuously sets an appropriately fair value. While it is cost effective and less subject to the ever-possible management errors, the 401(k) and index fund structure may have created several other systemic problems by allowing the market to lose sight of fair value and thereby creating significant risk exposure. First, 401(k) plans deliver automated, continuous inflows of fresh capital from buyers who may be otherwise uninvolved and have little understanding or interest in value of the asset they are buying. With this lopsided buyer/seller relationship, prices are likely to rise ever farther. Secondly, this money is directed toward capitalization-weighted index funds which maintain portfolio allocations based on each company’s stock value. The result is an increasing spiral of investing in expensive stocks, which further increases their capitalization and becomes ever more expensive. This is wonderful while it is occurring, however, if (or when) the support should unravel, the embedded risk would eventually be recognized in spades.

The inherent knowledge risk of the 401(k)/index fund structure has spawned a possible solution: the target date fund. It has correctly become accepted wisdom that a diversified portfolio reduces non-systemic risk by balancing out the zigs and zags of the prices of individual positions. Additionally, there can be a benefit by mixing stocks and bonds for the same reason. A prudently diversified portfolio has characteristically been thought to be composed of 60% stock and 40% bonds. Further, there is wisdom in the idea of becoming more conservative with age. The target date fund reduces stock exposure on a predetermined “glide path” as the investor approaches retirement. This concept may address some of the dangers associated with automatic index investing, but not all. Issues that may arise stem from the fact that the 60/40 prudent allocation became popular during a period of falling interest rates and consistently good bond returns. This is not likely to be the case for the potentially inflationary intermediate future. It is the systemic risks that are of concern for both the stock portion of the portfolio, which is concentrated in a few large companies, as well as the bond portion that could react poorly in an inflationary environment.

As always, have a plan. Gain knowledge. Be aware. Choose additional alternatives beyond the 401(k). We hope you have found Outlook & Trends to be helpful and enjoyable over the years.