Advisors Focus on Income Goals

The May 21 issue of Investment News reported that a recent survey of advisors at an Allianz summit showed that 88% of the advisors at the meeting believed that clients' major priority has now shifted to creating income at retirement. In earlier surveys, advisors priority had been to help clients accumulate wealth.

Of those advisors surveyed, 69% believed that purchasing an annuity was the best way to meet that particular need. "I think retirement income will be the market for the 21st century," said Robert MacDonald, chief executive of Allianz Income Management Services. "The companies that can solve this problem will emerge as the leaders."

Shocking, isn't it, that the CEO of an annuity provider would make such an outlandish statement?

In this case, however, there might actually be some truth to it. Annuities are good products for those earning mega-incomes who just can't put enough away in a traditional retirement plan. Good options for many of those people might include opening Simplified Employee Pensions (SEPs) or, for a few, even creating their own personal Defined Benefit Plan. But many high earners who don't control the business structure they work in may not be able to create these tax preferred structures. For them, rolling a big bunch of money into a tax deferred annuity and letting it grow tax deferred for a long time (to offset the relatively high fees in this products) can make sense.

The other folks who ought to be looking at the annuity products, however, are on the opposite end of the spectrum. In retirement, with not a lot of money and little tolerance for taking risk, these investors ought to consider a plain vanilla "immediate annuity" that will pay them an income stream for life.

These annuities take a lump sum investment and each year pay a portion back to the annuitant, for life. The risk facing the elderly is that they outlive their financial resources. An annuity transfers that risk to an insurance company, which can better afford to take the risk because they can spread the risk out among millions of customers.

Other tools in the planning kit include reverse mortgages and better comprehensive financial planning. A good plan should separate income oriented investments from "growth" oriented investments. The income oriented investments are all about wealth preservation and income generation. These include bank CD's, money market funds, bond portfolios, and annuities.

Growth portfolios ought not focus primarily on income generated. Long-time market commentator Ray DeVoe of The DeVoe Report wrote many years ago that, "more money has been lost 'reaching for yield' than at the point of a gun." Many high yield investments provide great current income, until you realize that what you thought was "income" was really "return of principal," and not even all of your principal was ultimately returned.

It is interesting to me that in the energy industry, some of the most expensive assets are those paying the highest dividends. They may only pay 6% now, versus 10% a few years back before their stock prices rocketed skyward, but 6% is still better than a Treasury bond so it sounds good, even if you will lose principal in the long run. That 6% dividend may represent 110% of earnings, but we like dividends because they are a "sure thing," at least until they're cut in half.

"Income" is the ultimate goal for most retiree portfolios. Annuities are a simple approach. Many of the closed-end funds being marketed to income oriented investors are high-risk high-fee products developed primarily in order to scoop up retiree assets while the scooping is good.

Caveat emptor. Buyer beware. Don't confuse a "return on equity" with a return OF equity. Watch out for the business end of a slick high yield packaged product. It could kill you.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Markets On High Alert

When we said, two months ago, that the February 27 sell-off would ultimately prove to be a “non-event,” we honestly didn’t expect to be quite so right…quite so quickly.

Now, 1120 points later (to the upside) where does this market stand?

The typical bull market doubles in price off the market bottom in a rally that lasts, on average, 2 years and 9 months from beginning to end. This rally, now almost 4 ½ years young, is the fourth longest in U.S. history since 1900. However, in percentage terms the rally has been sub-par, which suggests more upside opportunity ahead. So is the rally almost over, as the calendar suggests, or is there more money to be made?

Two key variables will likely determine the outcome. In spite of many traditional signs of a slowing economy, the job market is strong so workers remain confident of their future, willing and able to keep spending. Jobs are a lagging indicator, though, with cutbacks usually a result of Corporate America tightening its belts in the face of declining profits. Each week’s unemployment claims news release may soon take on the same significance that money supply numbers held for the market 25 years ago, particularly as the Presidential campaign season progresses.

The other thing to watch is whether weakness in the dollar will ever result in foreign investors, particularly in China, Japan, and the United Kingdom, reversing their willingness to continue funding our government and trade deficits. They don’t need to sell their current holdings, which are massive, to impact our interest rates. They just need to stop buying, which would likely force our long-term interest rates much higher, make bonds a more attractive alternative to stocks, and cause some of the private equity folks (and their bankers) to re-think their “let’s leverage this thing to its eyeballs” mode of doing business.

Neither one of these indicators currently suggest that it’s time to step to the sidelines. April was certainly a fun month to be fully invested, and so far the year has been kind to investors. The bull market lumbers on. But it would be a particularly bad time to be complacent.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Local Stocks Lag in a Strong Month for the Market

The Scout Partners Index of Western Colorado Stocks rose in April, gaining 3.4% versus a 4.4% monthly gain for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad. Though the energy sector had a strong month overall, local energy service stocks generally lagged the market which contributed to the overall index underperforming the broad market.


Rising 17.5% in the month, Arch Coal (ACI) ended the month at $36.07 and was the strongest performer among local stocks. “Arch Coal raised its dividend and announced earnings that beat Street expectations,” said Doug May, President of Scout Partners, LLC. “but most of the stock’s run-up was early in the month, ahead of the announcement,” May said. May attributed the strong stock price to more talk about a new coal-to-liquids conversion process where the company is supplying coal to Houston-based DKRW. “DKRW just signed a contract to sell the synthetic gas to Sinclair Oil where it is used to produce ultra-low sulfur diesel fuel,” May observed. According to company officials, the process is economical as long as the price of oil remains above $40 per barrel. In mid-April, when the stock was running up, oil prices spiked up to $66 and closed the month at $65.71. Earlier in the month, the CEO of Arch Coal hinted that his company might be looking to acquire other coal mining assets after a judge revoked four permits allowing Massey Energy to mine coal in Central Appalachia, an obstacle that could make mining more difficult, raise coal prices, and boost the value of today’s reserves.

Mesa Air Group (MESA) was the worst performer in the index, returning -10.36% during the month of April including a 1.89% decline during Monday’s market decline. So far in 2007, the stock has declined 20%. “The analysts just hate the stock,” May said. “The Prudential analyst cut his target price from $16 to $9, and after the stock declines from to $8 a Credit Lyonnais analyst downgraded the stock from Add to Neutral and cuts the target price even further, to $7.20.” Six months ago, Mesa Air’s estimated 2007 earnings were $1.24 but estimates have since fallen to less than $1.00 per share.

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions inWestern Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 6.6% for the year while the overall market has returned +5.1% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Tis The Season

The Barron's mutual fund "Cash Track" update suggests that seasonal money flows into the equity market once again peaked during the first quarter of 2007 and are beginning to roll over. This often happens as year-end bonuses are paid, early during the following year, and recipients roll this money into brokerage accounts for subsequent investment. This annual seasonality, while not fool proof, has been a reasonably reliable indicator of market sentiment and performance.

According to AMG Data Services, equity mutual fund money flows are down to $1.3 billion, versus weekly money flows of over $10 billion at the top of the market in February, when the market hit a new high. The market has subsequently recovered most of what it lost, but fewer and fewer buyers are pushing the tape up, and evidence that economic weakness may finally be impacting the payroll statistics isn't an encouraging development.

Flows into money market funds are up, which is pretty typical prior to tax day on April 15, while flows into taxable and tax-exempt bond funds have been relatively stable.

There is an old investing maxim, "sell in May and stay away" which reflects this seasonal activity in the market, with the current (bullish) season typically giving way to "the summer doldrums," which is a nice way of saying the market goes down as the summer progresses, and then every fall investors have to decide whether to get back into the market or not. Most of the time, it pays to be "in" the market.

This year, however, investors might want to see just how far the real estate defaults spread. If the bursting of the real estate bubble impacts the jobs market, investors might turn skittish. Similarly, is rising gold prices and dollar (currency) weakness causes foreign investors to turn tail and run, then rising interest rates will give the asset allocators a good excuse to sell stocks.

It may not be time to turn tail and run, but this continues to be a high risk market.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Retirement As Never Before

The March 2007 issue of Financial Advisor magazine includes an article about "The Exponent of Life Expectancy" that underscores the notion that "retirement," as we've begun to experience it, is a new thing...something never before attempted.

Nick Murray observes that when King Tut, "the boy king," died at age 19 in 1325, the average life expectancy at the time was only 25 years. In fact, it book about 3,000 years for life expectancy to advance to age 30 (in Europe during the year 1400 AD). That sad rate of advance, 1 year of added life expectancy for every 6 centuries, would mean that today's average life expectancy would be only 35. But obviously advances in health and civilization have improved.

Between 1400 and 1800, life expectancy lengthened so that during the lifetimes of Thomas Jefferson, John Adams, Tecumseh, Lewis & Clark and Aaron Burr, the average life expectancy was 37 years of age.

By the end of that century, in only 100 years time, life expectancies increased by 10 years to age 47. During the next century, life expectancies increased by another 30 years to 77. Murray writes that "seventy is the new 50," and then goes on to speculate, "what if 100 is the new 70?"

When Social Security was created, it promised lifetime income to everyone over age 65. At the time, the average life expectancy was 63 years. Less than half of the population even had an opportunity to retire, and for most it was a short-lived season of life. Now, Money magazine has cover stories focused on "early retirement," say around age 55, which for some folks means that they will live almost half of their life "in retirement."

Is there any wonder why the Social Security numbers don't work? Does it really make sense that workers pay about 15% of their income to underwrite this grand new social experiment called "retirement?" Should poverty-stricken working parents be forced to cut back on food and healthcare for their children so that able-bodied workers have the means to spend more time on the golf course?

Retirees need to realize that the whole notion of a retirement portfolio is relatively new, primarily because the notion of "retirement" has probably been around for less than a century. Folks nearing retirement need to make provisions to take care of themselves until age 100, because that might just be where the average life expectancy resides in a few more decades. And everyone might want to think long and hard about just how "entitled" we ought to feel about Social Security, which has been a wealth transfer program since inception, despite the bluster and promise claimed by the politicians.

All that money you gave to Social Security? It's already spent.

Workers need to take care of themselves, and Social Security would function a lot better if it once again functioned as a "security blanket" for those folks who live much longer than expected as the average life expectancy moves inexorably forward.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Sub-Prime Hits the Fan

Problems with Subprime loans (loans made for too much money against too little collateral to people with too little sense and too many other bills to pay) again dominated this weekend's Barron's reporting. In "Just How Sub Is Subprime," Jacqueline Doherty details just how many folks on Wall Street had a hand in the Subprime mess, as mortgage brokers shovel this financial manure into the Wall Street product engine where it is sold, repackaged, and re-sold (just) before the first month's payment is ever missed.

Brokers purchased subprime loans by the millions, which local mortgage "bankers" dutiful sold to U.S. consumers desperate for a plasma screen TV and a new house to put it in. The brokers then dump these IOU's into a separate trust so that when they go bad, they won't imperil the brokers own bonus pool. The trusts are then carved up into separate "tranches," some of which are more likely to get paid back, hopefully with interest, than others. The most likely tranches to actually pay off as advertised get a high ("AAA") rating, while more speculative pools receive lower ratings. These tranches can be sold directly to big mutual funds or pension fund investors, but the stuff that is particularly toxic was best suited to be placed in yet a separate bankruptcy remote entity, so-named not because of the remote chance of bankruptcy, but again to protect the hard earned equity of the broker promoting this scheme. The recipient of the multiple tranches of toxic subprime IOU paper is called a Collateralized Debt Obligation (or CDO), which is often funded on money borrowed from honest folks who usually don't charge a lot of interest. This creates a "spread" for the CDO manager, usually some other Wall Street maven, who buys a bunch of high yielding toxic crap using honest money that doesn't pay very much and for a time, as long as the boom lasts, everyone is happy.

Wall Street is happy because it charges a pretty penny, paid up front in cash, for packaging this financial nightmare. The CDO managers are happy because they are leveraged up the wazoo and control billions of dollars of assets, if only for a time, on which they can suck out as much as 1% annually to pay for their new flat overlooking Central Park. The borrowers are happy because they got to see Grey's Anatomy on a TV the size of their grandma's washing machine, and the lenders are happy as long as the economy is robust and the borrower's can afford to pay this month's mortgage.

When the borrower's can no longer afford to pay because, for example, the artificially low 2002 interest rates adjust upward, as might have been anticipated by anyone with a brain sized larger than an ant's, the entire financial "package" begins to unravel. The "overcollateralization" which is supposed to protect the lenders is compromised because loans to deadbeats really aren't worth 100 cents on the dollar. If this economy tips into recession, the problems worsen. Suddenly, some of those tranches are no longer money good, though it's tough to know which right away, and the bankers and hedgies who lent money to the CDO's in order to buy the toxic financial crap want their money back, which seriously inconveniences the investors who had to cut short their ski trip to Aspen in order to begin reading the fine print in the offering statements of the subprime loan agreements.

Naturally, Wall Street (the packager of this toxic crap), who knows what sort of manure is spread throughout the traunches, is one of the few players in a position to offer liquidity to the now distressed subprime lending industry, and Wall Street always stands ready to offer liquidity - at a price. It's a little early to know just how big a haircut the major on-their-way-to-bankruptcy subprime lenders will have to accept. But the same loans that Wall Street once packaged and repacked for $1.00 (less their fees, of course) are likely to receive bids somewhere in the range of 60 - 75 cents on the dollar, if the sellers are lucky. Unfortunately, the subprime industry is very leveraged, meaning that there really isn't 25 - 40 cents of equity for every loan out there, meaning that even non "subprime" lenders are exposed, because anyone who made a loan to New Century or one of several other now bankrupt lenders is also exposed. Not badly exposed, but bank earnings at even the high quality institutions are going to feel a pinch.

Doherty points out that the subprime lending industry is not a "cottage industry." It's big business, and the major Wall Street firms and hedge funds have had a direct hand in packaging this garbage, and now in bidding on the dredge that it created. How can Goldman Sachs afford to pay out annual bonuses of roughly $722,000 per employee? How does Blackstone Group justify a $40 billion price tag to shareholders (when the lions share of its winnings are sure to find their way into the hands of employees)? Because Wall Street gets investors coming and going.

Yet investors continue to delude themselves into thinking that the investment bankers at Goldman and Merrill and Smith Barney, et. al., are their side! These bankers are only loyal to the annual bonus pool, and don't really care which side of the fleecing will generate their fees.

They packaged and repackaged internet companies and IPO'd ideas on a napkin for billions of dollars in market capitalization that vanished overnight. Then, five years later, they packaged the real estate bubble for pension fund investors, who are the primary supporters of the hedge fund excesses, and now we'll watch them switch sides to become bidders, at cents on the dollar, of the financial garbage they manufactured just a few years earlier.

It's a replay of the junk bond debacle and the Resolution Trust Company "solution." And it's probably the second oldest profession, albeit less upstanding by far. No doubt, White House Chief of Staff, Joshua Bolten, New Jersey Governor Jon Corzine, U. S. Treasury Secretary Henry Paulsen, Clinton Treasury Secretary Robert Rubin, and former New York Fed Chairman John Whitehead will want to ensure that such shenanigans never happen again - except that they all came up through the Goldman Sachs grist mill, and aren't likely to bite the hand that once fed them.

At least we know who to thank for the pain we are about to feel.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Local Stocks Nudged Lower in March

The Scout Partners Index of Western Colorado Stocks fell in January, returning -0.30% versus a much sharper -2.2% decline for the widely followed S&P 500 stock index. The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad. The performance of Denver-based telecommunications giant, Qwest, helped stabilize the February index performance.

Rising 9% in the month, Qwest (Q) ended the month at $8.88. “Qwest was awarded some fairly minor business contracts during the month and announced a small reduction in staff mid-month, about the time that the stock took off,” said Doug May, President of Scout Partners, LLC. “Qwest also received favorable mention by “Mad Money” showman and former hedge fund manager James Cramer after Wall Street investment firm, CIBC, upgraded the stock on February 12th,” May said. Later in the month, the Federal Communications Commission moved to eased price controls on Qwest’s long-distance services. More recently, on the last day of the month Qwest announced that its CFO, Oren Shaffer, will retire effective April 1.

Choice Hotels (CHH) was the index laggard, returning -11.4% during the month of February. Choice Hotels operates as a hotel franchisor with lodging properties under the Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Econolodge, Rodeway Inn, MainStay Suites, Suburban Extended Stay Hotel, Cambria Suites, and Flag Hotels brand names. May noted that “the company announced in January that the CEO was leaving, but in February they announced a special charge to earnings of 3 cents per share to buy a really nice gold watch for the departing CEO,” and a number of Wall Street research firms cut their ratings on the company subsequent to the disappointing earnings guidance.

 

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 0.57% for the year while the overall market has returned -0.47% over the same time period.

 

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