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Scary Stuff

Jonathan Clements

IT’S HALLOWEEN, but not much frightens me—at least financially. My portfolio is broadly diversified, I have the insurance I need, and I have enough set aside for retirement. The highly improbable could happen, but I’m not going to lose sleep over that.

Still, even for those of us in decent financial shape, I see two key reasons for concern. We have no control over either—which is why they might seem scary—but we can take steps to limit the potential fallout.

Rising rates. I’m not forecasting a sharp increase in interest rates. But if that came to pass, not only would bonds take it on the chin, but also we could see grim short-term stock market returns.

U.S. stocks have spent much of the past three decades at what was once considered nosebleed valuations. The long decline in interest rates is a key reason. As the yields on bonds and cash investments have fallen since the early 1980s, investors have become increasingly willing to buy stocks, and that’s driven up price-earnings multiples.

On top of that, U.S. stocks have been nudged higher by two other factors. Corporate tax rates have fallen sharply in recent decades, while company profit margins have been at historically high levels. But these tailwinds could become headwinds: Interest rates might climb, corporate tax rates could rise and profit margins may narrow further.

Still, I think there are two reasons to believe stocks will continue to sport above-average price-earnings multiples. First, as the world has grown more prosperous, investors have more money to invest and an increased appetite for risk, and that’s led them to buy stocks.

Second, today’s big technology companies—as well as other businesses focused on building intellectual capital—almost inevitably look overpriced based on standard market yardsticks, and that’s affecting average valuations for the broad market indexes. What’s the issue? Current accounting standards punish the earnings of companies that spend heavily on research and development, while the intangible assets that often result typically don’t appear on corporate balance sheets.

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The upshot: I believe stocks remain an investor’s best bet for earning healthy long-run returns that beat back the twin threats of inflation and taxes, and I don’t think share prices will return to average historical valuations. But because of the risk from rising interest rates, it’s crucial to keep money you’ll need from your portfolio over the next five years in bonds or cash investments, and you might opt for even more if you have a low tolerance for risk. At the same time, I’d also favor shorter-term bonds, so any rise in interest rates doesn’t badly damage your bond portfolio’s value.

Needing workers. There’s been a lot of handwringing over the dwindling Social Security trust fund and the yawning federal government budget deficit. This handwringing was widespread even before this year’s massive COVID-19 government stimulus spending. But as I’ve argued before, these are just symptoms of a far bigger problem: The U.S. and other developed nations have increasingly unbalanced economies, with too few workers and too many people dependent on their labor.

This fundamental problem shouldn’t be news to anybody. We’ve known for decades that the retirement of the baby boom generation would create this unbalance, and yet (no surprise here) we’ve done very little about it. From an accounting point of view, we could “fix” this problem by, say, cutting Social Security benefits or raising taxes. But these fixes only truly work to the extent that they push folks to stay in the workforce for longer.

The fact is, in the absence of major technology breakthroughs that raise the productivity of workers or a widespread willingness to spend less, we simply can’t have people continue to leave the workforce at an average age of 62, because we won’t have enough folks producing the goods and services that society demands.

And, no, encouraging workers to save more for retirement is unlikely to solve this problem. What would happen when these folks spend their savings? We’d still have the same fundamental problem—not enough workers producing the goods and services that society wants. The only solution is to get workers to postpone retirement.

If that doesn’t happen, we could potentially see all kinds of economic dysfunction. Demand could outstrip supply, leading to rising inflation. Government budget deficits would balloon further, as tax revenues fall, while the cost of Social Security and Medicare increases. Trade deficits may widen as we try to solve our supply shortage by importing more goods. Eventually, the result would be some mix of inflation, smaller government benefits and higher taxes that, taken together, would force retirees back into the workforce or dissuade them from retiring in the first place.

You might respond that we shouldn’t be much bothered, because a rising average retirement age is almost inevitable. You might also respond that it probably isn’t great to have folks sitting around doing nothing for the last 20 or 25 years of their life, so a rising retirement age would be a healthy development. And you might note that, while others may be forced to work longer, you and I should be okay, as long as we’ve done a decent job of saving for retirement.

Perhaps.

But even if you and I are okay financially, retirement won’t be much fun if our fellow seniors are struggling financially and the economy is in turmoil. What’s the solution? I think it starts with better political leadership. We need policies that encourage folks to stay in the workforce for longer and encourage businesses to create jobs suitable for older workers. That way, we might avoid the economic distress caused by inflation, painful cuts in government benefits and sharp increases in tax rates—and those in their early 60s might not feel so shortchanged when they discover that they need to delay retirement by a few years.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Irksome AdversariesWhere We Stand and Game Over.

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Laura Bignami
Laura Bignami
10 months ago

Interesting, as always. What you write about tech companies would imply that CAPE ratios are not much use going forward both in predicting likely future returns of US stocks, and in comparing valuations of US stocks vs Int’l (because US stocks have a much larger tech sector). Am I understading this correctly?
Btw other people like say Larry Swedroe wrote that CAPE should work independently of sectors, so they appear to have a different view form that expressed here.

Jonathan Clements
Jonathan Clements
10 months ago
Reply to  Laura Bignami

Vanguard has an interesting study — I think the folks there have done it twice — that found that valuations aren’t a great predictor of returns over the next decade. They found both CAPE and P/Es based on one-year earnings explain around 40% of future returns, and I wonder whether it’s even less now. At one time, I thought it was useful to look at valuations as you ponder likely future returns, but I’m not so sure these days.

David Baese
David Baese
10 months ago

What about inflation indexed US Savings Bonds?

Laura E. Kelly
Laura E. Kelly
10 months ago

This is the key statement: “encourage businesses to create jobs suitable for older workers.” Many of my friends in their late 50s/early 60s have been forced out of their long-term jobs by buyouts or an industry so changed they no longer are seen as viable and have been downsized (without pensions usually). They have been unable to find full reemployment, probably because of age (healthcare costs) and skills issues. So it’s not like “postpone retirement” is much of an option for a huge group of folks. We need a better alternative for those “put out to pasture” through no choice of their own. (What are the proposal details for “encouraging businesses” to help?)

TroonTown
TroonTown
10 months ago
Reply to  Laura E. Kelly

Agree. I was let go at 63 due to “Covid headcount reductions”. I am discovering not many companies have jobs for relatively senior executives with 30-40 years experience. I wanted to work 3-5 more years, now I am retiring because few other options.

parkslope
parkslope
10 months ago

My wife and I retired at 70 and 71, respectively, and see little reason why the SS full retirement age shouldn’t be moved up to 70. Exceptions could be made for those in manual labor jobs that are difficult for workers to physically continue working for three more years than the full retirement age for those born in 1960 or later.

Thomas
Thomas
10 months ago

Another potential solution to problem #2 would be to reform our immigration policy so that the US is better able to attract skilled immigrants (see: https://www.sltrib.com/opinion/commentary/2017/09/25/noah-smith-immigrants-are-a-fiscal-boon-for-us-not-a-burden/ ). We could model such a policy after those of Australia and Canada.

Roboticus Aquarius
Roboticus Aquarius
10 months ago
Reply to  Thomas

A very thoughtful comment. People freak out over the idea of immigration these days, but immigration has long been a source business growth and success in the US. Many of our largest companies were built and managed by immigrants and children of immigrants. It’s overtly bad policy to chase out the people that are helping to build the future right here in America.

Jim Gentile
Jim Gentile
10 months ago

Something that nobody is talking about is Covid’s effect on Social Security. Now I am a numbers guy so bear with me. As of 10/28 in the united States 212,328 people have died of Covid, about 168,000 were 65 and over. Lets assume that 150,000 were collecting Social Security. The average benefit is about $1600 a month. Plug those numbers into your calculator and you will be shocked as how many benefits $’s are no longer on the books. In my opinion you don’t want to work longer but instead retire as soon as you can.

Roboticus Aquarius
Roboticus Aquarius
10 months ago
Reply to  Jim Gentile

Leaving the ghoulish nature of the discussion aside for the moment, that’s about 0.25% of total SS receipients. The reduction in payments, as large as it seems, represents about 0.02% of annual GDP. Not likely to make much of an impact. Plus, Logan’s Run is a distinctly repulsive way to approach SS viability.

The looming baby boomlet is likely to have a much bigger impact… but they need good jobs if that’s going to happen.

MutantDog
MutantDog
10 months ago

What we need, as investors, or even speaking for the post-modern world in general, is a change in accounting practice to properly account for ‘capitalization of accumulated knowledge’. The reliance on ‘arm’s length transactions’ to record values is hopelessly ‘laggy’.

Roboticus Aquarius
Roboticus Aquarius
10 months ago
Reply to  MutantDog

Yes, but such a practice would open the floodgates to fraud. No way to stop it. It’s hard enough with real assets, which many have shown can be manipulated in ways that very much misrepresent their value.

David Baese
David Baese
10 months ago

Jonathan – If you’re concerned about interest rates rising wouldn’t it make sense to finance either a new home, or refinance your current mortgage for 30 years at today’s historic low rates? If interest rates do rise, and you could obtain a positive net spread, you could offset your mortgage with bonds that yield more than the interest on your mortgage.

Jonathan Clements
Jonathan Clements
10 months ago
Reply to  David Baese

That’s an interesting idea, but I wouldn’t favor that step for two reasons. First, while I view rising interest rates as a risk, I’m far from certain it will happen. Second, the rate on a mortgage will be above the current rate on my bond holdings, so it would be a losing proposition in the short term — and perhaps the long term, too.

David Baese
David Baese
10 months ago

Jonathan – It makes me feel like Luke Skywalker arguing with Yoda, but I disagree with you. With our first home, bought on a 30 year 8.5% fixed mortgage in 1978, I was soon buying equivalent coupon GNMA pools in my self managed tax deferred retirement account at discounts to yield 15% to maturity. Our monthly payments were about $400 per month. When we sold the house 25 years later the fair market rental value had grown to about $1200 per month. It seemed to me that I was getting $800 per month in tax free housing value. Plus we sold the house for about four times what we paid for it. It won’t hurt my feelings if you demonstrate to me that I’m wrong. – Dave

Roboticus Aquarius
Roboticus Aquarius
10 months ago

Jonathan, great discussion on rates.

I’ll fight you tooth and nail on retirement age though. Too many people get tossed out of their firms while still in their 50’s, let alone 60’s. Increasing the retirement age can’t happen until people have some level of protection against getting frozen out of the market long before they start SS. I’d only change my mind if there were national workplace protections for people over 50 that go well beyond what we have now (esp. as the current law is far too limited, and even then often unenforceable.)

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